Think back to when you selected investments for your 401(k), IRA, or other retirement savings plan. How did you pick which funds you wanted to invest in? If you're like most investors, you probably identified the funds that had the best one- or three-year returns, and just went with those.
While that seems like a logical move, picking funds based solely on recent performance has been proven time and time again to be a losing strategy. Even the best money managers in the business go through performance slumps -- and dumping a good manager during one of these inevitable slumps could punish your portfolio.
Even the mighty fall
A new study out by Baird's Advisory Services Research sheds some light on how talented money managers perform over the long run, and how investors typically react to that performance. Baird's study, which looked at 1,500 mutual funds with a 10-year track record as of the end of 2010, identified 370 funds that outperformed their benchmark during that decade with less volatility. The average manager in this group beat the relevant benchmark by nearly 3 percentage points annually. Now those are the folks you want in charge of your money!
But the study found that even these top managers suffered short-term bouts of underperformance. For example, 85% of these managers had at least one three-year period in which they underperformed their benchmark by 1 percentage point or more. On average, they underperformed during six separate rolling three-year periods, out of a total of 29. Roughly 50% of the group lagged by 3 percentage points, while 25% of these funds trailed the benchmark by 5 percentage points or more for at least one three-year period.
The data also looked at fund flows after various funds were upgraded or downgraded in Morningstar's star ranking system. Not surprisingly, they found that after a fund had been upgraded from three to four stars and from four to five stars, net flows into the fund in the following 12 months were positive -- averaging $14 million and $331 million, respectively. On the other hand, when a fund was downgraded from three stars to two stars, fund flows reached a negative $65 million on average in the following year, while a downgrade from two stars to one star spurred negative flows of $257 million -- proof positive that investors are chasing returns.
Taking the long view
For years, I've been trying to impress upon investors that even the best money managers in the business will lag the market -- sometimes by a lot, and sometimes for an extended period of time. That's why it's so vitally important not to chase short-term performance or dump underperforming managers if they hit a soft patch. Odds are you'll just be moving into funds after their biggest run-up, while missing out on the rebound your discarded funds will likely stage in the next few years. There's a reason why I'm so adamant about focusing on long-term results. This study just adds more fuel to that fire.
Of course, it's easy in theory to say that you should hold on to underperforming funds, but much harder to do in practice. For example, let's look at Brandywine (BRWIX). This former high-flyer has been in an absolute slump lately, landing in the bottom 5% of all mid-growth funds over the past five years.
However, the vast majority of the fund's recent underperformance stems from its poor 2009 showing, when it returned just 8.6%, nearly 38 percentage points behind the Russell Mid Cap Growth Index. Given that riskier, more speculative companies shot to the top of the charts in that year, it's not surprising that Brandywine lagged, since it looks for more stable companies that managers expect will exceed earnings estimates. Firms like that underperformed by a wide margin in 2009.
So investors shouldn't count Brandywine down for the count just yet. So far this year, the fund ranks in the top quarter of its peer group. And Brandywine owns many names which should fare well in a slowly improving economy. Top holding Apple
Another comeback kid
Another example of a slumping fund that likely has better days ahead of it is Bridgeway Large-Cap Growth (BRLGX). Bridgeway is a quant shop, using computer models to identify attractive securities. Unfortunately, quantitative approaches got slammed in the bear market and had trouble adjusting to rapidly changing investor sentiment in the early stages of the market rebound. As a result, Bridgeway Large-Cap Growth now ranks behind 81% of all large-growth funds since early 2006. However, Bridgeway has a long history of quant investing with its current approach, and its long-term results remain excellent. Recent performance has been nothing to write home about, but I think investors should stick around here.
Similar to Brandywine, the fund's models look for companies that will beat earnings estimates while selling at reasonable valuations, so it's not surprising that the fund has lagged in recent quarters. But Large-Cap Growth owns many solid names, and it has a big bet on the technology sector, which I think should do very well in 2011. In addition to top holding Apple, low-P/E tech names such as Intel
Ultimately, investors need to keep in mind that even the best managers will fall behind the market from time to time, and that such inevitable underperformance is not cause for panic. Remember to focus on long-run performance, and don't let yourself get swayed by funds with hotter short-term track records. It's not easy to ride out the storm with funds that have hit a slump, but once you find those skilled managers, hold on to them for dear life. That's how you beat the market over the long run, no matter what happens from day to day.
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