Guess what? Buy-and-hold works

If an investor can hang on during short-term periods of underperformance, it turns out the old buy-and-hold argument for well-managed mutual funds may be right after all. That's one of the key take-aways of research conducted by Robert W. Baird & Co. Inc. The firm recently analyzed nearly 400 equity mutual fund managers who have been able to beat their benchmarks with less volatility over the past 10 years. Even top portfolio managers, however, can look lost from time to time. Of the 370 mutual funds that made the cut by consistently beating their benchmarks by at least 1 percentage point on a 10-year annualized basis, a quarter experienced 12-month stretches when they underperformed their benchmarks by 15% or more. And 201 funds had 12-month periods of underperforming their benchmarks by 10% or more. “There are always going to be short periods when portfolio managers can look foolish, but the value is added over longer periods of time,” said Aaron Reynolds, a senior portfolio analyst at Baird. Considering a slightly longer perspective, the research found that 25% of the funds underperformed their benchmarks by 5% or more annualized during a three-year period. And half of the funds underperformed their benchmarks by at least 3% annualized during three-year stretches over the 10-year period ended Dec. 31. Such short-term underperformance, combined with adjustments to popular fund ratings, can lead to investor mistakes, according to Mr. Reynolds. It is no surprise that investment flows tend to follow the ratings systems used by firms such as Morningstar Inc. But by allocating assets based on stars, investors are unwittingly moving away from performance potential. Over the 10-year study period, whenever one of the funds received a rating upgrade to four stars, from three, or to five stars, from four, the net inflows over the next 12 months averaged $14 million and $331 million, respectively, per fund. But when a fund in the group studied was downgraded to two stars, from three, it experienced average net outflows of $65 million over the next 12 months. When the star rating dropped to one star, from two, the average fund had net outflows of $257 million over the next 12 months. This is a vivid illustration of how perverse investor behavior — buying high and selling low — is reinforced by the awarding of an additional star after a period of strong performance and the removal of a star after a fund has underperformed. “Sometimes it's too easy to just throw in the towel when the market takes a tumble, which is what we saw in 2008 when investors moved heavily out of stocks and into bonds,” said Jeff Tjornehoj, senior research analyst at Lipper Inc. “From a high-level view, discipline is what investors need the most,” he added. “Unless you have the gift of market timing, market cycles will take you for a ride.”

IT PAYS TO STAY

As the past few years have illustrated, the ride can be frantic at times, but staying put with a good manager has a history of paying off. Using the star ratings again as a proxy for performance cycles, the Baird research shows that over the three years following a ratings change, the downgraded funds on average outperformed the upgraded funds. The average annualized return in excess of the benchmark of funds upgraded to four stars, from three, was 1.4 percentage points, while funds upgraded to five stars, from four, beat their benchmarks by an average of 1.7 percentage points annualized over the next three years. Meanwhile, funds downgraded to two stars, from three, and to one star, from two, beat their benchmarks by an average of 2 and 2.1 percentage points annualized, respectively, over the next three years. “Investors need to remember that when they invest in a mutual fund, they are investing in the portfolio manager, not a short-term track record,” Mr. Reynolds said. “And the ideas that the manager is investing in won't always be in sync with what the market is rewarding.” Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.