How to Lose $1.5 Trillion While Really Trying

Investment advisors commonly warn their clients about the risks of changing strategies – those warnings are frequently unheeded, because it is all so tempting to switch. You’re in a conversation with a neighbor, who brings up a hot mutual fund she owns, having out-performed the market by a gazillion percent. And there you are just barely meeting your goals, with one fund in particular lagging in performance. Doesn’t it make sense to switch from your plodding fund into her outstanding fund? The answer is NOOOOOOOOOO!

To see whether fund switching helps or hurts portfolios, I did a study of all 2,357 mutual funds with at least 10 years of history. I used a helpful statistic that the mutual fund research company Morningstar provides. In addition to total return, which is the return an investor received if they bought a mutual fund in 2002 and sold this year, Morningstar also calculates “investor return,” which is the average return investors actually earned in the fund, based on when investors bought and sold shares in the fund.

The difference between those two return numbers I will call the fund switching return – if investor return is higher than total return, then investors made good decisions in trading in and out of the fund. For example, Harbor Capital Appreciation earned an annual average return of 6.8% over the past 10 years, while investors in Harbor earned an average return of 7.0% per year – the switching return was 0.2%. On the other hand, Marsico 21st Century Fund earned an average annual return of 7.8% over the past decade, while investors in Marsico actually lost an average of 4.3% per year. In that case the switching return is negative 12.1% per year.

On average, investors have generated a switching return of negative 1.5% per year over the past 10 years, which means that they have not done a good job of timing their mutual fund switches. The reason why is because individual investors tend to chase the hot fund – i.e., make fund choices mainly on the basis of short or intermediate term performance, without looking at other factors such as risk and investment discipline. A good case in point is the Marsico fund. It used to be a relatively small and unknown fund. Then, on the basis of outstanding performance (it beat its benchmark several years in a row), and some good PR (Kiplinger’s magazine listed it as one of its top 25 funds in 2007), investors flocked to the fund. Very few of its investors in early 2008 had owned the fund for all of the ride up in value, but each one of those investors suffered in 2008 when it lost 45% of its value (vastly underperforming its benchmark).

To see the aggregate magnitude of investors chasing hot funds, I estimated the total amount of wealth lost by investors over the past 10 years from poor timing of switches – the answer is a staggering $1.5 trillion! To put that in perspective, the total amount of U.S. government debt has grown by $7.5 trillion over that same time frame. Retaining that lost wealth would go a long way to solving our government deficit.

To focus on an individual investor level, suppose an investor had $1 million of an investment in 2002. An investor who didn’t switch funds, who bought an average fund in 2002 and held it for the next 10 years, would have accumulated an additional $910,000 in compounded wealth. An investor who bought in 2002 and earned the average investor return (including the value lost by fund switches) would have accumulated only $660,000 of wealth. That means such an investor would have lost $250,000, or 38% of their actual dollar returns, from poor fund switches.

So what does this mean for you? While chasing good performing funds seems like it will add value, it is fool’s gold. An unbiased investment advisor (one who doesn’t make money based on commissions) will look at a multitude of factors in choosing funds, including manager risk controls, stability of fund management, expense ratios, a logical investment process, historical risk, and, yes, past returns. If the sole basis for your fund selection is looking at past performance, then you are better off choosing index funds.

Scott Lummer, Ph.D., CFA Chief Investment Officer

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