Mutual funds - watch out for flapping feet

(Published in the South China Morning Post on 20 August 2006)

Most of us know of the proverbial swan, sailing seemingly serenely across the surface of a lake, while obscured by the water its legs paddle like crazy. The performance of certain mutual funds brings to mind an inverted swan: with its big feet flapping in the air, frantic activity is there for all to see, but the poor thing is going nowhere, and probably drowning.

Put simply, paddling to and fro is not in itself a measure of achievement. Indeed, it is often counter productive. A 2003 research report by CSFB of US mutual fund data from Morningstar revealed that funds with lower turnover performed better over all periods of more than two years. That is why looking at the "turnover" of a fund's portfolio is very instructive.

According to the study, funds that turned over an average of less than 20 per cent of their portfolio annually returned 179 per cent of value over 10 years. This compared with a 143 per cent return for funds that turned over an average 20-50 per cent of their portfolio a year, 130 per cent for those that turned over between 51 and 100 per cent of their portfolio, and a miserable 112 per cent return for those that turned over more than 100 per cent.

In other words, funds that did the best were holding on to their investments for an average of at least five years. This simple statistic raises two basic questions. Why does taking a longer-term view yield better results? (The higher transaction costs associated with high turnover can only explain a smidgen of the divergence.) And why, given the clear facts, does anyone invest in higher turnover funds?

The explanation for the attraction to many of the higher-turnover funds is rooted in the often-irrational characteristics of human behaviour, specifically a phenomenon known as "myopic loss aversion", a term coined by leading behavioural economists Shlomo Benartzi and Richard Thaler in 1995.

This phenomenon refers to the fact that humans are much more sensitive to losses than to gains (loss aversion) and that we compound the problem by evaluating our portfolios over short timeframes (myopia). In other words, we tend to look at our portfolios too often, and compounding the problem, when we see a dip, we overreact.

If we were able to stop ourselves from looking at short-term price fluctuations, we would be far less likely to be aware of the dips, and therefore much more comfortable holding onto shares or funds for the long term, an approach that, as we have seen above, yields the best results.

Why do they yield best results? Investment returns reflect one's ability to predict future share price movements. Every individual share price movement, over any time frame, is a function, in varying proportions, of the company's profits on the one hand, and market psychology on the other. Over the short term, market sentiment almost entirely influences share price movements, but over the longer term profits dominate.

The difference between short-term investing and long-term investing is the difference between predicting how investors are going to behave versus how a company's assets are going to behave. To illustrate why the latter is easier, take the hypothetical example of a listed property investment company that owns one new office building. Would you be more confident in predicting the company's share price in six months or predicting whether the building will still be standing five years from now?

Many fund managers' investment decisions are the result of herd mentality and panic: buying shares that have recently performed well or selling shares that have recently fallen, actions that more often than not tend to backfire. Few stampeding cattle have the objectivity or distance to really understand why they are running, or to assess whether they are at the front, back or in the middle of the herd. Nor would one expect many to have the strength of mind to stop for a little quiet reflection.

In addition, many fund managers often feel compelled to be doing things, to be frequently making decisions, to buy and sell, all the while egged on by brokers. How can you be guaranteed to avoid such managers? By investing in funds with low turnover. As best-selling financial author Roger Lowenstein pointed out about high-turnover funds in his SmartMoney column: "They aren't investing in stocks any more than a cheap date on Saturday night is akin to an engagement."