Why you might want to stick with your fund after it has lost you money

After a period of investors exiting a fund, outperformance is more likely. 

Funds and Investment Trusts March 26, 2019 by Tom Bailey

When investors buy into an actively managed fund, they will typically be paying a management fee of around 1%. Understandably, therefore, they expect results in the form of market outperformance.  

To track this, funds usually chose a benchmark – usually a market index of the sort of stocks they will be picking – to measure their performance against. The worst thing a fund manager can do is to underperform this benchmark for a sustained period of time.

Underperformance should, in theory, lead to an outflow of investors and potential job loss. Although, as Money Observer has repeatedly pointed out, investor inertia is commonpace, which is why there are some many substandard funds in existence.

However, according to some number crunching carried out by Morningstar, investors should not always rush for the exit when a fund manager is going through a bad patch of performance.  

Morningstar notes that a number of well-known studies have shown that institutions tend to hire managers that have outperformed in the past, only for those same managers to underperform in their new job. In contrast, fired managers often went on to outperform.  

Looking at US equity mutual fund data between 1996 and 2018 (the equivalent of open-ended funds in the UK), Morningstar found that US investors often made the same mistake when picking funds.

As Morningstar’s Jeffrey Ptak notes: "We found that active US stock funds ‘hired’ by investors (receiving a large amount of inflows) fared better against their benchmarks than ‘fired’ funds (those with outflows) before hiring and firing, respectively.

“However, the performance of hired funds eroded post-hiring, while fired funds saw their performance improve after they’d gotten the hook, as shown below.”

 

Morningstar also narrowed the scope of the study, including using just the oldest share class of funds as well as comparisons for peer groups. The results were broadly the same: after a period of negative outflows (or investors ‘firing’ a fund manager), outperformance was more likely while inflows made future underperformance more likely.

Ptak, however, does point out a slight caveat. While many of the funds that were fired provided ‘outperformance’ the figures do not include funds whose performance became so bad they were liquidated or merged. 

To take into account ‘failed’ funds that merged or closed shop, the success ratio is used. This looks at the number of funds that outperformed a benchmark divided by the total number that began the period. When compared this way, ‘hired’ fund managers were a bit likelier to provide better performance.

 

However, argues Ptak, the results still show investors should be cautious of trading on a fund managers reputation and past performance alone. He notes: “The clearest takeaway is that while investors appear to have put a lot of weight on past performance in making hiring and firing decisions, it is insufficient on its own.”

 

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