Mutual Fund Longshots

April 9, 2006

George Mason did very well in the NCAA playoffs: the underdog college basketball team got all the way to the final four. Few thought it was possible – the odds of the Patriots winning started out at a long shot 150-to-1. Such odds, which are set by experts and betting behavior, meant that almost nobody thought the Patriots would do as well as they did.

In fact, the Patriots were this year's Cinderella team – even beating favorites like UCONN and North Carolina. With sports, big upsets are quite rare. With mutual fund investing, the favorites often lose.

There is a high correlation between past performance and future performance in sports. Chances are, Tiger Woods will beat most other golfers this year. Mike Tyson, in his prime, was a near-guaranteed winner. Just having Michael Jordan on your team practically assured an NBA championship.

Betting on proven winners in sports is such a safe bet that bookies have to set high hurdles of success (point spread or regular odds) for such a wager to pay off – otherwise almost everyone would win all the time.

The main reason choosing mutual funds winners is so difficult is that just because a certain fund or manager has done well (beaten other funds) in recent years doesn't mean they will continue to do so going forward. As strange as it sounds, funds with strong three-year records have about the same chance of performing well over the next three years as a fund chosen at random.

With sports, unlike investing, skill is apparent, and luck doesn’t carry you very far. It is pretty clear who will win – so clear that odds makers in Vegas can determine, with a fairly high degree of accuracy, how many points one team will score in beating another. Fund odds makers are called analysts, and their record is far spottier. In mutual funds, streaks end.

Fund investors often follow the recommendations of various magazines, top fund lists and the like in placing their bets, or they make decisions that are based largely on past performance. Either way, they are betting on the fund beating most other funds, and the relevant index, or they would buy another fund or the index.

Certain funds bring in billions of dollars based on the assumption that the winning ways of the past will continue. These collective wagers tend to lose primarily because money changes the odds. In sports, the bookies change the odds based on inflows of money (bets). In funds, the money ruins the odds all by itself.

We have written extensively over the years about how inflows of money can dampen returns for a mutual fund going forward. Here is one way to look at it:

Unlike sports figures, fund managers have to carry their winnings with them into the game. They have to invest more and more money successfully and reproduce their past performance with the dough. If Michael Jordan had to carry all the money that was wagered on him in a backpack during a game, bookies wouldn’t have to put a big point spread on a Chicago Bulls game – the weight of the money would create a handicap that the underdog wouldn’t be burdened with.

Even worse, money ruins returns for all parties involved as more and more of it chases the same ideas. Eventually you have additional dollars making investments that simply can’t return enough to payoff all the investors. If everybody decided to open a pizza place in their town because a new Pizza Hut did, well, eventually everybody would be having financial problems because there would be more pizza than customers. What works for the few doesn’t automatically work for the many.

This is why some of the favored funds of recent years have performed so poorly. Go back to 2000 and the favorites were anything managed by Janus, Firsthand, Turner, Oak Associates, and PBHG. All went on to have multi-year “slumps” while the other funds won. Pick any fund with a strong record over the last five years and chances are, few investors were betting on it in 2000.

More recently, after the bear market, the “favorites” moved to new families and funds. Money literally was being transferred from any given Janus fund to Clipper (CFIMX), Jensen (JENSX), and Oakmark (OAKMX). These relatively unknown funds from the 90s brought in billions while Janus and others lost billions as shareholders departed in droves.

Today, these three favorites are at the bottom of the barrel. Throwing darts would have worked out much better. Over the last three years (compared to hundreds of similar funds) Clipper is in the bottom 1%, Jensen the bottom 4%, Oakmark the bottom 2%. You’d have done far better in just about any Janus fund – old favorites that started wining again once they stopped being favorites.

When a mutual fund can’t float like a butterfly, the shareholders often get stung.