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The Hot Hand Vs. Passive Investing

Do individual investors chase hot managers of funds? It
would appear so. Is there a tendency to jump ship when an
investment or manager lags? That also appears to be the case.
Let's look at Morningstar Domestic Stock Manager of the
Decade, Bruce Berkowitz, and his fund, the Fairholme fund.

The Fairholme Fund(MUTF:FAIRX) recorded a 14% annualized return
from inception through the end of December 2010. The fund in
2011, however, landed at the bottom of the barrel in the
large value category , losing -32.4%! Since the fund has
run into heavy headwinds, investors have fled in droves
and the fund has shrunk from over $18 billion to less than
$11 billion in assets. These investors that sold have locked
in their losses.

Lest you would think this is an isolated case, let's look
at one of the most highly touted managers, Ken Heebner,
and his fund, CGM Focus(MUTF:CGMFX). According to a recent article
by Max Magee on Tickerspy(www.tickerspy.com/newswire/?p=1284),
the Wall Street Journal listed CGM Focus as Stock Fund
of the Decade. Its track record has been incredible this past
decade. Manager Ken Heebner led this fund to an 18.2% annual
gain in a decade for which the S & P 500 was in the red, placing
him tops among all domestic equity fund managers during the
last decade ending December 2010, besting the S & P 500 index
and Russell 1000 by 20 percentage points.

Since it has had such a good return, shouldn't you have put this
in your portfolio? Not so fast! First of all, with an average
turnover ratio of 333%, you could have ended up with a huge tax
liability, as in 2007, when CGM Focus declared a distribution of
$9.91 a share or 18% of the funds end of year share price.

Still want to chase these returns? Lest you think you can handle
this volatile fund, let's see what actual CGM Focus investors
made. According to Morningstar, most of the fund's investors did
not make 18.2% compounded, not even close. The average CGM Focus investor earned a negative 11% annually over the past decade! That translates into a total loss of 68.8% for the decade. This kind of return over an entire decade will definitely hamper your investment goals.

How could this happen? Well, let's take a quote from an interview
with Mr. Heebner." A huge amount of money came in right when
the performance of the fund was at a peak," says Mr. Heebner,
the funds manager since inception. " I don't know what to say
about that. We don't have any control over what investors do."

This herd behavior of investors and how they goof things up for
themselves is a huge lesson and must be recognized and understood in order to be avoided. So what did investors in the CGM Focus fund do in 2011? They bailed out just like the investors in the Fairholme fund. More than $630 million dollars have been pulled out from the fund, leaving
less than $2 billion in assets. These shareholders must not have been satisfied with a return of -26.3% in 2011.

Since it is obvious that investing in a hot performing managed fund is a losing game to many an average investor, what is the preferred course of action? Investing exclusively in individual stocks can add significant single company risk to a portfolio, if there are too few holdings. A far better approach would be to consider broad based, low cost, passively managed exchange traded funds(ETF's) for the bulk of a portfolio. As core holdings, this approach takes the hot or cold streak of the manager out of the equation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.