Previously, we discussed the pitfalls of investing based on past performance, citing two mutual funds: Bill Miller’s Legg Mason Value Trust and Ken Heebner’s CGM Focus fund.
Factors that halted their period of outperformance and contributed to a stretch of poor returns, were the financial media elevating these fund managers to star status. The hype and obsession with past performance resulted in massive inflows of investor cash. Even for a superior manager, substantial cash inflows can overwhelm the ability to rationally invest in attractive investment ideas.
Other examples of mutual funds stung by their own popularity were the Janus family of mutual funds, which have never been able to regain the prominence they reached during the dot-com bubble. The Fidelity Magellan Fund achieved a 13-year, 29-percent annual return under Peter Lynch who retired “on top” in 1990. Magellan continued to grow its assets to $100 billion, becoming the world’s largest mutual fund, and yet, despite several high-profile managers since, the fund was never able to again materially outperform an index fund. Magellan has shrunk back to $21 billion following investor withdrawals and a large capital-gain distribution in 2006.
Conversely, encouraged by the financial media, investors have also made the mistake of abandoning solid mutual funds at the wrong time. Back in the late 1990s, Robert Sanborn, respected manager of the Oakmark Fund, was widely castigated in the press for not steering the fund into technology stocks. Oakmark had performed well throughout the decade, but stumbled, losing 10.5 percent in 1999. The media scrutiny and investor outflows (that left presumably to chase tech stocks) led to the defiant Sanborn’s firing in March 2000—the very month the NASDAQ market peaked.
Don Yacktman, who was Morningstar manager of the year in 1991, began to struggle during the late 1990s tech bubble. Investors bailed out of the Yacktman Fund, whittling its assets down from $1.1 billion in 1997 to $88 million by March 2000 when Mutual Funds Magazine named him “Flop of the Year.” Since then, the Yacktman Fund has returned over 13 percent annually versus the markets’ negative-7-percent return.
The venerable investment research firm Morningstar is tops in the field when it comes to analyzing mutual funds. However, several studies have concluded that its ”Stars Ratings” system—used by many investment advisers to select mutual funds—is a poor predictor of mutual fund returns, namely because the stars system is based solely on past performance.
Of course, what really counts for any investor is what his return will be going forward. One study concluded that managers with a disciplined and consistent strategy tend to outperform.
To achieve outsized returns, whether in mutual funds or individual stocks, investors must avoid the hype and reliance on past outperformance (rearview mirror investing), and instead find ignored and undervalued investments that few investors are willing to buy. To paraphrase Wayne Gretzky, an investor should “skate to where the puck is going, not to where it has been.”
A few examples to ponder: Should one invest in the Fairholme Fund, run by Bruce Berkowitz, a smart value manager with good results, who is getting plenty of media attention and investor assets? Given one choice, would you purchase Apple Inc. stock or Eli Lilly shares?•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or [email protected]