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Braden Holstege
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  • The Danger Of Chasing Mutual Funds 0 comments
    Jan 25, 2012 8:09 PM

    When investors go to chose a mutual fund, there is a tremendous temptation to throw out all their knowledge of portfolio theory and asset allocation, and instead focus only on a funds return record. Indeed, this behavior is reinforced by many popular consumption investments sites, which rank mutual funds on the basis of past performance and sell this to investors as valuable information. Investors will even be tempted to jump between actively managed mutual funds, aggressively trying to chase down returns greater than the broad market.

    This temptation, the drive to "chase alpha" for actively managed funds, in almost all cases a terrible idea for an investor. To demonstrate this, I have compiled data on Vanguard's 7 core actively managed mutual funds: Convertible Securities (MUTF:VCVSX), Managed Payout Distribution Focus (VPDFX), Managed Payout Growth and Distribution (MUTF:VPGDX), STAR (MUTF:VGSTX), Wellesley Income (MUTF:VWINX), and Wellington (MUTF:VWELX).

    Fund Name

    1 year Alpha

    3 year

    5 year

    10 year

    VCVSX

    -7.49

    4.91

    0.98

    0.25

    VPDFX

    1.24

    0.77

      

    VPGDX

    0.12

    -0.5

      

    VGSTX

    0.18

    0.03

    -0.79

    -0.103

    VWINX

    8.82

    5.06

    3.41

    2.28

    VWELX

    3.22

    0.77

    0.38

    0.1

    Absolute Avg.

    3.51

    2.01

    1.39

    0.683

    There are a couple important observations to be made here. The first is that if you took 1 year Alpha as a predictor of 3 year Alpha, you would get very poor correlation. The fund with by far the lowest 1 year value was close to the highest for the 3 year period. Indeed, I suspect that if you asked someone to match up values in a blind test from the 1 year and 3 year columns, they would be hard pressed to do so.

    But even more interesting is the trend line for the absolute average of alpha values (which is to say the average of the distance from an alpha of 0). At the 10 year time interval every single fund approaches the expected efficient market value of 0, and when we compare all funds across each time interval the average alpha gets closer and closer to 0.

    This is a quick example, not a rigorous statistical study. But those studies generally support my assertion: rapid movement between mutual funds chasing past returns is financially harmful. Trailing performance does not accurately predict future performance for a specific fund, and switching between funds incurs transaction costs and potential realization of capital gains.

    When picking a mutual fund, focus on the three primary factors of long term investment: the expected return of the funds underlying asset allocation, your risk tolerance to the expected variance of those assets, and the costs associated with the fund. Chasing alpha after the fact is a fool's game.

    Themes: Mutual Funds
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