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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Why chasing mutual fund performance is bad?

Posted by Muthu on January 7, 2016

As Arthur Levitt said, chasing fund performance is often the quickest way to hurt your mutual fund returns.

Please read this article which talks about a study done by Vanguard.

This study confirms what we’ve been repeatedly saying. Stick to the chosen portfolio with conviction despite ups and downs. Don’t chase returns and performance.

We should make changes to portfolio only when it is absolutely necessary. It need not be ‘never’ but should definitely be ‘rare’.

I’ve given some excerpts from the above article:

“The other study was authored by U.S. ETF giant Vanguard, which looked at the histories of more than 3,500 equity mutual funds in order to compare a basic buy and hold strategy to a frequent-trading strategy that simulated the effect of performance chasing.

The study looked at three-year rolling return performance between the years 2004 and 2014, across nine equity groupings (this is roughly in-line with the time the average fund investor holds an equity mutual fund). The simulation also tracked the Sharpe ratio of the average fund in the category, a measure of risk-adjusted return.

The “rules” of the buy and hold were relatively simple: the simulation invested in any fund, and held it to the end of the time period. If the fund was discontinued, the simulation simply reinvested its money into the median-performing fund within the grouping.

For the performance-chasing portfolio, the simulation invested in any fund with an above-average three-year annualized return. If that fund turned in a below-average performance for the next three-year rolling period, that fund was sold and the simulation re-invested the proceeds in equal amounts into in the top twenty funds in the asset grouping.

At the end of the day, the simulation produced a total of more than 40 million return paths – a pretty good yardstick for measuring whether performance-chasing or buy-and-hold is the more sensible strategy.

Category             Buy & Hold       Performance chasing

Large Blend           6.8%                     4.5%

Large Growth         7.1%                     4.3%

Large Value            7.0%                    4.7%

Midcap Blend          8.9%                     4.9%

Midcap Growth       8.6%                     5.7%

Midcap Value          9.2%                     7.6%

Small Blend             8.9%                     6.3%

Small Growth          8.6%                     5.7%

Small Value             9.3%                      5.8%

The chart above illustrates that buy and hold was the clear winner, beating performance-chasing in all nine style boxes. Note the size of the performance gap between the two strategies.

The Sharpe ratio was better (i.e., higher) for each of the buy and hold portfolios, meaning there was less volatility along with better returns. Talk about having your cake and eating it too! “

I want to mention here what I wrote you last year:

You may know Peter Lynch, one of the best mutual fund managers who managed Fidelity Magellan Fund and produced an outstanding performance. He once said that more than 50% of the investors in his fund lost money despite the fund being an outstanding performer. Reason? Inflows were more after few good quarters and outflows were more after few bad quarters.

Boston based Dalbar releases a QAIB (Quantitative Analysis of Investor Behavior) report every year. Dalbar compares how much the investment gave versus how much the investors made. The difference is called performance gap. From 1984 to 2014, for a period of 30 years, the S&P 500 has given an annualised return of 11.11%. Whereas equity fund investors earned only average annual return of 3.69%. The performance gap is 7.42%.

Why performance gap? When a fund, after expenses, over a 10 year period, gives 18% returns, the investors also should have also made the same. But this rarely happens in a real life scenario. Investors invest more when the markets are high and redeem more when the markets are low. Added to that they keep chasing performance. A good fund is ditched because it had a bad year. A risky fund or not so good fund but which shows recent good performance gets lot of inflow. All these ensure that investors as a group earn less than what the funds provide. In many cases, people actually lose despite markets and funds doing well over a period.

You are aware that we rarely make changes to portfolio. Our general advice is always to stay the course through both ups and downs. There are many advisors in the markets, mostly banks, who keep churning the portfolio very frequently. Recently there was a news item that Standard Chartered Bank churned a customer’s portfolio 200 times over a period of 19 months.

Churning is done for both psychological and monetary reasons. Investors constantly want action in their portfolio. Not all investors are matured like you to understand that inactivity is best when it comes to investing. Every time there is a churn, the advisor earns an upfront commission. That’s why unscrupulous advisors cater to the investors’ misplaced need of constant activity to line up their pockets.

Though our longevity is increasing, we are getting more and more short sighted with the investments. Investors need to control their habit of constantly tinkering with their portfolio and show the door to advisors who encourage this habit for their personal gains.

2 Responses to “Why chasing mutual fund performance is bad?”

  1. dilip said

    If we have to go by abover article…if one fund does not perform Good , we can put additionaal new investment in New better peforming fund but continue non performing funds…
    But averaging effect in this existing fund in such scenario will not work and returns over longer period will be less….?
    Compared to this fund if i enter new performing fund and that to at low price as currently..it will show very Good performance. so comparing is not on common platform.
    How to control and act in such scenario..
    thanks.

    • Muthu said

      Select 5 diversified equity funds from 5 different fund houses. Then just stay the course for minimum 10 years, preferably 20 years. You would do well.

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