New funds are designed to sell, not to make you prosper

Posted by Robin Powell on December 2, 2015

New funds are designed to sell, not to make you prosper

 

There’s a Wall Street proverb which perhaps sums up the fund industry better than any other, and it goes, “When the ducks quack, feed them.” Funds.

It was particularly popular during the dotcom boom of the late 1990s. Tech was all the rage — investors couldn’t get enough of it — and since Wall Street’s business was to make money, tech-related products were what it had to provide. It really didn’t matter if you half-suspected it would all end in tears for your clients. The more overpriced investments you could sell them the better.

Investors need to remember that fund houses are there to sell you funds, not to make you prosper. The same with those seemingly helpful experts from the fund shops who impart their “fund tips” in the weekend papers. They know that people like to chase what’s hot and avoid what’s not. So those are the predilections they unashamedly (and indeed understandably) appeal to.

A new study by Research Affiliates, Chasing Performance with ETFs, serves as a reminder that what the industry wants to sell you it often isn’t in your interests to buy. ETFs are the investment du jour — demand continues to soar — so, commercially, it makes perfect sense for fund providers to keep churning out new and exciting ETFs to appeal to every taste. But, the researchers found, there’s one factor more than any other which governs the types of fund that are launched, and that’s recent strong performance.

The study specifically looked at ETFs launched in the US between 1993 and 2014. It found that, on average, in the three years prior to launch, the underlying index on which the new ETF was based had delivered annualised excess returns over the Russell 3000 Index of nearly 5%. The cumulative outperformance over the three-year period was around 15%. More interesting still, when the researchers rolled the clock back by six months to the approximate time the business decision was made, they observed a peak in outperformance. Funds.

In other words, it was at precisely the point at which a sector was at its hottest that fund providers decided to launch a new product. Of course, by definition, average returns levelled off after that peak. Generally, Research Affiliates found, performance flatlined in the three years after the fund launch. In many cases the new fund underperformed the wider market.

The central problem, to quote the study is this: “What’s hot may change abruptly, but investors’ penchant for what’s hot is steady, because it is sustained by ingrained psychological forces and habitual cognitive biases.”

Alas, the media doesn’t help in this regard. News is about what’s new and what people are talking about now. You can hardly blame money journalists for writing about what’s in vogue, the latest fads and products. But sensible investing is about blocking out today’s noise and focussing on the long term; it’s about being market-agnostic and seeing the value in what others might consider dull and dowdy.

Study fund performance in any detail and you’ll notice that the most persistent characteristic is a lack of persistence. Funds do well for a few years and then often suffer a losing streak. You can argue whether outperformance is down to luck or manager skill but, either way, it’s largely a function of investment style. In the markets, as in many other walks of life, fashions change. What’s “in” one year might well be “out” the next.

Buying a hot fund is like buying a height-of-fashion garment; sure, you might get away with it for a couple more years; or you could be embarrassed to wear it in six months’ time and regretting the price you paid. By then, you can bet the industry will already be onto the next big thing, the next must-have investment. You wouldn’t want to miss out on that now, would you?

 

Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

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