Investors punish funds for bad behavior

(MoneyWatch) It's a fact of investing life that investors tend to chase performance by moving into what has recently been hot. That's why for every single fund family, the returns investors have actually received over the past 10 years have lagged the performance of the funds themselves. (Investors don't actually put their money into the fund until after it has performed well, so they miss some, if not all, of the upside.) And according to a Morningstar analysis titled "It pays to mind the gap," the larger the lag, the more trouble the fund family has had gathering assets.

A little background

To see how investor return can lag the fund return, consider this fictional example. Let's say that in 2010, the Allan Roth Global Performance Chasing Fund (ARGPCF) had $100 million in assets and earned 20 percent. Because I was so good at marketing my fictional brilliance, I attracted another $900 million at the start of 2010. Unfortunately, my luck ran out on my billion dollar fund and I lost 15 percent in 2011 for my investors. The math reveals that the fund earned an annual 1.0 percent positive return while investors (as a whole) lost 6.9 percent annually over the two year period. So I attracted $1 billion in capital and lost $133 million, making the gap between my investor return and the fund return 7.9 percent.

Morningstar's forward ratings
Morningstar grades 10 largest fund families
Have DFA advisors helped clients avoid mistakes?

In the graph below, Morningstar has plotted the 10 year gaps between fund family return and investor return against each family's ability to attract more investor capital. It turns out that fund families that minimized the gap in bad behavior (performance chasing) generally attracted more investor capital. Fund families that attracted bad behavior (larger gaps) declined.

Morningstar

The four families with the least bad behavior, Vanguard, JP Morgan, PIMCO and Blackrock all attracted new investor money at a pretty healthy clip. Three fund families had a behavior gap of roughly 3 percentage points or more -- DFA, Oppenheimer, and Dodge and Cox. All but DFA saw investors taking funds from those families.

Don Phillips, president of Morningstar's Investment Research division, notes in past studies that DFA has had very small gaps. The more recent numbers reflect the huge gaps in the company's emerging market funds as institutions and advisors poured money into these funds, which subsequently had weak performance.  Phillips says the gap will narrow if emerging market stocks turn around.

The bottom line

Performance chasing has been known to be hazardous to your wealth. I've heard a fund manager or two say it isn't their fault if investors flock to their funds after great performance. It turns out, however, that the fund family may benefit by discouraging the performance chasing. Thus, closing a hot fund to new investors for a period of time is not only in the best interests of the investor, it is probably in the best interests of the fund family itself.

[JerryNA100]

Hi Allan,
The words attributed to Philips, above, (the gap will narrow if emerging market stocks turn around) could apply to any fund in any investing category that has ever lost money, pretty much for any reason whatsoever. Why does DFA get a pass when the reality is that they lost a lot of their clients' money due to a bad strategy, not simply market forces? I have mentioned my skepticism of DFA's actively managed index funds which are only sold through financial advisers. There are two added points of failure in the DFA actively managed index model compared with true indexing: the active management (which lost so much money in emerging markets relative to other funds that it brought their whole asset value down), and the paid adviser's interpretation of the client's instructions. Point 1 is clear from the chart. Point 2 is clear from the advertising of some of the higher fee DFA salesmen (I mean financial advisers), warning people away from lower cost advisers... without revealing their own returns for comparison. I think that DFA has revealed its' model's risks in this chart, Allan, and you should not have let this very weak defense stand unchallenged. (I know those were not your words, but you did mention them.) Of course, I appreciate reading the chart and your take on the problem of investors losing money by performance-chasing. regards,
Jerry
p.s. Did you see Michael Zhaung's blog today on hedge fund managers raking off more money in fees than they made in investor gains? Likely, they actually lost more money for clients than gained, as well as ripping them off with huge fees. You have said something similar before, if I recall correctly, but the numbers are both shocking and illuminating. -JA