Scores of investors rely on the advice of financial advisors and planners to manage their money and help them plan for a secure retirement. And while we at the Fool have always encouraged folks to learn enough to take charge of their own financial future, we know that sometimes sitting down with a professional for some personalized advice is the best course of action.
Unfortunately, investors need to be careful when it comes to buying investments recommended by their trusted advisors. As a new study shows, many professionals have some preconceived ideas about how to pick the best funds for their clients.
An incomplete selection process
A recent survey conducted by consulting firms kasina and Horsemouth sheds some light on how advisors pick mutual funds and exchange-traded funds for clients. Apparently, the criteria the majority of advisors use to select ETFs are the same exact criteria they use when picking actively managed mutual funds: correlation to other investments and past performance. But using these factors to choose the best funds doesn’t result in long-term holding periods for the average advisor. The same study showed that advisors tend to hold traditional mutual funds for an average of 36 months, while the hold time for ETFs was only 22 months.
Now, looking at correlation and performance are important aspects of examining ETFs and mutual funds, but they shouldn’t be the only considerations when picking investments. Correlation is a very important factor in building a portfolio, but I would guess that most advisors tend to use shorter-term historical correlation measures (three- or five-year numbers) in their calculations. If you’re going to examine correlation, you really need to look at very long-term figures to get an idea of how closely correlated your investments may be. And correlation alone can’t tell you whether a fund is a good or bad investment or whether it may be appropriate for any particular individual’s portfolio.
Likewise, focusing heavily on past performance can lead to weak returns in the future. Since the tendency for the vast majority of investors and advisors is to focus more on recent, short-term historical performance, most funds are chosen based on how they have done in the past few years. That means you’re more likely to move into funds after they have already had a run-up while ignoring other funds that may not look as solid in recent history but have more room for growth since they generally hold stocks with lower valuations. Chasing performance is a loser’s game, so it’s better to not even play it in the first place.
The full picture
If you’re looking for the best actively managed mutual funds, past performance is actually one of the last things you should look it. You should first look for funds with a manager or management team that has been in place for a long period of time. If a new manager has taken over, the fund’s prior track record doesn’t mean much. You should also look for no-load funds with low expenses that have a history of investing consistently using the same process. You don’t want a fund that changes its stripes each time a new investing fad comes around in the market. And lastly, an actively managed mutual fund should have a long-term track record of solid performance in both good and bad market environments and not just one or two years of outsized performance that carries the fund’s track record.
One prime example of how focusing on past performance and hype can lead to bad fund selection can be found in the case of Fidelity Magellan (FMAGX). Magellan gained fame under the leadership of the legendary Peter Lynch in the 1980s. The fund put up fantastic numbers and even though Lynch left the fund in 1990, investors continued to pile into the fund based on its stellar past performance.
By the late 1990s, Magellan became the largest mutual fund in existence. However, the fund went through a series of manager changes in the 1990s and was plagued by lackluster performance. Now, the fund ranks in the bottom third of its peer group in the past decade and a half. The fund may have better days ahead of it, as current manager Harry Lange has built a solid portfolio of reasonably priced stocks in the undervalued health-care and technology sectors, arguing that Applied Materials
Investing on the cheap
Investors who are content with just matching the market’s return with a low-cost strategy may prefer the relative ease of exchange-traded funds. Here, manager tenure and past performance relative to the market aren’t as important, since the goal is simply to track a segment of the market, not beat it.
In the case of ETFs, investors should focus on broad-market funds that track a wide swath of the market and that do so at the lowest cost available. There’s no manager skill involved here, so cheap is the way to go. For example, the Vanguard Total Stock Market ETF
Ultimately, if recent data is any indication, advisors are at least on the right path when it comes to picking funds. However, past performance and correlation can’t provide the total picture. So whether you’re working with an advisor or picking funds on your own, be sure to look beyond the most commonly used measures to get a better idea of whether an active fund or ETF should earn a place in your portfolio.