Mutual fund investing isn't as easy as some people think it is. It's not just a question of finding the right funds, but also of sticking with those funds through good times and bad. It's easy to hold on to a fund when it's leaving the market in its dust, but when your manager is on a losing streak, staying put requires a lot more discipline.
Theory vs. reality
Historical fund returns are easy enough to find and to evaluate, but those returns don't give the whole picture. For the actual return that investors experience during certain time periods, we can look at investor returns, also known as dollar-weighted returns. These figures take purchases and sales into account during the period of time in question, giving us a better idea of how the average investor in the fund actually fared, based on cash flows going into and out of the fund. Since investors tend to buy funds after they have done well, and sell them after they have done poorly, there's a significant potential for their personal returns to vary from what the fund experiences over the long-run.
As a Morningstar article recently noted, some funds, such as Fidelity Leveraged Company Stock (FLVCX) suffer from an incredible disconnect between fund returns and investor returns. While the fund itself has posted a 10-year annualized return of 13.6% through the end of June, the average investor's 10-year return is just 3.2%!
The biggest factor contributing to this disparity is the fund's incredible volatility. The fund posted an eye-popping 96% return in 2003, and proceeded to beat the S&P 500 by wide margins from 2004 to 2007. But because the fund invests in heavily debt-laden companies, the fund was hit hard in the financial crisis, losing nearly 55% of its value. Investors bailed out en masse, only to watch from the sidelines as the fund posted a roughly 60% gain in 2009. Wide swings like this motivate folks to buy and sell at the wrong times, leading to the generally poor returns we see here.
But the Fidelity fund isn't the only fund whose volatile nature has contributed to lagging investor returns. CGM Focus (CGMFX), a highly concentrated, high-turnover growth fund run by Ken Heebner, has suffered some of that same fate. This fund landed at the top of the charts prior to the financial crisis, partly fueled by an 80% return in 2007 that lead to heavy investor inflows. Investments in energy and industrial stocks, such as Canada's PotashCorp (NYSE: POT ) and Chinese oil firm CNOOC (NYSE: CEO ) , helped buoy performance that year, as both stocks gained more than 80%. But since that time, the fund has fallen on hard times, losing an annualized 13% from January 2008 through June 2011, compared to a 0.8% loss for the S&P 500, sending investors running. While the fund sports a three-year annualized loss of 19.3%, investor returns over that time frame have seen a 25.7% loss.
Likewise, former highflier Brandywine (BRWIX) -- whose performance tends to run hot and cold from quarter to quarter -- has been running on the cold side lately. Although the fund has had tremendous success in the past picking companies with earnings momentum, companies that beat earnings expectations have simply been passed over for more speculative fare in recent years.
As a result, the fund now sports a three-year annualized loss of 5.7%, but investors in the fund have fared worse, losing 11.3% as they piled into the fund when performance looked good and are fleeing now as things take a turn for the worse. I think investors should stick around here; the fund looks like it is in the initial stages of a turnaround, and it boasts many solid growth names, like top holding and perpetual earnings-crusher Apple (Nasdaq: AAPL ) . Once the market gets back to rewarding firms that exceed expectations, Brandywine should be back on top.
How volatility costs you
While volatile funds like those above can still be suitable long-term investments for more patient types, reality has taught us that most folks are pretty bad at sticking it out through the hard times. Unless you are a supremely patient investor who doesn't mind sitting on a few years of fund underperformance from time to time, you might want to rethink investing in funds like these that experience wide year-to-year swings in performance. Before buying any mutual fund, you should always take a look at past performance. If you see big wins and big losses in any given year, that's a clue that the fund may follow a riskier strategy that can lead to lumpy performance. When such a fund hits a losing streak, you're going to be tempted to sell. If you think you'll find it difficult to stay invested for the long-run, avoid high-risk, high-volatility funds like these.
There's also another warning for investors here: don't chase performance! If you buy a fund simply because it's sitting atop the performance charts, be aware that may change pretty quickly. One prime example is Fairholme (FAIRX), which ranks in the top 1% of all large-blend funds over the past decade. Despite a first-rate track record, the fund's hefty bet on beaten-down financials AIG (NYSE: AIG ) , Citigroup (NYSE: C ) , and Bank of America (NYSE: BAC ) has pulled the fund to the very bottom of its peer group over the past year as the financial sector has stumbled. Investors have pulled roughly $2.5 billion out of the fund in the past three months. Odds are good in another year or two, investor returns for Fairholme will diverge meaningfully from fund returns as impatient investors will have already thrown in the towel.
If you've got a good fund, stick with it for the long run, and don't bail out when the going gets tough. Investor returns highlight the simple truth: Chasing performance and giving up on good funds is a losing strategy. Do yourself a favor -- don't play that game.