A P: Never chase performance

In India, chances of mid-cap stocks outperforming the broad market are limited

There have been numerous studies highlighting how poorly mutual fund investors have done despite generally rising markets over 20 years. There was a famous article in Forbes (Dec 22, 2003) titled "Our Own Worst Enemy", which highlighted the fact that mutual fund investors have let more than a trillion dollars slip through their fingers in the US over the past decade alone, and all because they were trying to chase performance.

By chasing performance, one means the tendency of investors to pour money into the latest hot sector, investment style or mutual fund complex which has had strong recent performance. In the year 2000, investors poured unprecedented amounts of capital into technology funds (at the height of the tech bubble) because they had shown 2-3 years of great performance.

Investors adopting this approach are investing looking in the rear view mirror, continually betting on yesterday's winners and projecting out a few years of good returns infinitely out into the future. They are going against the tenet of reversion to the mean, and end up suffering as a result.

The data on this suffering are quite amazing, based on work done by Dalbar (a Boston-based market research firm), which has done extensive surveys of the results of mutual fund investors' behaviour.

Its 2004 report, "Quantitative Analysis of Investor Behaviour", comes to the sad conclusion that the average mutual fund investor in the US has only realised an annual return of 3.51 per cent (from equity mutual funds) compared to 12.98 per cent for the S&P 500 over the past 20 years.

Some of this poor relative performance can be traced to the funds themselves underperforming their benchmarks but the majority of the performance gap can be traced to investors trying to time the market/investment style or chase performance.

Dalbar has segmented the data into those investors who are systemic or consistent investors (investing on a regular basis independent of market movement) and those who are trying to time the market (investing more when markets are rising and moving money across sectors and value and growth styles, depending on recent performance).

Those who tried to outsmart the market actually realised a negative return of -3.29 per cent per annum over the past 20 years, while the more steady investor had realised returns of 6.8 per cent per annum.

Chasing performance and trying to play short term momentum have had very serious consequences as the above data and numerous other studies clearly indicate. The question then is that why this still happens when the data are so unambiguous.

One answer is because of the human tendency to fall prey to what behavioural finance gurus call the Recency effect. This is the tendency of investors to attach more weight in their decision-making process to any event that has just happened.

Investors basically have a strong tendency to look at their recent past experience and extrapolate that into the future. Thus, if investors have made good returns in an emerging market fund and lost money in a bond fund, their natural tendency is to put more money into the emerging market fund and reduce their allocation to the bond fund (basically chase performance).

Another aspect of why this happens is the role of the mutual fund marketing and distribution machine. The mutual fund shops have churned out various variants of sector and style (growth versus value) funds to exploit whatever may be the latest fad.

They fully understand investors obsession with short-term returns and do their best to serve this desire to chase performance. It becomes easy for the fund company to raise billions of dollars and all the management fees that come with these inflows.

All they have to do is promote their most recent best-performing fund through full-page ads, touting its recent superb (but unlikely unsustainable) performance or launch new funds playing into the latest hot sectoral- or style-fad.

It is a sad fact of the mutual fund business that the maximum money is normally raised for a particular sector- or style-fund just when it is the worst time to be adopting this investment approach. However, can you really fault these funds? They are running a business after all.

The more important issue for serious investors is how they use this clearly demonstrated bias of the typical retail investor for their benefit. If investors adopt more independent thinking and a contrarian approach, their investment results should improve.

Work done by Evergreen Capital Management and quoted by John Mauldin indicates the efficacy of such independence of thought.

They have analysed mutual fund flows into and out of various style-specific categories from 1979 to 2004 (e.g. large cap growth) and found a clear inverse relationship between extreme inflows/outflows and subsequent returns. The critical element is to look only at extreme flows and also combine these with a view of the underlying fundamentals of the asset class.

For example, when inflows into large cap growth funds are at an extreme and the stocks are at stretched valuations, the odds are very high these types of stocks/funds will underperform the broad market over the coming two years.

In the work done by Everest, they find that the odds are as high as 77 per cent that whenever one sees extreme inflows/high valuations in any category of stocks/funds, these stocks will underperform over the subsequent two years and that too by -4.9 per cent per annum.

Similarly, the odds are nearly 91 per cent that if one sees a category of stocks like mid-cap stocks, experiencing outflows/cheap valuations, they will outperform and that too by nearly 9 per cent per annum over the next two years. Again this underperformance is over a two-year horizon, though positive momentum may persist in the short term.

While these results apply to the US, dealing as they do with human psychology, they are applicable also globally. The phenomenon of retail investors chasing performance is seen everywhere, remember all those tech funds launched in India in the beginning of 2000 and their subsequent fate.

The idea of serious investors with an independent mind being able to use this herd mentality to go against conventional wisdom and outperform is also as applicable to India as anywhere else.

As for what all this means for today's marketplace, I think the clear issue is with the current craze on mid-cap stocks in India. One is seeing every mutual fund complex in the country launch special mid-cap schemes, and attract large sums of money.

Even among the foreign players there are numerous hedge funds being set up, specialising exclusively on Indian mid capitalisation stocks, and all the foreign brokerages have now special mid-cap stock analysts.

Even if one were to look at the fundamentals, the mid-cap universe is now trading at a higher valuation multiple than its large-cap brethren, something which is unusual and had only happened previously in 1994-95, after which these stocks got crushed.

Even then, like today, the mid-cap stocks had two years of great relative performance, and got discovered and hyped, after which the stocks collapsed, got massively de-rated and became illiquid. Could it happen again?

One clear conclusion should be that the odds of mid-cap stocks as an asset class outperforming the broad market over the next 2-3 years in India are limited. There will of course be some great mid-cap stocks that will perform well but the category as a whole is unlikely to maintain its superior performance.

Investors pouring fresh capital into mid-cap funds/stocks today should be aware that the odds are not on their side.