Investing a bit in mutual funds is a bit like running a pro football team. Everything is fine if you make the playoffs or see the progress you expected, but if a season ends and the numbers are ugly, you want to fire the coach.
That’s what many stock mutual-fund investors are going through now. Dim 2011 results from fund managers is enough to convince them to “Throw the bums out.”
Alas, that knee-jerk reaction to raw numbers can create problems.
Stay or go
Beyond calendar-year results, investors also will be getting annual reports from their funds that include the manager’s explanation of the fund’s performance. Those reports let shareholders determine whether the result is what they expected when they hired the manager, and to decide if the fund or its manager still fits their needs.
That’s also where things get tricky.
Football team owners and fans have a simple standard for coaches: Don’t make the playoffs by the third year of your tenure, or fall from contender to patsy, and you’re out. About one-third of NFL teams make the playoffs; the investing equivalent, therefore, would be finishing in the top third of the fund’s peer group.
The notion that past performance is no gauge of future results is more than a boilerplate warning. With the exception of occasional momentum swings or trends that cross from one year to the next, there’s little empirical evidence that results over the last three-, five- or 10 years will look remotely similar going forward.
Investing in mutual funds is a bit like owning a pro football team. Everything’s fine if you make the playoffs, but after a losing season you want to fire the coach, says Chuck Jaffe.
That’s not a surprise — the market determines returns more than any manager, which is why so many industry watchers prefer indexing over active management — but it makes it hard to judge what just happened in a fund and what to do next.
“Any manager can have a bad year; the talented ones usually come back and that’s why you don’t base your decision on one year,” said Charles Rotblut, vice president of the American Association of Individual Investors and editor of AAII Journal.
Rotblut noted that investors buying a new fund should be prepared to give the manager three to five years. “Worse, if you dump the fund, you’re likely to go to a manager who just had a good year, and that could have been the fluke.”
Beyond the numbers
With that in mind, fund-investing specialists say that managers — unlike football coaches — are best judged on something other than won-lost record.
“The track record is very noisy and provides virtually no reliable signals, thus we ignore it when evaluating funds,” said C. Thomas Howard, director of research at AthenaInvest, a Colorado-based investment research firm. He said that “strategy, consistency, conviction” are the most important signals for superior performance going forward.
Investor expectations are crucial, as is the manager’s role in the portfolio. Jim Lowell of the Fidelity Investor newsletter noted that his evaluation process starts with whether “we need [the manager’s] skill sets again this year. … The first question is an allocation one, the second gets to buying the manager.”
David Snowball of MutualFundObserver.com, said a manager who meets expectations matters more than annual results. “In general,” he said, “if a manager is posting positive absolute returns that are reasonable, I’ll ignore years of relative underperformance. A good example is T. Rowe Price Spectrum Income which can be substandard for four or five years in a row — like 2001 through 2005 — but which is still doing the job I bought it for: mid-single-digit returns with low volatility.”
Ultimately, most experts suggested that a bad year should not trigger the urge to purge, but rather alert the investor that a manager is on thin ice.
“People with great records are bright and pathologically competitive,” said Michael Stolper, a San Diego-based wealth manager. “When results flag, they are absolutely driven by the need for redemption.”
But investors have trouble waiting for that redemption, Stolper said. They get it in their heads that the manager is out of touch, or the world has changed.
Indeed, barring ethical issues, mass shareholder departures or big fee hikes, investors probably should not be in a rush to fire a manager over a bad calendar year.
It can pay to be patient. Said Stolper: “Replace the manager three years after you think it’s immediately necessary.”
Source: MarketWatch
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