A pioneer in fund tracking explains how simple errors can lead to lower returns in this article from the April 1988 AAII Journal.

Investing should be profitable, and for most investors it is. However, many individuals earn lower rates of return on their mutual fund investments than they should, given the risks that they assume.

Frequently, when analyzing suboptimal investment performance, I have found that the causes of inferior investment returns can be traced to one or more mistakes commonly made by investors. Elimination of these errors almost invariably would have increased investment returns. In some instances, avoiding these errors would have turned investment losses into gains.

Mistake #1: Setting investment return expectations too high.

Over the past 65 years, common stocks have returned an average of 12% annually. Thus, a well-diversified portfolio of common stocks of average risk—the average common stock mutual fund—can be expected to provide a similar rate of return in the future. Yet common stock investors have been spoiled by the bull market of the 1980s. Over the period 1982–1987, common stocks have returned an average of 17.7% per year even after accounting for the October market disaster. In three years out of the last six, common stocks have returned more than 21%. In addition, some mutual funds and investment advisers have been touting astronomical performance numbers. However, many of these advertised performance results are taken over short time periods, and they frequently represent investment strategies that embody significant risk.

The capital markets are reasonably efficient. That is, investment return is closely tied to investment risk. The pursuit of greater returns usually entails the assumption of greater risks. The unsuspecting investor who pursues a return of 20% or more annually must assume risks so large that they cannot reasonably be tolerated.

Remember, the goal of investing—whether using individual stocks or mutual funds—is not to get rich overnight. Reasonable returns obtained by the assumption of reasonable risks can pay off handsomely over time.

Mistake #2: Attempting to time the market.

The proliferation of no-load mutual funds has provided an easy mechanism for investors to time the market by switching among mutual funds. Yet, while there are times to be more heavily invested in common stocks than others, it usually doesn’t pay to jump in and out of the stock market on a frequent basis. So-called stock market timers are fond of pointing out how much you would have saved by avoiding severe stock market downturns, and they claim to have systems that can tell you when to get out in time. But despite claims to the contrary, market-timing schemes are not accurate enough to ensure larger-than-average returns over the long run. A study reported in the Harvard Business Review indicated that in order to ensure a return higher than that of a buy-and-hold strategy, a market-timing scheme would have to be right more than 80% of the time, yet most market timers attempt to be right only 60% to 70% of the time. Furthermore, market timers frequently fail to climb aboard a rising market in time, thus giving up substantial returns. Finally, although there are no transaction costs for no-load mutual fund investors, frequent trading results in the premature payment of income taxes on gains, which can wipe out any advantage of short-term market timing.

Mistake #3: Investing without knowing a mutual fund’s investment objective and portfolio management strategy.

Very few investors would turn over their hard-earned cash to an investment adviser without first knowing how the portfolio will be managed. Yet many individuals invest their life savings in a mutual fund without first finding out what will be done with their money.

Before investing in any mutual fund, obtain its prospectus, latest annual report and statement of additional information. First, study the statement of investment objectives: Do these agree with those you have set for your portfolio? If not, pass on this fund and look for another. Second, look at the portfolio of stocks listed in the annual report: Are these the type of stocks you would buy if you were investing for yourself? Finally, compare the fund’s year-by-year historical annual returns with those of the S&P 500 index. Be especially cognizant of the swings in fund return relative to the market return. A fund whose return swings more violently than the market return is riskier. The fund’s management most likely has chosen this course, and chances are that returns will continue to vary by more than the market in the future. The purpose of this exercise is to assess the roller-coaster ride you are in for during the next market cycle. If you can stand the ride, the fund is an acceptable investment. If not, look for a fund with a level of risk that is more tolerable.

Mistake #4: Selecting a fund merely because it was one of last year’s better performers.

Many investors select funds only because they were among the top performers during the previous year. However, to be a successful mutual fund investor, you must select the better-performing funds before the year begins rather than after it ends. History, at least in terms of top-performing funds, rarely repeats itself. Recently, I examined the return for the top-10 best-performing funds over a recent five-year period. Of the funds that made the top 10 list during the five-year period, only five made repeat performances. In addition, most of the stars of one year failed to even beat the market during the next year. In fact, of the top-10 best-performing funds in one year, only 35% managed to beat the market during the next year, even though 57% of all funds managed to beat the market during a particular year. While past performance is important, it must be considered in light of the risks that are taken, and it should not be the only consideration in choosing funds.

Mistake #5: Investing in a fund with a load.

The majority of dollars invested in mutual funds today have found their way into load funds, sold by brokers, insurance salesmen and financial planners who are compensated by commissions that can amount to more than 9% of the money initially invested in the fund. No-load funds are sold commission-free. What’s the difference, other than the load? The only difference is that no-load funds tend to outperform load funds by the amount of the sales commission or load.

Mistake #6: Investing in mutual funds with highly concentrated portfolios.

One of the biggest benefits to individual investors of mutual fund investing is portfolio diversification, which reduces risk without sacrificing long-term investment return. An investor would have to have a fairly large and diverse portfolio of individual stock holdings to achieve diversification on their own. This benefit is not provided by sector funds. The portfolios of these funds, while containing numerous stocks, are generally concentrated in a particular industry or market sector. Thus, the forces that drive the price of one stock down tend to drive all stocks in the industry down. As a result, sector funds possess a high degree of return variability—risk—which is not accompanied by greater return. The objective in using these funds is to forecast which one will perform the best during various segments of the market cycle. This is called sector rotation, and investors are supposed to move from sector to sector as market conditions change. However, guessing which sector will outperform other sectors over the short run is nearly an impossible task. While history tends to repeat itself, it’s not a Xerox machine. Investors who attempt to jump from sector fund to sector fund earn returns over the long run that don’t favorably stack up against the risks that they assume.

Mistake #7: Investing in option income funds.

Option income programs have been widely touted by stockbrokers in recent years as a means to increase income while reducing risk; some mutual funds have incorporated this same strategy into their investment objectives. The concept is straightforward. An investor writes (sells) call options on the stocks in their portfolio. A call option gives the holder (the purchaser) the option to buy a predetermined number of stocks at a predetermined price by a certain date. For this option, the purchaser pays the option writer a premium. The premium provides income to the option writer if stock prices remain stable; if stock prices fall, the premium partially makes up for the drop in value of the option writer’s stocks. However, if stock prices rise, the option holder will exercise their option and purchase the stocks at the stated option price; although the investor/option writer does not benefit from the price rise, they do receive the premium.

Although this strategy is supposed to produce extra returns with little added risk, this claim does not stand up under scrutiny. When stock prices rise, the option writer loses profit opportunities when the stocks are called away; when stock prices sink, the option writer is left holding stocks with large unrealized investment losses and the premiums received by writing calls usually pale when compared to the declines in portfolio value. In addition, the option writer must pay income taxes on all premiums, even if the underlying stocks have suffered a loss. For all of these reasons, this strategy never made a lot of sense to me, and this holds true for their use in a mutual fund, as well. In a mutual fund context, the strategy makes even less sense because you lose the tax swapping advantages of individual stock ownership.

A look at the performance of these funds underlines the point. When I compared the returns of all option income funds with a portfolio consisting of 50% common stocks and 50% Treasury bills, I found that none of these funds were able to outperform even this conservative low-risk portfolio.

Mistake #8: Investing in Ginnie Mae funds.

Ginnie Mae funds invest in Ginnie Mae securities, which are pools of mortgages whose interest payments and principal repayments are guaranteed by the U.S. government. Since home buyers’ monthly payments include principal and interest, holders of Ginnie Maes receive both interest income and a return of principal each month. This puts Ginnie Maes at a disadvantage to other fixed-income instruments. Why? Like other fixed-income instruments, Ginnie Maes are affected by changes in the level of interest rates: When interest rates rise, the price of Ginnie Maes falls, and when interest rates fall, the price of Ginnie Maes rises. However, Ginnie Maes suffer from an additional interest rate risk: When interest rates fall significantly, home buyers opt to refinance; Ginnie Mae holders are repaid the principal amount of the note and are left to fend for themselves in a lower interest rate environment. Thus, although Ginnie Mae prices rise when interest rates fall, they do not rise as much as other comparable fixed-income instruments. As a result, government bonds, which are also guaranteed by the U.S. government, tend to produce greater rates of return over short-term periods than do Ginnie Maes.

I recently compared the returns of all Ginnie Mae funds with the total return on long-term government bond funds over the last five years. From 1983 through 1987, the average long-term government bond fund returned a total of 92% while the average total return on available Ginnie Mae funds was 70%. Investors seeking current income will find that investing in bond funds of comparable risk will generally produce greater returns than investing in a Ginnie Mae fund.

Mistake #9: Investing in funds with high portfolio turnover.

The more frequently a fund manager trades securities, the greater is the fund’s portfolio turnover ratio and the greater will be transactions costs, which will lower net investment returns. This can be seen in a study I did that compared the returns from 1984 through 1986 of the 20 equity funds with the highest and lowest portfolio turnover rates. The turnover ratio for the high turnover group averaged 203% per year (which means that, on average, a security was held for six months), while the ratio for the low turnover group averaged a scant 20% (on average, securities were held for five years). The compound three-year total return for the high turnover group was 34.1%, while the low turnover group returned 50.7%—a difference of nearly 17%. Clearly, the low portfolio turnover funds had the edge over the high turnover group.

High portfolio turnover funds also tend to pay larger capital gains distributions than low turnover funds. This is bad news for taxpaying investors. The early payment of income taxes on such distributions reduces net investment returns even further.

Mistake #10: Selling out on market declines.

Bear markets frighten investors. Day after day, they watch the market value of their portfolios decline. After a while, many investors become so upset that they sell out—usually at or near the market’s bottom. The wise investor, on the other hand, uses these temporary dips in stock prices to accumulate more shares. He knows that after a while, prices will stop falling and reverse direction. While some stocks that head south in a bear market never rise again, diversified portfolios always head to higher ground once a stock market decline runs its course.

These are the 10 most common mistakes that I have seen mutual fund investors make. Avoid them, and you’ll improve your long-term investment returns. Although the annual improvement in investment returns may appear small compared to the claims of some advisers who tout returns two and three times the market average, they will pile up over time. 

Related

Mutual Funds

The Top Mutual Funds Often Don’t Continue to Outperform

Related

Mutual Funds

Qualitative Guidelines for Mutual Fund Selection

Related

Mutual Funds

The Truth About Top-Performing Mutual Fund Managers