Mutual Fund Mania – Choose wisely during RRSP season!

Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.

Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:

  • A great track record of top quartile performance over at least three to five years.
  • Billions of dollars invested in it, so it is “safe.”
  • Offered by an investment firm with a long and “distinguished” history.

Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.

It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.

The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.

A great track record might actually guarantee poor performance.

When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”

There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.

Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?

I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:

Results:

  • 100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
  • All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.

Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.

It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.

Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:

  • Fund performance begins to soar.
  • Fund attracts lots of new money.
  • Marketing folks want more and more time from portfolio manager for meetings.
  • Money pours into the fund in droves.
  • Portfolio manager’s head swells (the “I’m a genius” syndrome).
  • Performance begins to deteriorate.
  • Money leaves the fund in droves.
  • Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
  • Performance sucks, and it takes two to three years for things to get back to normal.

Size really doesn’t matter…unless the fund is humongous.

A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.

Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.

Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.

The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?

Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.

Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.

Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.

This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.

With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!

Mal Spooner

 

 

 

Some happy year-end thoughts!

An interesting year on many fronts – financial and societal. But have I learned anything I can use in the future? From a financial perspective, I very strongly believe we are going to get more of the same in 2013 that we had in 2012 – notwithstanding the “fiscal cliff” nonsense taking place in the Untied States (deliberate). Resolved or not, my best assessment is that world markets will be slightly chaotic for at least the next 2 years before some level of stability re-appears. Am I psychic?? Absolutely not – but I am a fiscal realist. On a relative basis, Canada is better off that just about everwhere in the world with the exception of New Zealand. For my younger audience, NZ did go bankrupt as a country about 30 years ago – and ever since have kept things fiscally responsible.

Canada may be the best of a bad lot, but we are certainly not having the country’s finances managed in any way, shape or form in a conservative manner. Quite frankly (and I am not, have not been and never expect to be a member of ANY political party), our proclivite spending habits are much more reminiscent of Liberal and NDP spending patterns.

Over the past 18 months or so, there has been a real shift around the world to a more socialistic approach to all levels of government. Citizens of all countries are demanding more services and support from their governments yet no-one wants to pay the price. It is the same in North America, Europe, South America, the Far,Middle and Near-Easts plus the former Soviet states, the Indian sub-continent and Australasia. The people in the Sahara and sub-Saharan regions in Africa are facing even more serious issues of civil wars and genocoide, on one or more levels. The Scandinavian folks are much quieter about things in their part of the world, but they are facing the same issues as the rest of the Eurozone as our our friends in Iceland.

Governments have no money, unless they print more – which brings inflation back into the picture in a big way – something no-one in the world can afford. Some parts of South America are dealing with double-digit inflation now – but on a WEEKLY basis – not annually! So with no money for governments to spend, national debts are growing in leaps and bounds (regardless of the “blue” colours of some leaders), from where does the money originate?

People are still hesitant to invest for the long-term and are spooked every time a politician anywhere in the world, talks about defaulting, restructuring, devaluing or cutting deficits without raising taxes. All of which makes for choppy markets. Yes the Warren Buffet’s and George Soros’ of this world will always make money, because they take the long view.

I haven’t mentioned China and South Korea (or the rest of the Asian-Pacific Rim countries) because despite generally higher levels of “state” control over their economies, they are in no better shape. Closed and partly closed economies may appear to be doing better, but we never really see the complete truth – so in the absence of clarity, investors tend to shy away from them as well.

So what to do now? Stay happy and think positive thoughts! Stay short on the fixed-income side of things and use GIC or GIA ladders to protect yourself against upward movement in rates. Keep at least 5% to 7% in cash. In equities, for less than 15 years holding, stay with large caps that have good dividend histories, or mutual funds/seg funds that hold those stocks. For 15 years and longer – right now, your guess is as good as anyone’s! Have a safe and happy Christmas Season! Cheers Ian