It is important for investors to understand the challenges and motivations that mutual fund managers face as they manage fund portfolios. For many of us, mutual funds are the primary investment vehicles in our employer-sponsored retirement plans. However, the misguided behavior of chasing returns has created an investing environment that works counter to the investor’s goal of successfully investing for the long term.
THE WRONG INCENTIVES
Studies show that investors tend to chase returns. Earlier this year, YiLi Chien of the St. Louis Federal Reserve wrote The Cost of Chasing Returns. He used data from the Investment Company Institute that tracked the buying and selling activity of mutual fund shareholders over the last twenty-eight years. The data indicates that, as a whole, mutual fund shareholders tend to “chase returns” by buying more when past returns are high and selling when they are low. This behavior clearly hurts investors’ long-term returns. It also incentivizes mutual fund companies to cater to this behavior by emphasizing the recent performance of their “top funds.” Investment companies know investment dollars will flow into funds that “beat their benchmark.” We have likely all seen an advertisement or two highlighting funds that have performed well recently. These advertisements likely encourage the type of return-chasing behavior that costs investors’ money over time.
MANAGING TO A BENCHMARK
Most mutual funds are graded on how they perform relative to a benchmark. This incentivizes the manager to focus on relative performance with respect to abenchmark over short periods, as opposed to optimizing portfolios toward a long-term objective. For example, the S&P 500 is the most commonly used benchmark for funds that invest primarily in large, U.S.-domiciled firms. If a fund that is evaluated against the S&P 500 has performance that differs significantly from the index, questions are likely to be raised. If the performance is positive: Is the manager a future star and should the financial press be notified to promote her genius? Conversely, if the performance is negative in comparison to the benchmark: What is wrong with this manager? The incentive to focus on relative performance, which is more short-term in nature, rather than on identifying opportunities that present long-term value is clear.
SWIMMING AGAINST THE TIDE
The behavior of chasing returns puts fund managers in a position where they are swimming against the tide. The study referenced above indicated that as performance improves, more investors tend to buy into a fund. All too often this happens during the latter stages of a market cycle. Perversely, the fund manager is given larger quantities of money to invest after the market has gotten more expensive. At this point, there is more pressure on the manager to not hold cash, because the market is in the midst of a rally and shareholders in the fund want to participate. The end result is that fund managers end up buying more stocks as they get more expensive. Unfortunately, as the market cycle turns and performance suffers, investors tend to sell their fund shares. More than likely, holdings in high-quality stocks have just become a better value, but ironically the fund manager is in a position where he is forced to sell holdings in order to satisfy redemptions.
Mutual funds provide a relatively inexpensive way for the average investor to invest. However, the challenges and motivations of fund managers and investment companies that promote the funds should be understood by anyone that uses these products. The tendency of investors to chase returns and for fund managers to manage to a benchmark is generally counter-productive relative to the achievement of long-term investment goals. The prudent investor should always evaluate each investment in her portfolio on an individual basis based on the merits of each investment opportunity.
Finally, when constructing a portfolio, it is critical to clearly define an investor’s long-term investment goals along with her tolerance for risk. The portfolio’s performance should, correspondingly, be evaluated over long periods. Focusing on short-term results relative to a benchmark all too often distracts us from achieving our long-term objectives.