That trendy new mutual fund is not your friend: James Saft

By James Saft

(Reuters) - Trendiness might be a good way to gain popularity in high school but it is a terrible way to pick a mutual fund, particularly a newly launched one.

Like in every area of human activity, fashion plays a role in investment management, both in terms of where people choose to put their money, and, in consequence, in what kinds of products the industry creates.

Mutual fund companies, ever alert to a new way to attract investors, try to ride the waves of trends. This has been going on for a long time, in varying guises, from the large-cap funds of the early 1970s “Nifty Fifty” boom to the technology and internet funds of the late 1990s right through to today’s “low-volatility” offerings.

And while there is nothing wrong with fund companies wanting to make profits, the question for investors is how well they will do out of the deal.

On the evidence of a new study, following the creation of more than 6,000 mutual funds over more than 20 years, not so well at all.

“The incentives to launch trendy funds exist regardless of whether the fund sponsor is skilled or expects future outperformance. Newly launched trendy funds generate significant additional inflows in their first twelve months, yet underperform over their first five years compared to non-trendy funds,” Jason Greene of the University of Alabama Huntsville and Jeffrey Stark of Bridgewater State University write. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2826677)

“Our results suggest that mutual fund launches appear to be motivated by considerations other than skill.”

There are two broad motivations for launching a fund, the authors posit. The first is skill, the belief that the manager has a particular skill or advantage which will create good results and thus attracts funds.

The second, and here we enter the realm of the trendy, is demand-motivated funds: those which are created because the manager thinks there is an appetite for a particular strategy.

The authors sort funds by trendiness, using fund names as a proxy and grouping them by how often descriptive words in a name are used in new funds. So, a fund with the word “Internet” in its name launched in a year with many other similarly named funds gets a higher score. So with “dividend” or “cautious” or any other given term.

A GOOD BUSINESS, BUT WHERE ARE THE CUSTOMERS’ YACHTS?

What they found was firstly that the business of launching trendy mutual funds is a good one. The trendiest new funds reap additional inflows of $180.25 million, equal to almost 75 percent of net assets, over their first year.

Interestingly, it is only the trendiest names which get much by way of extra flows.

Sadly, however, starting a fund in a hot or trendy area seems to be a recipe for underperformance. Looked at over the first five years after launch, the trendiest funds lag the least trendy by 1.03 percentage points annually on a standard measure of alpha, or outperformance. In raw terms, the least trendy fifth of funds make 6.85 percent a year while the most trendy return only 5.28 percent. In fact, using various measures of alpha, only the funds in the least trendy quintile show a positive alpha.

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And guess what? The trendiest funds also carry higher fees. Annual expense ratios for trendy funds are 20 basis points per year higher than those which are not trendy, a difference which is as much as the entire expense ratio of some passive mutual funds.

Two questions arise: why does this happen; and what should an investor do?

The study proposes that fund firms which lack a skill advantage are drawn to areas which are sexy and therefore will help to attract flows. That’s certainly possible and is very likely part of the story.

There is also the fact that trendy areas go hand in hand with high valuations and the creation of not just sub-par investment vehicles but sub-par financial assets. Part of what we are seeing here may simply be that if you buy into an internet fund in 1999 you are not just getting a mediocre manager but asking him to buy you expensive and doubtful assets.

Or take the current vogue for low-volatility stocks and funds. Demand has been so great that low-vol stocks are now as richly priced compared to high-volatility ones as they have been since the 1990s.

In other words, the study may partly simply show a weakness in momentum investment - buying what has just gone up - as a long-term strategy.

As for what one should do? That seems simple. Give trendy new funds a miss and go for the ones with out-of-fashion names and approaches.

Their fees are lower, and their results are better.

James Saft is a Reuters columnist. The opinions expressed are his own