Smart investing requires patience. A new study from Baird, a wealth management firm, shows that many investors lack that resolve. Time and time again, they chase short-term performance, selling funds that perform poorly and buying funds that have done well over short periods. Often, this bad habit leads investors to break one of the most important rules of investing: buying low and selling high.
"The data shows investors do actually chase performance, and it's often a hindrance to long-term results because what they're, in effect, doing is buying high and selling low, which is the exact opposite of what you're taught in basic investing," says Aaron Reynolds, senior portfolio analyst at Baird.
For the study, Baird screened stock funds to find those that outperformed their respective benchmark over the 10-year period ending Dec. 31, 2010, by one percentage point or more on an annualized basis. Additionally, Baird screened for funds that exhibited less volatility than their respective benchmark. The final list contained 370 top-performing funds.
The results showed that even the best fund managers go through rough patches. Approximately 85 percent of those top-performing funds had at least one three-year period in which they underperformed their benchmark by at least one percentage point. Of the funds screened, 81 percent experienced below-average returns compared with their peers for an average of almost an entire year. On top of that, a quarter of the funds went through at least one 12-month period in which they dramatically underperformed their benchmark by 15 percentage points or more. "Active management performance is cyclical," Reynolds says. "It doesn't mean that fund managers get extremely smart or extremely stupid overnight."
Reynolds says investors can use actively managed funds to add value to their portfolios, but that if they choose that route, they should be aware that some strategies take time to develop. "Most fund managers invest with some type of process," he says. Whether that's investing with, say, a value or growth bias, it takes time for some strategies to take shape.
To gauge investor behavior during this 10-year time period, Baird looked at fund flows and changes in Morningstar's star ratings. (The ratings are based on past performance relative to peers over the past three-, five-, and 10-year periods, adjusted for risk and sales charges.) When top-performing funds in Baird's study were upgraded from either three to four stars or four to five stars, net money flows over the following 12 months were positive—$14 million and $331 million, respectively, on average, per fund. In comparison, top-performing funds that were downgraded from three stars to two saw outflows of about $65 million, on average, per fund. Funds that were downgraded from two stars to one star experienced outflows of $257 million, on average, per fund.
In the three years following the rating upgrade (of either three to four stars or four to five stars), the funds returned 1.4 and 1.7 percentage points over their peer average, respectively. But the funds that were downgraded over the same period of time performed even better. The downgraded funds returned 2.0 and 2.1 percentage points higher than the peer average, respectively. "Most high-performing managers can and do make up for lost ground and add excess return following periods of weakness, particularly during an intermediate-term time period," according to the study. In effect, investors left gains on the table because of shortsighted decisions.
The study also found that it's important for investors to hold onto funds for longer periods of time if they want to capture gains. Over one quarter, the managers of top-performing funds in the study outperformed a little more than half of the time. Further down the line, they performed much better. Over seven-year holding periods, more than 80 percent of the top-performing funds beat their benchmarks. "It is critical to avoid making judgments based on short-term performance and to evaluate money managers over periods of time that are long enough for them to prove their worth," according to the study.