Tuesday, November 6, 2007

Mutual Fund Mantra: Focus on Long-Term Returns

My last post discussed how mutual fund managers close, rename, and merge mutual funds with a history of low returns to hide their poor record. To counter this, investors are advised to choose funds with a long history of good returns. Typical advice is to focus on 10-year returns.

Investors do tend to choose funds with a history of high returns. However, they often focus on just the past 1 or 3 years of returns, rather than looking at longer periods. Not surprisingly, mutual fund managers are aware of this.

Because mutual fund managers are paid a percentage of their fund’s assets each year, they are motivated to attract as many investors as possible to the fund to drive up its total assets under management. This has led to an interesting practice among some mutual fund companies to drive up reported returns.

Incubation

Some companies start up several mutual funds with small amounts of private money and run them aggressively. After a while, the poor performers are closed and the strong performers are ready to be advertised to the public. This process is called incubation.

The returns on these incubated funds look great initially, and they attract a lot of investor money. Of course, once the managers have to invest a big pot of new money without the benefit of quietly closing losing investments, the returns tend to be just mediocre.

Incubating funds to get high reported returns is a bit like holding a lit match under a thermometer to warm a room. The thermometer will report a nice high temperature, but the room will be just as cold.

If the management company keeps an incubated fund open to the public after the first year or so, the returns during the incubation period can be dramatic enough to unrealistically influence even the fund’s 5 and 10-year returns.

I have no idea how to find out if a particular fund has inflated its reported returns with incubation. This makes it hard to put much faith in any mutual fund tables full of investment returns.

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