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It's a well-known secret that investors, as a group, are terrible market timers. When an investment starts to become widely popular with large groups of investors, you can pretty much bet that its days in the limelight are fast coming to an end. And while it may not be surprising that individual investors are more likely to get caught up in of-the-moment trends, new research shows that professional investors may be just as likely to follow the herd.
A recent study by Massimo Massa and Vijay Yadav at the INSEAD graduate business school examined the holdings of nearly 1,000 mutual funds to determine whether the funds were biased toward or away from "high sentiment" stocks. They found that most funds tended to gravitate toward stock market favorites and away from low-sentiment stocks that were out of favor in the market. This is a problem, since previous studies have shown that stock market darlings tend to underperform low-sentiment stocks over time.
What's more is that investors actually reward fund managers for loading up on popular stocks by channeling assets into those very funds. The study concluded that many portfolio managers are deliberately sacrificing performance in order to create a portfolio that attracts investor attention and boosts assets under management. That's pretty depressing news for the millions of investors who rely on mutual funds to save for retirement.
Blaze your own path
So what can investors do if they want to avoid this trap? Well first of all, this study should serve as an important check for your own investing patterns. Are you buying a stock just because it has been in the news a lot or because your Uncle Bob owns it or because it seems to be really popular among investors? If so, then you need to re-examine your approach. High-sentiment stock market favorites may get a lot of press coverage, but they aren't likely to outperform over an extended period of time. To find the real bargains, you need tolook at unpopular, undiscovered areas of the market and be willing to pass up the favorite stock of the moment.
Secondly, while it may be true that many mutual funds place asset gathering ahead of performance, investors need to take responsibility for their part. After all, fund managers wouldn't tilt their portfolios toward high-sentiment stocks if investors didn't reward them for it! If you're considering investing in a fund because it buys lots of popular, in-favor stocks, think twice before pulling the trigger. In the future, investors will simply need to be more careful with respect to which funds they buy. It will take a little bit more work to figure out which funds place market-beating performance ahead of gathering assets, but there are some managers who do just that.
Thinking outside of the box
For example, take legendary investor Bruce Berkowitz, manager of the Fairholme Fund (FUND: FAIRX ) . While Berkowitz has amassed a category-beating track record, he has done it by not being afraid to go against the grain and invest in beaten-up, unpopular companies. Right now, he is making big bets on out-of-favor financials AIG (NYSE: AIG ) ,Citigroup (NYSE: C ) , and Bank of America (NYSE: BAC ) . Berkowitz believes that government intervention and years of scrutiny have forced these firms to clean up their balance sheets. Given their current low valuations and their future earnings power, he believes them to be attractive opportunities.
Similarly, Janus Contrarian (FUND: JSVAX ) manager David Decker likes to invest where others fear to tread. He has long invested heavily outside of the U.S., currently allocating nearly 18% of portfolio assets to Indian companies. Right now, Decker is also big on financials, which account for almost one-quarter of fund assets. Rather than banks, Decker believes mid-sized real estate development companies St. Joe (NYSE: JOE ) , CB Richard Ellis (NYSE: CBG ) , and Plum Creek Timber (NYSE: PCL ) are the best way to play a recovery. Although the fund has encountered some bumps in the road from time to time, over the past decade it has handily beaten 94% of its large-blend peers, thanks to Decker's willingness to invest in out-of-favor and low-sentiment stocks.
I have long warned investors that chasing performance and following the crowd is a losing strategy. While it may provide comfort in the short run, over time all it will do is get you further behind the market. The same thinking applies to investing in mutual funds: Don't chase performance, and don't buy funds because they invest in popular, high-sentiment stocks. If you want to beat the market, you've got to go where the market is afraid to go.