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The "Mutual Fund Merry Go-Round" |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. “Fund Of The Month” Club – Don’t Be A Member 2. The Dalbar Studies – Some Sobering Statistics 3. Why Most Of Us Have Bad Timing 4. Resources For Mutual Fund Investors 5. Some Potential Landmines To Watch Out For 6. Emotions Often Overpower Rational Thought Introduction In recent weeks, I have been writing a series of E-Letters on How To Save & Invest Wisely. While that series will continue in the weeks ahead, I want to shift gears slightly this week and focus on a big problem many investors have when it comes to investing in mutual funds. This is another article you may want to share with your adult children or grandchildren, or whoever might benefit from it, so feel free to do so. Month after month, the newsstands are filled with magazines and periodicals that want to tell you how to invest your money. Ditto for the talking heads on the cable TV financial shows, where everyone purports to be an “expert” so it seems. Many of these so-called experts focus on mutual funds and offer you advice on which funds to own and which funds to avoid. There is a constant drumbeat of advice on which mutual funds you should buy. In the case of the cable shows, they have new advice almost daily. If you followed the investment advice in the financial media, you would be making wholesale changes in your portfolio almost every month! I call it the “Mutual Fund Merry Go-Round” – buy this, sell that, ad nauseam! In this issue, and more to follow in the weeks ahead, I will discuss why many investors are on a mutual fund treadmill, hopping from fund to fund to fund. We’ll also see why many investors are continually chasing the latest hot-performing funds, only to be disappointed year after year. I call it “The Fund Of The Month Club.” The Mutual Fund Merry Go-Round I subscribe to a lot of investment and business related magazines and periodicals, plus I watch the financial shows on cable TV. Frequently, these sources report the latest mutual fund performance results for the prior month or quarter or year, and they “slice and dice” the funds’ performance in various and different ways (best, worst, etc.). And they also make recommendations on which funds you should invest in now. You see the frequent headlines: “Which Funds To Own Now,” “Top 10 Mutual Funds,” and on and on. The newsstands are full of magazines like this, especially each January, and the cable programs regularly trot out panels of so-called “experts” with their advice on which funds (or stocks) you should buy now. The problem is, almost all of them recommend that you invest in DIFFERENT FUNDS every year or every quarter and some even more frequently! Yet at the same time, they tell us we should be “long-term investors”!! How can anyone be a long-term investor when we are advised every year, every quarter and even every month to invest in the latest hot performing funds? Because there are so many mutual funds (over 15,000 in the US alone), the top performing funds are rarely ever the same in any given consecutive time periods. Many investors end up switching from fund to fund to fund throughout the year as a result of all the conflicting advice. It’s a mutual fund MERRY GO-ROUND! Even worse, these publications and shows rarely analyze how you would have done if you followed their previous advice. The reason for this is simple: they don’t have to. Since these publications don’t sell securities, they don’t have to register with the regulatory agencies, and as a result, they are not required to give specific past performance information. So they usually don’t. Basically, it’s BUYER BEWARE. Chasing The “Hot” Funds Various studies have shown for years that the “average mutual fund investor” does not make what the average mutual funds make. Let me explain. If you bought and held a mutual fund for five years (with no additions or withdrawals in the account), then you would make exactly what the fund made over that period. If it made 50% over that period, and you held it the whole time, then you would make 50%. But most investors don’t buy and hold a fund for five years, or even 2-3 years. Many investors are on the Mutual Fund Merry Go-Round. They buy and sell their mutual funds (or stocks) frequently, often several times a year, and usually because they get so much conflicting advice in the media and elsewhere. They are continually chasing the latest “hot funds.” The problem with chasing the latest hot funds is that they can go cold – or lose money – just as quickly as they got hot. Many investors buy the latest hot funds only to see them under-perform or lose money. Sometimes funds are the victims of their own success. Being one of the “hot” funds attracts a lot of investor money. Some funds grow so large that the manager and/or the strategy can’t continue to produce the big returns, and may even lose money. There are several other reasons why hot funds can go cold in the future, but the bottom line is that you should never invest in any mutual fund just because it was the best performer over the last year. The Dalbar Studies One of the most widely followed sources for this kind of information is Dalbar, Inc., a market research firm in Boston. Periodically, Dalbar publishes a study which shows what the average stock and bond mutual funds made (performance) versus what the average investor in those same funds made. The results are surprising! To illustrate, I will use a good period in the stock markets. The following numbers from Dalbar represent diversified stock mutual funds, which tend to track very closely on average with the S&P 500 Index, and bond/fixed income funds, which tend to track closely with the long-term Government Bond Index. Read these numbers closely. In the period from 1984 through 2002, the S&P 500 Index gained 12.22% on average per year; however, the average investor in stock mutual funds gained only 2.57% on average during that same period. Surprised?? In the same period, 1984-2002, the long-term Government Bond Index gained 11.7% on average per year; however, the average investor in bond mutual funds gained only 4.24% on average. The problem is, most investors jumped around from fund to fund during that period, often buying high and selling low. Yes, the investors who bought the average stock fund(s) and/or bond fund(s), and held them for that entire period (1984-2002), made roughly what the market indexes made: 12.22% on average for stock funds and 11.7% on average for bond funds. But the results of the Dalbar study indicate that most investors didn’t. Due to bad timing, they didn’t make nearly as much as the average funds. And this was during the greatest bull market in history for stocks! Lousy Timing In the case of stock mutual funds, the average investor made less than a quarter of what the funds made on average. In the case of bond funds, the average investor made less than half what the funds made. I don’t know about you, but I was shocked when I first began to look at Dalbar’s (and others’) numbers on this in the early 1990s! I had no idea that many investors, as a group, were jumping from fund to fund to fund so frequently, and with such disastrous results. My observation in dealing with thousands of investors over the last 30 years is that most people do not have good timing when it comes to the markets. We have a tendency to buy things when they are hot, not when they are cold. In most cases, it should be the other way around. While the media is certainly a willing accomplice along this line, we are all influenced by greed and fear, at least to some extent. In other words, we sometimes let our emotions rule our investment decisions. As noted above, I have thousands of investment clients all across America. Most are “accredited investors,” generally meaning that they have a net worth of at least $1,000,000. In all these years, I don’t remember a single client telling me that they made most of their wealth from their investments. No, in most cases, they became wealthy as a result of their primary business or occupation. If you have a successful business, you know that it took a lot of hard work, a lot of experience and a lot of good decisions. Investing successfully is no different! I have never understood how prosperous businessmen and women think they can be successful investors right off the bat, without hard work and experience. The Dalbar numbers above certainly indicate that most investors are not getting the results they hoped for! Resources For Mutual Fund Investors One way to keep from becoming a “Dalbar statistic,” is to take advantage of the many resources available for mutual fund investors. One of the do-it-yourself techniques for mutual fund investing is to subscribe to one of the mutual fund rating services such as Morningstar, Value Line, or Standard & Poor’s. These services provide a wealth of statistical information on each of the mutual funds they cover. In addition, each service has a proprietary ranking of the funds that are designed to help you shortcut the process (not always a good idea). For purposes of this discussion, I’ll concentrate on Morningstar, since they are the most well known rating service and are one of the tools we use in evaluating mutual funds at my firm. The first thing you encounter when dealing with the Morningstar software or website is the sheer volume of information provided. There is historical performance data, ratios, details about each fund’s holdings, etc., etc. Because of the huge volume of information, many investors just go to the rankings and pick the top-rated funds. But this can be very frustrating and sometimes just as counterproductive as selecting the latest “hot” fund as discussed above. Analyzing Past Performance Data For those more intrepid investors who are willing to wade into the sea of data, other challenges emerge. As with any performance information, the best any rating service can give you is a look in the rearview mirror. You can see what the fund’s manager has done in the past, but you can’t foresee the future. You might think that past track records are pretty cut-and-dried, since they represent actual numbers. However, even past track records must be studied carefully to see how the returns are spread among the years and months. Does the fund have a consistent pattern of good returns, or were there one or two fantastic years in the past that are now making the average annual rate of return look good? This is especially true in recent years as the markets declined. Even if you find funds with superior performance in these difficult markets, you have to continue to dig through the information to see if it is suitable. For example, did the fund have a relatively smooth pattern of gains, or were there high gains and then large losses – “whipsaws?” Most investors are more suited to a smooth pattern of gains, and usually exit those high volatility funds that have wide swings in their performance. Be Careful With Sector Funds You should also be careful when looking at the various “sector” funds. Over the years, different sectors rise and fall from prominence. Because of their hot performance, the top-performing sector funds tend to be at the top of the rankings, and get the most inflows of new money. This is what the Dalbar studies talked about when they said that investors hop from one “hot” fund to another, chasing performance. The likelihood that the same sector will be the top performer in the next year or two are low, and investors who chase the hottest funds usually end up with poor results, as evidenced by the Dalbar studies. Also look at the fund’s category. Morningstar segregates funds into various categories based not on the stated objective in the prospectus, but on what the fund actually holds. Sometimes funds drift from one category to another, possibly skewing the comparison between them and other funds in the same category. Once an investor pores over the data and selects a potential fund, the work isn’t over yet. Other things have to be checked. For example, is the portfolio manager that produced the impressive returns still running the fund? If not, when did the current manager take over? Has the performance been the same, better, or worse during the current manager’s tenure? Reaching For The Stars As I mentioned above, many investors want to take a shortcut around analyzing all of this data and just go by a single performance indicator. In Morningstar’s case, this is the “Star Rating.” Their top ranking is 5 Stars; their worst is 1 Star. Statistics show that as much as two-thirds of the new money flowing into mutual funds goes into funds with a “5 Star” Morningstar rating. However, are the star ratings an effective way to find superior funds? Matthew R. Morey of New York’s PaceUniversity has performed various studies on Morningstar’s fund ratings. He authored a report in 2003 stating that funds rated highly by Morningstar’s original star rating methodology did not tend to perform any better than funds with moderate ratings. However, Professor Morey’s study did not include changes that Morningstar had made to its star rating system in 2002. In a 2005 follow-up study, Morey examined the performance of mutual funds under the revised Morningstar rating system, and found that, “higher rated funds, for the most part, significantly outperform lower rated funds.” Before going out to invest in all of the five-star funds you can find, you need to understand some of the limitations of the new star rating system. Prior to 2002, Morningstar rated funds within only four broad categories. Under the new rating system, there are now over 60 such categories, which might be good if all funds stayed neatly within a given category. The problem is that funds can drift from one category to another, significantly affecting their own star ratings as well as those of other funds. A recent Forbes.com article highlighted the effects of jumping from one category to another and gave various examples. One such example was the Tocqueville Fund, which went from the 65th percentile in the category of mid-cap blend funds, to a five-star rating when investments in larger company stocks caused it to jump to the large-cap blend category. What had been a bottom-third mid-cap blend fund suddenly became a top performing large-cap blend fund. The fund’s manager, Robert Kleinschmidt, commented that in light of what happened to his fund, using only Morningstar ratings as a way of choosing funds, “is nuts.” This brings us to another limitation of any fund ranking system. A fund can be a five-star fund within a given equity category, but that doesn’t mean that the category is a good place to invest. In other words, if you invest in a five-star fund, but it’s in a category that is currently out of favor, you’re likely to end up with disappointing results. The moral of this story is that there is no shortcut to effective investing and financial planning. While Morningstar’s data is very useful, it is not wise to use their star rating system as your sole source of fund analysis. Even Morningstar states that, “the star rating is a useful tool, but it’s no substitute for doing your homework.” There is simply no substitute for poring over detailed information, crunching numbers, and doing periodic comparisons. If this doesn’t sound like a great way to spend your time, then you might want to seek out other alternatives. Investment Newsletters & Misleading Advertising Some investors realize that they do not have the time or inclination to do their own mutual fund research, so they turn to various newsletters or other “experts” for guidance. There are hundreds of so-called “investment newsletters” out there that give advice but leave it up to the reader to take action. Some have relatively small readership and are targeted at their local audience. Others are quite large in terms of subscribers, all across the country, and advertise widely. Most people reading this E-Letter have received direct-mail promotions for these types of services. Since I subscribe to so many investment-related publications, my name is on most of the mailing lists that are rented, so I receive hundreds of these direct-mail promotions every year. There are several problems with trying to invest based on a weekly or monthly investment newsletter, which I will discuss below. By far and away the biggest problem, in my opinion, is FALSE OR MISLEADING ADVERTISING. Question: have you ever seen a direct-mail promotion for an investment newsletter (or trading system) showing poor performance results? Of course not! They always look great, don’t they? Some people read these ads and assume the results are real. Sometimes they are, but more often than not, the results are either flat-out false or very misleading. You might wonder how these promoters get away with this. First of all, most investment newsletter writers and promoters are NOT REGULATED. Even though they give investment advice and recommend securities, they can avoid registration if they simply do not deal directly in securities or manage money directly. Ditto for newsletters that give commodity futures advice or info on “hedge funds.” If they deal in securities, they must register with the Securities & Exchange Commission (SEC) and in most cases must become members of the National Association of Securities Dealers (NASD). This subjects them to rules and regulations and compliance oversight (and periodic regulatory examinations). Because of this, many newsletter writers and publishers elect not to deal in securities, but rather just give advice. In this case, they are not currently required to register with anyone. [As noted in the past, my company is registered with the SEC, the NASD, and several other regulatory agencies and in all 50 states. You can click HERE to see our disclosure statement as required by the SEC.] Hypothetical Track Records – Buyer Beware! As noted above, publications or Internet promotions that offer to help you invest in mutual funds may have track records that may be misleading, or even simply made up. Other track records may be constructed via a method called “back-testing.” In this method, the person(s) goes back in time and constructs a track record with the benefit of hindsight. Unfortunately, they often fail to warn the reader that the track record is “hypothetical” and was never used in real time. Still others (and I can name a bunch in this category) advertise only their profitable investments and do not disclose their losers. I see lots of promotions where they boast of their winning trades, even giving you the actual dates when they bought this or sold that. Of course, these promotions always look spectacular. But that’s because they don’t tell you about all (or any) of their losing trades. You should never assume that any direct-mail or Internet advertisement is 100% accurate or honest! You should make them prove that the record is accurate and not misleading. Unfortunately, this is very tough to do. Many times, the promoters give misleading answers to cautious inquirers, like the following:
If you hear a CROCK like this, or anything along this line, you should hang up the phone. If they have a good service, they will be all too happy to send you performance information. If they won’t give it to you, or tell you they don’t have it, just hang up. Telephone & Fax Services Can Be Just As Bad There are many expensive “hotline” services out there. You pay a monthly or annual fee to get the “secret” hotline phone number. Each day or each week, the hotline promoter gives new advice on which stocks or funds (or futures) to buy and sell. Most of these services are very expensive, some as high as $5,000-$10,000 a year. Some of these hotline promoters advertise widely with very professional-looking mail packages. However, some that I know of advertise only their profitable trades and are generally silent about their losers. Again, you should never assume that any direct-mail advertisement is 100% accurate or honest! Other Problems With Newsletters & Hotlines In addition to the obvious problems with false and misleading advertising, there are other problems with trying to follow newsletters or hotlines. The most obvious is that you must read or hear the information as early as possible, and then be able to act on it very quickly. Since most investors have a day job, it’s not always possible to stop what you’re doing and do a trade. Second, the information is dated by the time you receive it, especially in the case of newsletters which are typically written at least a week before you receive them. While the Internet has cut down on this time lag somewhat, it hasn’t totally eliminated it. Even if you follow a daily hotline, market conditions can change dramatically overnight. Third, some of these services put out pretty complicated advice. If “this, that and the other” happen, then you buy or sell. If they don’t happen, then you don’t buy or sell. This can be very complicated and confusing, and there’s usually no one to call for clarification. A Few Good Ones While I don’t recommend that you try to invest by following a newsletter, fax service or telephone hotline, there are a few good ones out there. Our old friend, Richard Band, writes a very good monthly newsletter with lots of good information, in my opinion. Richard’s investment newsletter is one of the few good ones I have seen over the years. There are a couple of services that track investment newsletters and hotlines; they read or listen to the advice and then track the performance by “paper trading.” The oldest and largest of these tracking services is Hulbert Financial Digest (now a part of CBS MarketWatch). Hulbert tracks 150 or more newsletters and other services and estimates their performance. You can subscribe at www.hulbertdigest.com, but I don’t recommend it. Why not? With all of these subscription services, you have to: 1) be available to get the information, usually on a daily or weekly basis, even during vacations; and 2) you have to make the trades and/or implement the advice yourself. This just doesn’t work for most people, even if the information and advice are good. Internet Investment Services I couldn’t begin to name all, or even most, of the many investment services now offered online. There are probably thousands of various services on the Web. People are selling all types of investment advice, trading programs and systems on the Internet, most all of which advertise that they will make you wealthy. When it comes to shopping the Internet for investment advice, you really have to be careful. In this case, it is more important than ever that the firm you deal with be registered with at least the SEC and/or the NASD. The Internet is UNREGULATED, so people can put anything on the Web they choose, no matter how false or misleading. However, those of us registered with the SEC and/or the NASD are required to comply with the same rules and regulations on the Internet as we do elsewhere. Conclusions While this week’s E-Letter has discussed ways you can invest in mutual funds on your own, I still strongly believe that most investors would be better off by using professional money managers (and I don’t mean your broker) to direct most of their investments, especially stocks and bonds and mutual funds. One of the reasons I believe this so strongly is that no matter what you may think or say about risk when you make an investment, you really don’t know what your emotional reaction will be when hypothetical losses become real losses. The Dalbar studies highlight what happens when actual losses occur, and when greed for the highest return takes over. Investment Advisors see evidence of this almost every day. Most qualified Investment Advisors, including my firm, usually have each prospective client complete a detailed questionnaire asking the investor to provide information on their financial goals and investment expectations, but also to provide information on the amount of risk they think they can take. Since most investors know rationally that higher returns generally require higher risk, they often check the box next to a risk level roughly equal to their expected returns. However, Investment Advisors often discuss how some of these formerly rational investors start wanting to head for the exits when their investment programs experience a much smaller loss than what they had indicated they could withstand. I have had similar experiences with some of my clients. What happened? Emotions often trump rational thought, and the Dalbar studies seem to prove this. Since it’s not an easy thing to completely separate your emotions from your investment decisions, I recommend my clients turn over their investment decisions to qualified professionals. These professionals are known as Registered Investment Advisors (“RIAs”) and they are registered with the SEC. If you would like to learn more about these professionals, CLICK HERE. Otherwise, good luck in your mutual fund investing. Best wishes,
Gary D. Halbert
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