To keep earning safe, solid investment returns you have to adapt. The investment markets change over time, and you have to recognize and accept those changes. A failure to be flexible, to learn over time, and to accept changes is why most investors and even professional investment advisers pick mutual funds in ways that are almost guaranteed to fail.
Picking funds in the old days (about 15 years ago) was easy. There were only a few hundred funds. You decided the type of fund you wanted, narrowed the choices down based on loads and expenses, then picked funds with the kind of return history you were most comfortable with. After that, you simply held on for the long term.
Now, there are more mutual funds than stocks, and there are several services providing detailed reports on funds, including ratings scores. But most mutual funds tend to lag index funds. Most investors use the services to pick funds by zeroing in on two factors: past performance and ratings. We never used this approach, and new research (plus our experience) shows that was the right move.
Past performance and ratings are no indication of future performance. Other factors that aren’t helpful in forecasting a fund’s performance are a manager’s tenure, ratings by outside services, and portfolio turnover.
Two other factors are very important in picking a successful fund – size and age. In general, the smaller and younger the fund the better off you are. That’s why several years ago I wrote an article titled “Great, Little-Known Funds,” which I update periodically.
For example, one recent study found that over the last 10 years the smallest 25% of U.S. stock funds outperformed the other funds in their category 87% of the time. The largest 25% of funds funds outperformed their category averages only 48% of the time. More importantly, this difference has been widening in recent years.
There are many reasons a smaller, newer fund does better. The smaller fund can make changes more quickly and can buy or sell a stock without having a great effect on the price. A smaller fund also can concentrate on its manager’s best ideas by having its top 10 holdings amounting to 50% or more of the fund. Most large funds cannot do these things.
Here’s what has become the life cycle of a mutual fund. A fund starts out small, its manager buys the stocks he or she likes, and the fund does well. The strong performance attracts new investors. Soon so much money is flowing into the fund that the manager finds it difficult to buy and sell stocks or to shift the portfolio. Instead of owning a few dozen stocks, the manager owns 100 or more.
And decisions have to be made rapidly as money flows into the fund on a daily basis.That causes bad decisions that probably wouldn’t have been made if the cash flow was not forcing quick decisions about big changes. Some managers cannot decide what to do and let the cash accumulate to 30% or more of their funds.
There are some exceptions. A few large funds that have been large for a number of years and whose managers are used to investing tens of billions of dollars continue to do well. They will have bad years and quarters, but over long periods they tend to consistently outperform their peers and market indexes. For these funds new investments tend to come in at a steady rate, whereas a newly-discovered fund might see its size double in a few months. That’s verified by another research finding: The funds that attract the most money one year tend to significantly under-perform their peer groups the following year.
Another bit of research gives you an easier starting place for narrowing down fund choices. Mutual funds sponsored by brokerage funds are overwhelmingly represented among the consistently poor performers. Avoid these funds and your chances of getting a solid performer are improved. That also casts new light on the oft-quoted statistic that 90% of funds fail to beat the market index. Drop out the many funds offered by brokers and the percentage improves.
We reached many of these conclusions ourselves some time ago. In the Core Portfolios and sometimes in the large stock portions of our Managed Portfolios we use large funds that have been large for years and turn in consistent returns. But in the Managed Portfolios and small stock portions of the Core Portfolios we have more and more sought out new funds and small funds. As other investors discover our funds and throw money at them, we start looking for new funds, before the old funds get overloaded with too much cash.