Morningstar fund ratings foster short-term investment focusFrom quick bucks to fast dollars, our common lingo is filled with expressions reflecting a short-term mindset about investing our hard-earned wealth. Many within the financial industry and popular press further fan the flames of our worst, reactionary investment habits – the kind that causes us to chase yesterday’s news rather than position ourselves for future expected growth. In other words, taking a short-term outlook in one’s investment strategy is a fast path to achieving buy-high, sell-low results – exactly the opposite of your true goals as an investor. Fortunately, by recognizing the problem, we can begin to consider preferred solutions.

The Short-Term Investment Mindset: Exacerbated by Morningstar Ratings

At a recent State Street and CFA Institute conference I attended, former investment bank chief executive Sally Krawcheck told a story about a fund manager that illustrated her view on short-term investing, and how Morningstar’s ratings are among the original sins that lead to it. Krawcheck related the anecdote of one well-known, unnamed fund manager sweating bullets in her office one December 31st over a few tenths of a percent in his/her fund’s performance for the year. Implicit in the fear was the notion that a decline in the fund’s Morningstar ratings would lead to a loss of assets invested in the fund and therefore revenues for the fund. The evidence indicates that the manager’s career fears were not entirely unfounded:

“In 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds. … Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories.” – David Swensen, The Mutual Fund Merry-Go-Round. New York Times, August 13, 2011.

The Challenges Everyday Investors Face

While a fund manager may live or die on a tenth of a point, end investors are far better off adopting a long-range view with their own holdings, despite some of the challenges that stand in the way.

  • Challenge #1: The press and media perpetuate the notion of picking winners. Financial magazines and newsletters constantly trumpet the five or ____ (fill in the blank) funds you “have to” own to best position yourself for the current/next recession/recovery, or otherwise achieve success in ______ (fill in the blank). To be sure, there are articles on the value of wise diversification, keeping costs low, and developing a long-term strategy, but those decidedly less-exciting articles do not sell magazines the way hot (if pointless) tips do. Remember the media’s motivation:

“You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.” – Steve Forbes at the Anderson School of Business UCLA on April 15th, 2003.

Then there is a whole channel devoted to picking winners and timing the market: CNBC. While the experts interviewed can be informative, the general banter is most often speculative noise focused on tidbits of news and price movements. Their primary objective:

“Except for PBS, all of us in broadcasting and cablecasting only get paid if you watch our programming. Period. If you don’t watch and don’t get sucked into the subtle ads (precisely timed and priced) we get paid to air, then we don’t get paid. You make the decision. You. It is TV, not education.” – Former employee of CNBC on Bogleheads discussion group.

  • Challenge #2: Most mutual fund companies and managers focus on the short-term. State Street’s The Influential Investor, borrowing from John Bogle, notes (emphasis ours): “Between 1945 and 1965 the average fund held a typical stock for about six years in the 1940s and 1950s. By 2005, the holding period had compressed to 11 months.”Competition to find the winning stocks and bonds and avoid the losers is fierce, especially among talented fund managers with significant resources. As a consequence, fund attrition over 10 years exceeds 40% with less than 1 in 5 stock funds and 1 in 10 bond funds outperforming their benchmarks. For further details, see Investment Lessons from Mutual Fund Performance. When the Chips Are Down: How Underperformance Changes Fund Manager Behavior describes increased short-term orientation and its sources, including: fear of getting fired, a tendency to cut losses, loss of confidence, and declining objectivity.
  • Challenge #3: Investors also focus on the short-term. The onslaught of marketing lulls us into mistakenly believing that the search for winners is the only logical way to invest. Both retail and institutional investors ranked performance first, according to State Street’s The Influential Investor, ahead of unbiased high-quality advice, client service excellence, transparency, and many other value drivers.

Adopting a Long-Range Strategy to Guide Your Way

As an antidote to short-term orientation, it is good to step back and consider the following three Investment Lessons from Mutual Fund Performance.

1. Choose Your Friends Wisely. When you send your teenagers out in the world, you hope they’ll associate with peers who nurture their sensible side rather than feeding their herd behavior. Similarly, we seek to put investors in touch with the fund managers, financial press representatives and advisor community who have demonstrated a patient, long-term outlook in their own activities, just as investors themselves are advised to do. Dimensional Fund Advisors and Vanguard’s low-cost funds, as well as selected ETF’s, come to mind as adhering to the tenets of patient investing. Some of our favorite financial press includes Jason Zweig, Larry Swedroe, and Tara Siegel Bernard.

2. Before You Invest, Understand. Successful mutual fund investing is not simply a matter of choosing a fund that has a winning track record, despite financial media features on yesterday’s top-performing funds and their star managers. It’s no accident that even Morningstar itself emphasizes (repeatedly) that past performance does not predict future success. That’s because:

  • Fierce competition by investors to buy bargain stocks and bonds and sell/avoid overpriced stocks and bonds makes it difficult for funds to outperform their benchmarks. [Benchmarks are composed of stocks or bonds with similar characteristics (e.g., the S&P 500 Index or Russell 1000 for large US companies].
  • Most funds underperform.
    • High fund management costs drag performance down unless offset by great stock/bond picking and timing. This is difficult when so much research and so many resources are devoted to outperforming.
    • Excessive stock turnover (short holding periods) can translate to higher transaction costs, and can raise prices for large purchases and lower prices for large sales.
  • Even if you are able to identify a fund that beats it benchmark, the odds that superior performance will persist is low. The question of whether a fund manager is skillful or lucky is always present.

3. Manage What You Can Control; Avoid Being Distracted by the Rest. In lieu of popular but ill-fated attempts to chase past performance or future predictions over which you have no control, we recommend focusing on the factors that are within your ability to manage. In particular, build in those factors that academic inquiry has indicated contribute significantly to investors’ expected returns. These include:

  • Managing fund costs and other expenses.
  • Allocate your holdings according to the fundamental drivers of performance, which includes accepting appropriate levels of market risk to reflect your need for commensurate reward.
  • Diversify your holdings globally, to minimize the risk you must take on as you seek market returns.
  • Locate your investments for tax-efficiency.

If this basic advice is so effective, why don’t you hear about it more often? Maybe it’s because “Adopt a patient, evidence-based approach to building a long-term, globally diversified portfolio according to your own well-planned personal goals” just isn’t quite as catchy as, “Ten Stocks You Must Own [or Dump] TODAY.”

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This blog entry is distributed for educational purposes and should not be considered investment, financial, or tax advice. Investment decisions should be based on your personal financial situation. Statements of future expectations, estimates or projections, and other forward-looking statements are based on available information believed to be reliable, but the accuracy of such information cannot be guaranteed. These statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results and no representation is made that any stated results will be replicated. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

Links to third-party websites are provided as a convenience and do not imply an affiliation, endorsement, approval, verification or monitoring by Granite Hill Capital Management, LLC of any information contained therein. The terms, conditions and privacy policy of linked third-party sites may differ from those of this website.