By Jason Zweig | Nov. 12, 2016 9:07 pm ET
Image credit: William Blake Richmond, “Phaëton and the Horses of the Sun,” Warwick Museums, ArtUK.org
I’ve been writing for two decades about the tragedy of the gap between the returns that investments earn and the returns their investors earn. Here’s one early look at that issue (source: Money Magazine, April 1997).
With today’s runaway stock market starting to look eerily ebullient, it’s time for me to tell you something that sounds too strange to be true: Many shareholders don’t make any money even when their funds do.
To explain this peculiar paradox, MONEY set out to do something no personal-finance publication has ever done: We studied returns of hundreds of funds to see which funds really made money for most of their shareholders and which ones only appeared to do so. With the help of Charles Trzcinka, a former Securities and Exchange Commission economist who now teaches finance at the State University of New York in Buffalo — and Money reporter Malcolm Fitch — I analyzed the total returns reported by 1,008 U.S. stock funds for 1996 and by 834 funds for the three years that ended in December 1996. Then we calculated the return that was actually earned by the average shareholder of the funds over the same two periods. Our conclusion: In 1996, the average shareholder at more than a dozen profitable U.S. stock funds actually lost money. Among the high-performing funds whose customers came out behind: Dreyfus Aggressive Growth, John Hancock Special Equities B, PBHG Core Growth, Putnam OTC Emerging Growth and Van Wagoner Emerging Growth.
That’s right. Each of these funds made money — but its typical shareholder lost money. No wonder Stephen Nesbitt, senior vice president at the investment research firm Wilshire Associates in Santa Monica, Calif., calls funds’ reported performance figures “elusive numbers that do not reflect the wealth that investors have gathered.”
How can you lose money in a fund that makes money? By acting like a trader, not an investor. Attracted by hot performance, you buy after the fund soars and then sell after it slides. I’ve long argued that making money in funds is not a one-man show. Your investment results are a product of how the manager performs and what you do in response. Unless you hang around long enough to enable him to do his job, you’re likely to make little — or nothing. So how you pick a fund often turns out to be a lot less important than how you own it.
Here’s what we did — and what we learned:
The total-return figures reported in your fund’s documents tell you how the fund performed. But they don’t show how real-world investors like you did as they passed through the fund. A fund’s total return reflects only the growth rate — including reinvested dividends and capital gains — of a single investment made on the first day of the period and kept in place until the last day. It ignores any money that flows in or out during the measurement period. Nevertheless, this measure — what academics call the time-weighted return but I prefer to call the portfolio return — is the universal standard for fund performance. And it is the figure you read in MONEY and other financial publications.
To learn how actual investors fared, however, you need to see what’s technically known as the dollar-weighted return, or what we’ll call the shareholder return. By coupling the fund’s returns with its changing assets, this method shows the total amount of money gained or lost by the fund’s shareholders. (To calculate shareholder return for our exclusive study, we adjusted each fund’s performance by the amount of cash that came in and out each month, assuming it was invested or withdrawn at month-end.)
In effect, the portfolio return shows the performance of the first dollar put into the fund, while the shareholder return measures the average performance of all the dollars in the fund. Both methods are useful: The first tells you how well the fund manager did over time, and the second tells you how well his shareholders did. Many pension consultants wouldn’t think of hiring a money manager without checking both his portfolio return and his shareholder return.
Why do shareholders and the funds they own earn such different returns? Simple: Instead of marrying their funds by buying and holding on for dear life, many people have a series of flings — loving and leaving their funds far too soon.
Wilshire Associates’ Nesbitt studied the gap between portfolio returns and shareholder returns from January 1984 through August 1994. He found that the average stock or bond fund returned 10.96% annually over that period — but the typical shareholder earned just 9.88%, or 1.08 percentage points less. (Of course, as we’ll see below, in some funds the gap between the two returns is far greater.) Here’s what Nesbitt’s findings mean to your wallet. If you had invested $5,000 in the average fund in 1984 and let your money sit there until late 1994, it would have grown to $15,162; that’s the portfolio return. Unfortunately, because of the way the typical investor flitted in and out, his $5,000 grew to just $13,660, or 10% less; that’s the shareholder return that people actually earned. Nesbitt guesses that, in the nearly 11-year period he examined, the investing public threw away $8 billion by moving its money around rather than staying put.
That’s a lot of wampum, and it leads us to the first of what I consider the three great paradoxes of fund performance:
You can lose lots of money even if your fund makes money. Take a look at $456 million PBHG Core Growth, the gung-ho stock fund launched by James McCall, 43, of Pilgrim Baxter & Associates at the beginning of last year. In the first three months of 1996, as Standard & Poor’s 500-stock index rose 5.4%, PBHG Core shot up 18.2%. For the whole year, the portfolio returned 32.8%. If you had invested $10,000 on Jan. 1, you’d have ended 1996 with $13,280 — mighty nice even in a banner year when Vanguard’s market-tracking Index 500 fund turned $10,000 into a healthy $12,286.
But most people who bought PBHG Core missed out on its giant early gains — and many didn’t hold on for the whole year either. At the end of March, assets totaled just $31 million. The biggest batch of investors crowded into the fund in May and June, adding $204 million right before PBHG’s returns dropped as suddenly as an elevator whose cables had snapped. In the second half of the year, the fund lost 3.8% — and panicked customers yanked out $18 million in December, locking in their sudden losses.
In short, most shareholders didn’t own PBHG Core nearly long enough to earn as much as the fund. The startling truth: Even though the fund gained 32.8% in 1996, its average shareholder actually lost 3%. “It’s very painful for me to think of all the shareholders who got in at the peak and are suffering,” says McCall. “But we’re not going to change our approach just because the market turns against us.”
Another racy fund fueled by fast-moving small stocks, $92 million Dreyfus Aggressive Growth, gained 20.7% in 1996. But the bulk of the fund’s return came in the first three months, when it had less than $25 million in assets. Customers flung $122 million at manager Michael Schonberg, boosting assets to $154 million, just before the fund lost 22.2% in last summer’s small-stock crash; then they bailed out at the bottom, withdrawing $9 million in the last six months of 1996. Only the handful of folks who got into the fund at the beginning of the year — and stuck around until the end — made anything like 20.7%. The average shareholder lost a bloodcurdling 34.9%. Similarly, $638 million Van Wagoner Emerging Growth earned 26.9% last year — but its itchy-fingered shareholders lost an average of 20%.
Don’t blame these losses on McCall, Schonberg or Van Wagoner. They are talented fund managers who were doing their jobs. It’s not their fault that their funds had relatively few shareholders in the first quarter of last year, when their returns were spectacular, and many more investors in the summer, when their returns stank.
Who is to blame? The investors themselves — for chasing hot performance numbers, for bailing out at the first sign of trouble and for ignoring how important their own behavior is in determining how much they actually make in mutual funds. And that leads us to the second paradox of performance:
In the long run, a lukewarm fund can be better than a hot one. Let’s look at two funds in the three years that ended Dec. 31, 1996: $103 million Perkins Opportunity returned an annual average of 21.5%, but $481 million Delaware Trend A delivered just 12.4% annually. (By comparison, the S&P 500 averaged 19.7%.) So Perkins’ customers did a lot better than Delaware’s, right? Wrong. The average Delaware shareholder made 11.6%, while the typical Perkins customer actually lost an annual average of 5.8%.
How can this be? For most of the three years, Perkins was tiny; it didn’t surpass $50 million in total assets until September 1995. But it soon got noticed for its 70.3% return in 1995 — and $40 million poured in from April Fool’s Day to June 30, 1996. That raised the fund’s assets by 43% just as small stocks were imploding. In the second half of 1996, Perkins lost 22.7%. On its newly swollen asset base, that loss wiped out $32 million in shareholders’ wealth — $7 million more than all of Perkins’ investors had earned in the previous 2 1/2 years combined.
Now look at Delaware Trend. It began with $5.9 million in assets but grew more steadily over the three years. From April through June 1996, before that fateful small-stock crash, this fund took in a relatively scant 14% more in new money. Because most of its customers came in earlier, they got better average results — even though Delaware Trend had a much lower portfolio return than Perkins.
What really separates these two funds, then, is not the skill of their managers — it’s the behavior of their shareholders. Most of Perkins’ customers came in and went out at the wrong time; they were traders. Most of Delaware’s came in early and stuck around; they were true investors.
That contrast raises the third and biggest paradox about past returns:
The flashier the fund, the less likely you’ll profit. “Some investors have a perverse sense of market timing,” says economist Charles Trzcinka. “They buy at the top and sell at the bottom. The capacity people have to burn their own money this way is amazing.”
The gaudier a fund’s recent returns are, the keener this temptation becomes. That’s why nearly every fund we found with positive portfolio returns and negative shareholder returns was a small-cap, aggressive growth or sector fund. These are the categories most likely to post hot short-term numbers — and then, in the next market tumble, to spook all but their most devoted shareholders.
Here are the seven crucial lessons you should glean from our analysis of fund performance.
1. Don’t be tempted by “hot” returns. Remember, sizzling funds tend to make their gains in sudden streaks; the Van Wagoner fund rose more than 30% in the first three months of 1996. If you blinked, you missed it. Unless you think you can predict exactly when a manager like Van Wagoner will catch fire again, you should buy one of his funds only for the long term–five years at the very least. And don’t panic if he gives you a bumpy ride. That’s what he’s supposed to do; after all, if you don’t give him the chance to take greater risks, how can he get you a higher return?
2. Get ’em while they’re small. As I documented in “Today’s Hottest Funds Are Too Big for Their Britches” (Money, April 1996), tiny funds are often unable to sustain stellar returns when their assets grow rapidly. If a supernova fund — say, one that’s done twice as well as the market average — has already surpassed $100 million in assets, in my opinion you’re probably too late to capture much higher than average returns.
This rule can apply to families as well. When fund companies are young and fast growing, a disproportionate number of their funds will tend to produce high portfolio returns but low shareholder returns. That certainly doesn’t mean you shouldn’t buy a fund like Ron Elijah’s $643 million Robertson Stephens Value + Growth, but you shouldn’t expect to come in late and get the same juicy returns as the early birds–especially if you don’t invest for the long term.
3. Read the annual report. The performance history in the annual report can tell you whether a fund earned most of its return in a few short bursts or whether its returns (and asset growth) came in a more steady stream. If most of its gains occurred in a brief span, says Vanguard Chairman John Bogle, “then the returns have been earned by only some of the shareholders in only part of the period that the fund is bragging about.” That’s especially true if the big gains came when the fund was small. What you want is a fund that has continued to do well as assets have grown–as, say, Ralph Wanger’s $2.9 billion Acorn and John Laporte’s $4.4 billion T. Rowe Price New Horizons have done.
4. Concentrate on less trendy funds. Conservative funds that buy big, relatively cheap stocks, like $2.7 billion Davis New York Venture and $2.2 billion Neuberger & Berman Partners, are less likely to have investors stampeding in and out of them than, for example, the riskier funds run by AIM or PBHG.
5. Don’t kid around with sector funds. Portfolios filled with stocks from a single industry can produce wild swings in returns that challenge the staying power of any investor. The $200 million Midas Fund, which invests in precious-metals stocks, earned a 21.2% portfolio return in 1996–but, by our math, the average shareholder actually lost 14.5%.
And just look at the difference in returns at Dan Leonard’s $838 million Invesco Strategic Technology and Paul Wick’s $2.4 billion Seligman Communications and Information. At the Invesco fund, money came in gradually, so Leonard’s average shareholder made 24.3% annually in the three years that ended in 1996 — even better than the portfolio’s 23.2% annual return. But at Seligman, nearly all the customers stampeded into the fund in 1995, just before tech stocks crashed; so, while Wick’s portfolio earned 29.5% annually over the same three-year period, his average shareholder pocketed just 15.4%.
In my view, sector funds make sense only for people who fully understand the industry they are investing in and the riskiness of that narrow bet–and are willing to stay put for the payoff.
6. Embrace discipline. Anything that compels you to sit tight with your funds is a good thing. Some examples: dollar-cost averaging, which makes you invest a fixed sum at preset intervals over time; short-term redemption fees, which penalize you for selling too soon; and even those sales loads that we journalists have always told you to avoid. If paying a commission gets you a good broker who forces you to stay the course, it’s money well spent.
7. You get the returns you deserve. That’s one of my favorite expressions, and I think you should take it to heart. Back in 1970, the average investor held a fund for more than 16 years. Today the typical shareholder holds a fund for less than seven years. “The average holding period is so short it’s tragic,” says Vanguard’s Bogle.
Mutual funds are meant to be a long-term investment, not a trading vehicle. If you owned Michael Schonberg’s fund for a few months and sold it as soon as it dropped, you’ve got no one to blame but yourself. Your fund manager can make money for you only if you stick around long enough to allow his strategies to work. What’s more, your bad behavior makes his job even harder.
As Peter Lynch wrote in his book Beating the Street: “Shareholders play a major role in a fund’s success or failure. If they are steadfast and refuse to panic in the scary situations, the fund manager won’t have to liquidate stocks at unfavorable prices to pay them back.”
This is the only way to resolve the paradoxes of fund returns: Instead of loving and leaving a constantly shifting mix of hot funds, pick a handful of investments and marry them for the next five years, 10 years or longer. If you treat your funds right by standing by them for the long run, they should treat you right too.
￼Source: Money Magazine, April 1997