In an article last year, Slate.com writer Daniel Gross tackled why so many investors fare poorly in mutual funds, expounding on a study by economists Andrea Frazzini of the University of Chicago Graduate School of Business and Owen Lamont of the Yale School of Management. He started out by explaining that there's smart money, represented by "big-time hedge fund managers, private-equity honchos," etc., and dumb money, represented by . us, individual investors.
I find this a bit too simplistic. While there are indeed smart and successful hedge fund managers and others, they don't all have such great records. And I've met or read about too many successful small-time investors to consider them dummies.
Gross went on to make some good points, such as: "But as a class, mutual-fund investors are short-term return-chasers. If a fund puts up good numbers for a few quarters, it will attract lots of new cash. 'Individuals tend to transfer money from funds with low recent returns to funds with high recent returns, [Frazzini and Lamont] note.'" I've not only seen this happen, but have done so myself. It's natural to look for great places to invest your money among investments that have soared. But it's not generally the smartest way to go about it.
For example, many investments that have soared recently have actually soared right past their intrinsic value and are now overvalued. Even if they're trading at a fair value, why would you choose them over alternative solid investments that seem undervalued? The undervalued securities, after all, are the ones you can most reasonably hope to appreciate in the near term.
Gross then explained that when mutual fund managers are very successful, they attract more investment dollars, which they then have to deploy -- and they deploy them in suboptimal places, such as the same, now-overvalued stocks that took their fund to new heights recently. I'm sure that does happen, but it's not always the case. Much as we at The Motley Fool like to slam mutual funds for their often poor performance, there are some standout funds which have been beating the market for their investors for a long time.
For example, consider the Touchstone Mid Cap Growth A fund. (Touchstone is the name of a Shakespearean fool, by the way). Its average annual return over the past five years is 10.4%, and it's 15.6% over 10 years. The fund focuses on medium and large companies, and its recent top holdings included:
Will the fund continue to offer solid returns? No one knows. But some research can help you determine how confident you are in its management's skill and prospects.
Gross concluded by suggesting, soundly, that we not follow the crowds and their "dumb money." He prescribed: "Do the opposite of whatever the mass of mutual-fund investors does. It takes some data-crunching . a savvy individual who subscribes to the right services can compile mutual-fund inflow data, then download mutual funds' public filings that show their holdings each quarter, then replicate Lamont and Frazzini's calculations and figure out which stocks have been receiving lots of mutual-fund investment and which stocks haven't. Just follow the money. Then go the other way."
Yikes. That sounds like a lot of work. I invite you to try it out, if you're intrigued. But if you'd like to save some time, focus instead on those mutual funds with great records and managers.
We'd love to introduce you to many of them, via our MotleyFoolChampion Funds newsletter. Try it for free and see which funds our analyst Shannon Zimmerman is recommending and has recommended -- and why. Together, his picks have more than doubled the market's return (as of the last time I checked), gaining an average of 21% vs. 10% in the same time period. Out of about 36 picks, only two were underwater, and by no more than 2.1%.
Learn much more in these Zimmerman articles:
Omnicare is a Motley Fool Inside Value selection.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.