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Mutual Funds: Look Before You Leap
By Dorothy Brady
Contemplating diving into mutual fund investing but don’t know where or when to jump? The sheer number of choices can make your head swim. Over the past 30 years, the number of mutual funds being traded has grown from a few hundred to over 8,000. Some investors rely on friends’ success stories, read investment magazine headlines, or simply choose a fund at random.
But if you want to decipher a prospectus, learn the rules of the game, or plan a mutual fund strategy, tune into the advice of McCombs School Finance Professors Keith Brown, Ron Kaniel, Laura Starks, and Sheridan Titman. Their research has turned up tips you can use.
Read the Fine Print
Most individual investors think they are directly investing money when they buy a mutual fund. What they are really doing is turning their money over to someone—a mutual fund manager—to invest for them. The fine print in mutual fund prospectuses contains the details of the contracts that carefully define the relationship between investors and professional money managers.
Frequently, these contracts place constraints on the manager’s behavior. UT professors Keith Brown, Andres Almazan, and David Chapman, along with Murray Carlson of the University of British Columbia, wondered, “Why would an investor trust a manager enough to turn his money over to him, but then dictate what he can and can’t do with it?” They explored the type and frequency of the restrictions in mutual fund contracts and investigated how they affect investors.
Brown and his colleagues found three general categories of restrictions: those against the use of leverage, or borrowing additional funds to increase risk in the portfolio; those against derivatives, or coupling stocks with other securities to change payoff patterns or risk profiles; and those against having securities in the portfolio that aren’t liquid, or easily sold.
The good news is the restrictions work in the investor’s favor. Most mutual fund contracts base managers’ compensation on performance. “A manager who gets $100,000 as a base fee plus some percentage of the fund’s relative return performance might have the incentive to take on more risk than you as an investor might like,” explains Brown. Constraints are used as a passive way to make sure managers are working on your behalf instead of in their own self-interest.
Observe the Fund Over Time
Consumers also need to be aware of the strategies managers use to win their investment. Competition for your dollar is a key element in the research of Keith Brown and Laura Starks on what they call the “tournament” structure of the mutual fund market. “Though service counts, when it comes to attracting new investors, the emphasis is on returns,” Starks says.
Since the mid-1980s when Money magazine and The Wall Street Journal began publishing the rankings of mutual funds against an index, Starks and Brown have found that managers falling below the median of their peer group may have the incentive to increase risk in an effort to raise their relative performance ranking. Though not a major problem, investors can keep an eye on the consistency of their fund’s holdings by monitoring them on Bloomberg, Morningstar, or one of the other financial information Web sites.
Invest at the Right Time
The timing of your investment can also make a difference. Ron Kaniel and his colleagues studied evidence of the questionable practice of funds marking up their holdings. Some managers of high-end funds may artificially drive up the price of a stock in their portfolio on the last day of a quarter to increase the fund’s value. But since the inflation is artificial, it is in essence reversed the next day.
To make the best of this possibility, investors may be tempted to buy into equity funds on the second-to-the-last day of each quarter and then sell the next day to capture the inflation with little risk. However, it’s not realistic, Kaniel says, given prohibitive transaction fees. Instead, investors should simply not buy at the end of a quarter, but wait one day and buy on the first day of a new quarter, rather than at the end of a quarter. This might seem a minor concern—“Who is investing on New Year’s Eve, anyway?” says Kaniel.. “But, because month-ends are common investment dates in automated investment plans like 401k’s,” says Kaniel, “it is potentially serious.” To avoid the effects of managers leaning to the tape, investors participating in such plans should make sure their paychecks are deposited on the first day of the month rather than the last.
Learn How Fees Figure In
Take a good look at your manager’s compensation. In 1971 under the recommendation of the SEC, Congress prohibited manager fee structures that stipulate a bonus for beating the Standard & Poor 500 Index unless they also call for an equivalent penalty if the returns fall below the benchmark. Starks and colleagues looked at what happened to the funds that had to change their fee structures in response to the ruling, and found managers’ strategies did become less risky.
Investors can take advantage of new fee structures such as “fulcrum fees” instituted by one mutual fund, where bonuses as well as penalties are given, depending upon how it compares to the index.
Is There a Winning Strategy?
There’s no sure-fire way to beat the market, but you can take steps toward maximizing your returns. Titman describes a strategy that has been successful for investors in the past. Using the “hot hand” strategy, an investor buys the funds that performed best in the preceding quarter, holds them for a quarter, and then sells them off and begins again with that quarter’s hot funds.
“This strategy has actually made a lot of money,” he says. “It turns out that it wasn’t manager expertise in stock selection that was driving the returns, but rather the momentum of the individual stocks in the portfolio. Over the past 60 years there has been a tendency of stocks that have performed well over a 3 to 12 month period to continue to outperform the market in the following year.”
To take advantage of this momentum, an investor has two choices: buy the mutual funds that were hot for the last three to six months, or buy individual stocks that performed well. The advantage of the mutual fund strategy is that it requires lower transaction costs. “Both strategies worked, but I want to stress the past tense,” cautions Titman. “Academics are great historians,” he laughs, “we can explain the past—we just can’t predict the future.”
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