Sunday, December 20, 2009

Mutual Fund Front Running

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Among the games that mutual fund managers play to artificially boost reported returns, such as closing underperforming funds and fund incubation, you can add a practice called front running.

Larry Swedroe describes front running in his excellent book Rational Investing in Irrational Times. A fund family starts up a new fund hoping to report good returns and attract a flood of investors. They begin by choosing some stock that has low trading volumes so that a modest size purchase will drive its price up sharply.

The fund family then purchases a block of shares for the new fund. Then they purchase a larger block of shares for one or more of their large established funds. This will drive the price of the shares up and artificially inflate to apparent returns of the new fund.

Done correctly, the number of shares purchased for the established funds isn’t enough to make much of a difference to their returns. But, the new fund’s returns will look great and with a little advertising, new investors should flood in.

Of course, the reported returns don’t reflect any particular talent of the new fund’s manager. After the new fund swells, it isn’t any more likely than any other fund to do well. Investor’s should view the reported returns of any new fund sceptically.

2 comments:

  1. Good article.

    Too many investors make the mistake of chasing "5-star" funds. A better strategy is to buy a good fund when it is in the 4th quartile.

    - ThinkDividends

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  2. Think Dividends: Some analyses I've read say that there is almost no correlation between past returns and future returns in mutual funds. This would argue against your 4-star strategy if not for that pesky "almost". I suspect that your strategy is better than chasing the top funds, but that low-cost index funds are probably even better.

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