In conversations I have with investors, one of the biggest mistakes I see people make is to chase returns. One of the most common ways is when an investor sees an article in the paper, or possibly a Morningstar report about a particular asset class or mutual fund/ETF that has been having an amazing year with double digit returns. They look at it and think they are missing the boat on this and need to get on board. The problem here is by the time it has made the news, it is old news and they have missed much of the upside. In many of cases people find themselves experiencing Newton’s Law of Physics of “what goes up must come down” where as soon as they get on board, the asset class that was driving those returns start to correct. Now this great investment turns out to be a future tax loss.
The other way I see this is within mutual funds/active ETFs investors currently own. Most of the time this will happen when comparing a mutual fund managed by an active manager to the stated benchmark of the fund and you feel it is not keeping up. They originally got into the fund because they did the right research. The methodology the manager is using to manage the fund makes since and it matches what they are looking for in the fund. They look at the performance track record and it was giving them the returns that are acceptable for what they want out of the fund. They have owned it for a handful of years with no issues, but then the manager seems to hit a bad patch and the investor starts second guessing themselves and contemplates replacing the fund, which in the long run would have been the wrong move.
Do these scenarios fit your investing patterns? If so, how do you avoid chasing returns and making these mistakes? People need to take a deeper look as to why this was happening. Much of the time the benchmark that you are looking at to compare to can be a deceiving indicator of performance. For example, much of the positive performance of the Russell 2000 small cap index this year can be attributed to the performance of the Utility and REIT sectors. This year most quality active managers look at these sectors as being fairly to over-valued and are reluctant to allocate a greater amount of assets to the group as they are usually negatively impacted while interest rates rise. The active manager is taking a longer term view and sacrificing short term performance for greater long term performance and stability from volatility.
Something else to understand is how some of these indices change their composition and may not really mimic the funds composition. An index that can always drive you a little crazy is FTSE EPRA/NAREIT Global Real Estate Index. This is a popular index for Global Real Estate funds, in particular one fund that I follow closely. This is a pretty good Real Estate Fund which is an actual Real Estate fund and not so much a REIT fund. It invests in a variety of Real Estate related investments and generally only invests between 30-40% in REITs. The index at one point in time was composed 50% in REITs, however most recently is between 80-85% in REITs as of its last quarterly rebalance. The mutual funds methodology does not change to represent the Index’s methodology. So in a year like we are in right now, (where REITs are performing great), the fund is still performing well, but it cannot keep up with the performance of an index that is currently comprised of over double the allocation in REITs. Is the fund a bad fund? No. It is still performing well this year and in recent years, when REITs have not been performing well, the funds lower REIT exposure has helped it perform even better. So, do you walk away from a good fund like this because it is not keeping up with an index that does not represent the funds real composition and methodology? I would hope not, but some people need to chase those returns and if it is not keeping up with that index they feel the manager is lost their touch.
The bottom line to all of this is before you start making a bunch of changes that you think will boost your returns, remember to take those extra steps and dig a little deeper. In today’s internet age, most of this information can be rather easy to find. You just need to remember to look outside the Morningstar performance reports and also remember why you added the investment in the first place. Stick to your plan and put the blinders on to all the ancillary stuff that can cloud your judgement.