Performance

The first issue is the pursuit of outstanding performance in the face of mediocre or poor performance, or at least inconsistent performance. Most investors are choosing mainly actively managed funds in response to popular press articles touting the recent performers that stand out. Investors also use such criteria as Morningstar ratings. But should they be doing so, or simply using index funds? If they are going to buy actively managed funds, how should these decisions be made?

Insights

Much of the disappointment that investors experience in the area of mutual fund ownership arises from the issue of performance. Investor expectations get formed about what they should earn from a particular fund, often based on what the fund earned in the past. Additionally, investors are constantly exposed to ratings of mutual funds and articles about the top funds one should own now. The end result is that many investors are chasing performance, and most end up disappointed.

Funds that suffer poor returns hurt shareholders as they attempt to get back to even. If the value of a mutual fund share declines from $100 to $60, that is a 40 percent loss. However, getting back to $100 requires more than a 50 percent gain.

Much of what is involved in seeking superior performance with mutual funds is based on momentum. Funds seem to have some short- term momentum. Thus, the Janus Twenty Fund had returns of 73 percent and 65 percent in 1998 and 1999, respectively. Unfortunately, the same fund showed a drop of 32 percent in 2000, followed by another decline of 29 percent in 2001. Numerous other examples like this can be cited.

A study done by Financial Research Corporation analyzed flows out of and into mutual funds during the 1990s. ^[1] Following quarters when funds posted their best results of the decade , money flowed into these funds ”in fact, the amounts were 14 times greater than the amounts that flowed in following the worst quarters of performance. Thus, investors were attracted to funds that had performed well recently.

^[1] See Chet Currier, "What Goes Up Must Come Down," Bloomberg Personal Finance , May 2001, pp. 34 “35.

The sponsors of this research concluded that "many investors are purchasing funds based on past performance, usually when they are already at or near their peak." This study estimated that the indicated pursuit of the hottest funds at the time cost investors 20 cents of every dollar in gains relative to a buy-and-hold approach.

An issue related to the likely poor performance of many investors in choosing a mutual fund is simply this ”there are too many funds in existence. As we saw, the number of different mutual funds (not counting different share classes) grew from more than 3,000 in 1990 to more than 8,000 in 2000. As of November 2001, there were more than 8,300 mutual funds, according to data available through the ICI. This glut of funds makes it nearly impossible for investors to intelligently deal with the situation. Although it appears that the variety of funds is great enough for investors to find what they are looking for, the truth is there is much redundancy in funds, making it difficult for investors to find a good manager.

In effect, many mutual fund companies are bombarding investors with new funds in the hopes of attracting investor money and producing a fund that will perform well. Meanwhile, many investors are persuaded that they can pick the next great performer.