Investors are not loyal when it comes to their mutual funds, according to Forbes. They'll abandon a poor performer in favor of the newcomer with impressive credentials. But based on research from Yale University Professor Owen Lamont and the University of Chicago's Andrea Frazzini, it is likely that a new fund's positive returns may go South after six months.
This is a complete turnaround by academics and investors alike, who have previously suggested that latching on to new winners was the way to go. Two studies by the Journal of Finance in the late 1990s, for example, found the mutual funds that brought in new money resulted in better short-term returns.
The favored fund's hottest six months, however, are often a prelude to the portfolio's downturn, Frazzini and Lamont's research shows, based on market data from 1980 to 2003. The researchers suggest there are two logical ways to handle this downturn: avoid the hot funds completely or keep moving on to the up-and-coming performers.
"If you consistently bought every fund that did well in the last six months and held it for six months, that would be smart," Lamont said, setting aside the consequences of the capital gains generated. "But what everyone is doing, on average, is not that. They are overweighting the funds that have done well for years and holding on to them for several years."
Case in point, by the end of 1999, Cisco Systems, the stock du jour, had 18% of its shares in mutual funds. The already-soaring stock price was inflated by the excess demand, which resulted in Janus shareholders taking a hit when the tech bubble burst.
On the other side of the coin, cautious investors who stayed with Fidelity's more traditional offerings with smaller inflows, such as Federated Department Stores, fared better. Federated stocks went on to triple in the next five years.
Frazzini and Lamont offer the Dodge & Cox Balanced Fund and Fidelity Diversified International as two funds that have had large inflows in the last two years, making them ideal candidates to be underperformers in the future.
Among the small mutual funds on a hot streak for the past six months are Delaware US Growth-A and the Fairholme Fund. Their popularity is most likely the sign of a fund manager who will keep beating the market, but only for the upcoming six months.