Short-Termism: When Volatility Leads to Performance-Chasing

By Drew P. Wilson, CFA
This is the final in a series of posts about short-termism from FAM Value Fund Co-Manager Drew Wilson.

Human nature leads investors to strive for maximum returns and our industry may further condition them to always seek more, often in comparison to others. Investors feel compelled to chase performance – to sell funds (fire managers) that are underperforming and buy those funds (hire managers) that are outperforming. After all, how can one be maximizing returns if someone else is doing better? For financial advisors the temptation to chase performance may be amplified when a client asks the seemingly fair question, “Why are we keeping this underperforming fund?”

 

In a July 2014 Vanguard research study titled “Quantifying the Impact of Chasing Fund Performance,” the mutual fund firm found that performance-chasing strategies often diminish returns. The study used actively-managed, U.S. equity mutual funds available in Morningstar’s database that had been in existence for at least three of the 10 years ending 12/31/2013 (3,568 funds). With respect to this universe of funds, Vanguard took Morningstar’s nine style categories based on blend, growth, and value subsets of large-, mid-, and small-cap funds, and looked at hypothetical results for each based on buy-and-hold and performance-chasing approaches.

 

The buy-and-hold strategy was simple: invest in any fund, sell only if the fund was discontinued, and replace a discontinued fund with one of the median-performing equity funds within the style box.

 

The performance-chasing strategy invested in any fund that had above median 3-year returns for the period 2004 to 2013. Funds that achieved below median returns for a rolling 3-year period were sold and replaced with a fund that achieved an average annual return within the top 20 performing funds over the prior 3-year period. The results, detailed in the chart below, were conclusive: a performance-chasing approach may, in practice, be a hindrance to building wealth. *

* Source: Vanguard, “Quantifying the Impact of Chasing Fund Performance.” July 2014

We know the symptoms, but what’s the cure for short-termism? How should investors steel themselves against behavioral and external factors that may lead them to attempt to time the market or chase performance?

As advisors well know, the key is to have a comprehensive, understandable, long-term investment plan that can serve as a foundation. It is hard to stay the course if you do not know the course. In my view, performance against that plan should be the primary yardstick – not what others’ returns are or whether all your money managers are number one across multiple time periods.

When investors adopt long-term perspectives, the businesses in which they invest may very well do the same over time with their internal investments. I believe this prescription could be healthy for our economy and, by association, for investors’ long-term returns.

Please see Fenimore disclosure.