Thursday, February 15, 2007

Does Mutual Fund Upgrading Work? Part One

I'll be posting on a few of the commonly-encountered mutual fund upgrading approaches. Tip-off: there is essentially no objective research support for this idea. It is one approach to trend-following as an investment approach. We'll start with an overview of how these things try to work.

Fund upgrading approaches are often, but not exclusively based on someone's proprietary, undisclosed quantitative method for determining what kind of securities are moving upward, for which information you pay them. You would generally describe this as what is known as a technical approach. You buy the recommended funds, holding on to them as the trend continues to work, then selling and either going to cash if nothing is working or buying into a new trend when it shows up. It sounds powerful.

Is there a fly in the ointment?

Usually. Mutual funds generally do not like this behavior, as it screws up management of the fund. Cash moving in and out based on "market timing" systems forces them to buy and sell securities at times when they do not see doing so as beneficial to their investors, as short term gains are generated, portfolio trading costs are incurred, and their "steady" investors are left holding the bag. So they retaliate by imposing short-term trading fees and penalties, which can be as much as one or two percent of the amount invested. Get hit by charges like this two or three times in a year and you will be left wondering why you have fallen behind. The upgraders have evolved toward using exchange-traded funds and some funds which are more open to people trading in and out of them. Those funds typically nick you with hefty expense ratios though. So what you see is the upgraders having fewer choices with regard to actively-managed funds, and part of the appeal of that idea was the hope of finding the funds with managers on a hot streak, and getting in on the action while that fund's hot streak lasted. It's harder and harder to do that now. Index funds don't like people moving in and out like this either, for most of the same reasons.

But wait, there's more! Academic research mostly supports the idea that there is such a thing as a trend, sometimes. And, the research supports the idea that a trend can continue, for a time, sometimes. But trends end, randomly, unpredictably. Whenever it ends, it ends. Unless it doesn't! Sometimes they stutter. There is no research to tell you how to figure out when a trend will end. Market valuations can and do go to extremes, both high and low, sometimes. Sometimes trends end with a really bad reversal. Think dot-coms in the year 2000.

And that's not all! If you are out of the market when an investment style or asset class begins to move up, you miss participating in it. By the time you get in, you may have missed a good bit of it. Think of it as Investing 101: market timers just fall behind more and more over time. Steady investors (if they are well invested!) capture the full upward movement of the markets, including dividends, and their gains when they sell are long term and tax-favored, presuming we're talking about a taxable account of course. Patience wins big for you over the more impatient approaches. There is some justice in the world!

In the next week or so, I'll put up a few posts looking at returns of several trend-following approaches which have created mutual funds you can buy to get the convenience of their picks in one fund.

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