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Turning Lemons into More Lemons

For some mutual funds, simply changing their names can mean getting significant new dollars from investors, even though they're not doing anything new or different.

The study, "Changing Names With Style: Mutual Fund Name Changes and Their Effects on Fund Flows," gives us a glimpse into investor behavior and provides striking evidence to support the notion that investors act irrationally when allocating assets across mutual funds. It also provides evidence that the fund industry is quite aware of the irrational behavior and specifically engages in activities to exploit it.

The study analyzed fund flow patterns around name changes that reflected a change in the style (e.g., small or large, value or growth) when that particular style was "hot" or "cold." The authors found that:

  • One of the reasons funds changed their names was because they experienced significant relative reductions in inflows.
  • Many funds that change their names change toward the hot sector or away from the cold sector. For example, growth or "New Economy" funds changed the name to include value after the dotcom bubble burst.
  • When funds change their name to sound more like the hot sector (or at least stop resembling the cold sector), there's a dramatic (28 percent) increase in relative fund inflows the following year. This happens despite no improvement in performance.
  • It doesn't matter if the funds' holdings change to reflect the new name. The increase in fund flows is the same.
  • Funds that experience the greatest increase in flows switched to the hot style and also spent the most money marketing the new name.
  • Even funds that don't spend on marketing experience abnormal inflows. Just a mere association with the hot style is enough to drive investor behavior.
  • Fund performance after the name change is significantly negative.
The only conclusion that can be drawn is that investors are irrationally influenced by purely cosmetic changes.

Investors might not be so easily fooled if fund names actually meant something. Unfortunately, they mean virtually nothing. "While the SEC mandates that a fund must have at least 80 percent of its asset invested in whatever securities its name suggests, fund's have great leeway in the application of the rule. For example, a fund that uses small in its name must abide by the rule if the fund defines the capitalization category in its prospectus. And there are no restrictions on the use of value or growth."

Summary By chasing the noise of the market -- pouring money into hot sectors -- investors continually shoot themselves in the foot. When you do that, you end up buying lemons instead of lemonade.

There's a simple strategy that will ensure that you never buy a lemon -- build a globally diversified portfolio of passively managed funds and stay the course, ignoring the noise of the market and its siren calls that can cause you to stray from the winning strategy.

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