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Shopping for a New Mutual FundBy Jane Bryant Quinn
Tuesday, November 5, 1996
Conventional wisdom says that's dumb. Supposedly, a fund's past performance doesn't tell you how it's likely to fare in the future. But surprise, surprise- maybe it does. Some recent academic studies suggest that a hot hand persists, at least for a short period of time. In theory, you can fatten your investment returns by switching your money, every year, into the funds that have done the best.
Some caveats before I tiptoe into this controversial thesis. I'm talking only about well diversified funds -- not international, single industry or aggressive small stock funds.
Furthermore, what works on paper won't necessarily make you rich. You'll need time and discipline to pursue the hottest hands. Your reward may be marginal, after costs. Your quest will almost certainly fail if you pay sales charges when you buy and capital gains taxes when you sell. A hot hands strategy works best- if it works at all- for investors who purchase no load (no sales charge) funds, in tax deferred plans that offer a wide investment choice. Typically, that means an Individual Retirement Account or Keogh plan that you run yourself.
In a 401(k) plan that offers only a handful of funds, your best choice is still a combination of stocks and bonds that you buy and hold. But let's say you'd rather bet on some diversified funds that are rising fast. If they play them right, that's a gamble you won't regret, says Martin Gruber, chairman of the finance department at New York University's Stern School of Business.
In a recent, risk adjusted study of diversified U.S. stock funds during the decade ending in 1994, Gruber found that success breeds success, over short periods of time.
The study identified each year's top funds, all of them managed by investment advisers. Top funds tend to attract new money from investors. New money invested in managed funds earns, on average, 0.4 percent more than money invested in comparable index funds (an index fund follows the market as a whole).
After the first year, however, the picture begins to change. The gains on the money that was invested in managed funds begin to slow. In the third year, your hot fund probably won't be beating the market anymore. On average, Gruber says, the money that stayed in the managed mutual funds he studied underperformed the index funds by 0.45 percent.
In other words, if you want top performance, you have to switch mutual funds each year. If you don't want to move your money around, you're better off in plain vanilla index funds.
The simplest version of Gruber's system comes from Sheldon Jacobs, editor of the No Load Fund Investor in Irvington on Hudson, N.Y. At the start of each year, he invests in the highest ranked U.S. diversified equity fund (ignoring the internationals and the funds devoted to a single industry). Twelve months later, he takes his profits and rolls them into the next year's ranking fund. Had you followed this aggressive rule since 1975, a $1,000 investment would have grown to $78,108, Jacobs says, compared with only $15,534 for investors in the average fund.
How's he doing in 1996? So sorry you asked. Last year, Wasatch Mid Cap led the pack, but this year it died. Hot hands do turn cold. If the stock market drops, as often happens after a presidential election year, today's top performers could look bad. But so what? Jacobs' system guessed wrong in five years out of 22 and still produced super long term gains.
What if you'd rather buy stocks and hold them? For you, the hot funds run by money managers pose a risk, Gruber says. The longer you hold them, the greater the chance they'll underperform an index fund.
Gruber thinks buy and holders should keep their core investments in index funds- specifically, those with annual expenses under 0.3 percent. For the largest low cost selection stock funds, bond funds and internationals -try the Vanguard Group in Valley Forge, Pa. (800 662 7447). Over time, low cost indexers outperform most managed funds.
A few managed funds have defied the odds and yielded superior results, says Kurt Brouwer of Brouwer & Janachowski in San Francisco, who invests clients' money in mutual funds. His star list of stock funds currently includes Brandywine, Harbor Capital Appreciation, Oakmark, Selected American Shares (a no- load version of New York Venture) and Vanguard Wellington.
Jane Bryant Quinn welcomes letters on money issues and problems but cannot offer individual financial advice.