Squared Away Blog

March 20, 2012

Buy, Hold and Be Happy?

When an investor selects a mutual fund that’s hot, it usually backfires.

Morningstar Inc. generated the evidence for Squared Away: it essentially analyzed returns for two types of investors in the nation’s 25 largest fund companies – from PIMCO, Fidelity Investments and Vanguard Group on down. Using fund flow and performance data, it compared returns to a theoretical investor who stayed put for an entire decade to the returns that investors in funds actually experienced, given that they move into and out of funds.

Investors earned 3.8 percent per year, on average, over the decade ending Dec. 31, 2011, the Chicago fund tracker said. If they had stayed put, they would’ve earned 5.3 percent. The results were not equal, because some of us make brilliant moves but more of us make dumb moves, such as buying high and selling low.

The gap – 1.5 percentage points – “is bigger than [fund] expense ratios,” said Don Phillips, Morningstar president of fund research. Investors “really hurt themselves that much.”

To be fair to 401(k) investors, their inertia is great. Those who select funds from employer-run plans typically buy and hold. But more money – about $1 trillion more – sits in Individual Retirement Accounts, where investors are more likely to trade on their own or to have brokers or advisers recommending new funds, whether motivated by their own commissions or their clients’ goals.

To try to improve returns, Phillips listed three types of funds investors should avoid:

• Fads. You’ve seen them in the past – dozens of fund companies are suddenly introducing emerging market funds (mid-1990s), tech funds (late 1990s), international real estate funds (2007). Today, exchange-traded funds are springing like daffodils. Since ETFs typically track an index, they can be yet another way to jump into a hot asset class, country, or commodity. High-tech ETFs are hot this year; gold was in 2011. “That’s a danger sign,” Phillips said.
• Volatile funds. Since peaks are higher and lows lower, trading losses are amplified. Volatile funds, which tempt investors to trade, also “bring out your worst instincts.”
• Heavily advertised funds. If a fund’s hot performance is heavily advertised, its best days may be behind it – at least for a while. “Nobody’s going to take out an ad and say, ‘Look how much money we lost last year,’ ” Phillips said.

Fund companies routinely advertise award-winning funds: Putnam Investments and Fidelity issued press releases this month about their 2012 Lipper Fund Awards. But heavy-duty or highly visible advertising can create problems. Phillips said the classic example is Janus Funds’ television commercials during Super Bowl 1997, the biggest advertising day all year. Some investors who later lost money in its high-technology funds are still smarting about buying them at market highs, Phillips said.

Phillips doesn’t blame Janus fund managers, who’ve turned in strong performance over the long haul, he said. “It was the marketers who got out of control,” he said.