“Chasing Fund Performance May Be Hazardous to Your Wealth”

A good title grabs our attention. A great title combats our reduced attention spans and propensity for multi-tasking to capture our attention completely and draw us into the piece itself. Such was the case with a recent headline for a recent Vanguard podcast: “Chasing fund performance may be hazardous to your wealth.”

Interestingly, this wealth-eroding behavior has proven quite common among all investors, across all levels of financial education and wealth. Seemingly, investors can’t stop from chasing last year’s winners, in spite of mountains of evidence suggesting that’s not the way to build wealth.

Vanguard’s recent study details just how much in potential returns investors are leaving on the table when they chase hot-performing equity mutual funds, instead of investing with a buy-and-hold approach. Vanguard found that a simple buy-and-hold approach outperformed a performance-chasing strategy by 2.8 percent per year on average during the ten-year period that they evaluated.

Additionally, I recently read a report by S&P Dow Jones Indices which reviewed the performance of 687 actively managed domestic U.S. equity mutual funds. Out of the 687 funds that were in the top quartile as of March 2012, only 3.78% managed to stay there by the end of March 2014. The conclusion: past performance was not an indicator of future outcomes 96.22% of the time. Further, just 1.90% of the large-cap funds, 3.16% of the mid-cap funds and 4.11% of the small-cap funds remained in the top quartile.

So, why do investors continue to base their investment decisions on past performance? First, if it’s solid, past performance is often the first thing a mutual fund reveals about itself in marketing materials. Of course, those claims are accompanied by the relevant required disclosure that past performance doesn’t guarantee future performance, but that often comes in much smaller print. And, certainly the performance-promoting headlines of personal finance magazines and newspapers don’t give equal weight to performance and the warning that past performance doesn’t translate into future returns.

Second, really, nowhere else in our lives does the notion that past performance should have nothing to do with future results hold true. Colleges look at a student’s performance in high school to gauge potential for success at the college level. Employers evaluate a candidate’s past work history before making an offer. If you are renovating your kitchen, you check the contractor’s references and assume if he did a great job for your neighbor he’ll do similarly good work for you.

Finally, we all love a sure thing. We want to believe that we have some control over outcomes. If you spend time studying for an exam or preparing a presentation, you expect you will do well. Similarly, if you spend the time to research a mutual fund, you want to believe that your efforts will be rewarded with solid returns.

This universal investing mistake is all the more surprising, of course, because all mutual fund prospectuses include the familiar disclosure, “Past performance in not an indicator of future results.” And yet, quarter to quarter, year to year, investors pay no heed to that clear warning and direct their funds into the hot performing asset classes and sectors.

Commenting on the Vanguard report, Brian Wimmer, a senior analyst at Vanguard Investment Strategy, points out that individual investors are not alone in directing funds into top-performing funds or market sectors. In spite of better information and greater sophistication, institutional investors engage in this behavior too.

In fact, Wimmer details his conversations with institutional investors around the country who revealed that their active manager monitoring process revolves around three-year performance windows. He says, “The underperformers are often put on watch lists after maybe a year or two of underperformance. And then after year three, they’re usually sold because of their underperformance over that shorter two- to three-year time period. And to nobody’s surprise, they’re actually replaced with performers that have done very well over the last three years.”

Here’s our view: For retail and institutional investors, performance-chasing inappropriately focuses attention on the short-term. Further, it encourages the view that investment returns are the lone goal of investing and that it’s worthwhile to compare your portfolio’s returns with those of your colleagues or neighbors. Instead, we advocate building a properly diversified portfolio based on your risk tolerance, time horizon and goals that you can hold for the long-term. Market history and countless studies prove that this is the surest approach to build wealth and meet all of your goals.

 

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