Do Investors Need Protection From Themselves?

Vanguard has closed its top-performing fund.

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You've heard the old mantra "buyer beware." But now, with strains of consumer protectionism re-emerging in the market, get ready for "buyer be saved." Vanguard recently closed its top-performing fund, and one of its stated reasons was to protect consumers—from themselves.

"Despite our efforts—at both a company and an industry level—to educate investors about the perils of performance-chasing, we continue to be concerned about this behavior," Vanguard CEO Bill McNabb said in a statement announcing the closure of the Capital Value fund to new investors. "Closing the fund for a cooling-off period serves two purposes," he continues. "First, it protects existing shareholders from higher transaction costs that can result from short-term-oriented investors moving in and out of the fund. Second, it protects prospective investors from themselves, as high-performing funds will almost certainly drop off at some point."

Not so fast, says Dan Wiener, editor of the newsletter The Independent Adviser for Vanguard Investors. "The notion that this is to protect investors from themselves is silly on its face because there are other [Vanguard] funds that are taking in much more money based on momentum in the market, and if they really wanted to protect investors from themselves, they'd shut those down," he says. (Vanguard's website does, however, single out three other high-performing funds in a warning about chasing returns.)

While Vanguard maintains that recent inflows have not hampered the fund's strategy, Wiener believes that had it not been checked, the short-term growth could have become troubling for Capital Value, whose 68.5 percent returns year-to-date through September topped all other Vanguard funds. "They closed it because there was too much money running into it," he says. Capital Value manager Peter Higgins "likes to trade. The turnover on the fund is big. And if he gets too much money and he can't do that kind of quick trading . . . that could ultimately hurt performance." According to Morningstar, the fund's turnover rate is 186 percent.

But taken at face value, Vanguard's choice of wording has some interesting implications. In particular, as the economy rebounds and funds start posting big numbers, is it the role of fund providers to temper wide-eyed investors? Absolutely, says Morningstar analyst Dan Culloton, who covers the Capital Value fund. "Money management is not like selling toothpaste or Coca-Cola or something like that. It's a professional service that's done on trust," he says. "If you're really acting like a steward of someone's capital, you care about their overall, long-term experience in the fund."

Investors who jump into funds looking for short-term profits often have less-than-pleasant experiences. "Investors have shown time after time that they are prone to chasing hot performance," says Culloton. "There's a tendency to chase performance, and when you do that, you hurt your long-term returns."

Still, not all inflows into funds on a hot streak can be attributed to performance chasing. "In one sense, you have individuals who are long-term shareholders who are maybe just trying to rebalance or initiate a new position in a fund like that. And then there are your short-term investors that are trying to participate in what is currently a top-selling fund," says Peter Greenberger, the manager of mutual fund research at Raymond James. "And so in the former sense, [closing a hot fund is] hurting the long-term investor. In the latter sense, it's protecting those people who are chasing returns."

So what is paternalism's ideal place in the investing world? "If I knew that, I'd be writing books," says Greenberger.