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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
View the Weekly Insight archive
   

New funds: to buy or not to buy

CEMIL OTAR
From Canadian MoneySaver magazine
Friday, July 2, 1999

Do new funds give you higher returns? Isn’t it riskier to purchase a new fund? Do you ever notice how brand new funds never miss the opportunity to advertise their outstanding returns?

After close study, I believe that when it comes to diversified Canadian equity funds, you have a better chance of outperforming the TSE 300 index with a new fund in its first year.

However, be prepared to dump it after a year if it underperforms the index. The longer it continues to underperform, the less are its chances of turning around.

If you want to avoid the “flash in the pan” situation, observe the new fund until its second birthday. If the fund outperformed the TSE 300 index both during the fund’s first and second year, and it outperformed the index by 15% or more during this time, then there is a good chance that the fund will continue to outperform. However, eventually almost all funds lose their efficiency. So keep in mind that buy and hold does not mean buy and forget.

Here is how I studied new funds:

  • I included in my analysis only diversified Canadian equity funds. This enabled me to compare apples to apples.
  • I included funds that require less than $10,000 as the minimum investment amount. I wanted to analyze funds accessible to the average investor.
  • I disregarded index funds because they reflect returns of the underlying index and do not try to outperform it.


My study included 93 mutual funds that started between January, 1985, and December, 1994.
First, I calculated how much each fund would have returned in one year if I invested $1,000 during the month the fund opened.
Second, I calculated how much each fund would have returned in one year if I invested $1,000 one year after the fund opened.
Furthermore, I calculated how much each fund would have returned in one year if I invested $1,000 three years after the fund opened. I wanted to make sure that my findings in the first two steps were directionally correct.

For comparison, I also calculated the returns on the TSE 300 index for each coinciding period.

Here is the summary of my findings:

Outperformers

• 43% of all new funds outperformed the TSE 300 index in their first year. In contrast, only 22% of all funds outperformed the index!
• 20% of all new funds outperformed the TSE 300 index in their first year and second year.
• 63% of new funds that outperformed the TSE 300 index in their first and second year still outperformed the index by about 14% at the end of March 31, 1999.

Underperformers

• 57% of new funds underperformed the TSE 300 index in their first year.
• 30% underperformed the TSE 300 index in their first and second year.
• Funds that underperformed the TSE 300 index in their first year still lagged the index by about 18% at the end of March 31, 1999.
• Funds that underperformed the TSE 300 index in their first and second years continued to lag the index by about 21% at the end of March 31, 1999.
• Of the funds that underperformed the TSE 300 index in their first year and second year, only 14% subsequently managed to outperform the index at the end of March 31, 1999.

Are underperformers really that bad?

No, they are actually worse. When a fund performs very poorly, it may be dismantled, merged, or otherwise discontinued. I estimate that about 4% of new funds go to the chopping block. Fund databases only include funds that are still in the race. That is why the underperformers appear better here than they actually are.

If a new diversified Canadian equity fund underperforms the TSE 300 index in its first year, the odds are that it will continue to stay there. After all, if a portfolio manager cannot outperform the index when s/he starts with a clean slate, how can s/he outperform the markets when her/his plate is full?

There are two main reasons why a new fund has a better chance of outperforming its older peers.
If you trade stocks, you probably know the first reason very well — the buy decision is a lot easier than the sell decision. Most mistakes are made not when buying, but when selling.

In a new fund, as the money rolls in, the job of the portfolio manager is mostly selecting and buying stocks. A reasonable degree of diligence on the buy side can give rise to the fund outperforming its peers. Little energy needs to be spent on the sell side. However, after a year or two, the fund manager has to spend increasingly more of his or her energy on the sell decisions. If they are not as effective as the buy decisions, the portfolio performance may start sagging. After a few years, the fund may just become an average performer, or worse.

For example, in my DRIP (Dividend Reinvestment Plan) portfolio, I found the happy medium — I make the buy decisions, and my better half makes the sell decisions! (She likes to keep almost everything.) This way, we minimize the sell mistakes! Perhaps fund companies should consider having two fund managers: one doing only the buying, and the other doing only the selling, all within the framework of the fund style and objectives. That may improve their efficiency.

The second reason why new funds can outperform the index is their asset size. Asset size is generally not a consideration for international funds, but it does affect Canadian funds. In Canada, there are only so many good companies one can buy. After the portfolio manager reaches her/his natural asset size barrier, the fund becomes increasingly inefficient. The natural asset size barrier depends on many factors such as fund style, large capitalization or small capitalization, the degree of available talent and resources, the speed of execution of portfolio decisions, and many other factors. When the natural asset size barrier is reached, the portfolio likely becomes an average performer, or worse.
Conclusions

Note that, in my study, I was unable to take into account the effects of changes of portfolio managers. Manager history is not available in fund databases. If I had this information, then I’d re-start the clock each time a new portfolio manager takes the helm.

Remember that all of these conclusions are based on diversified Canadian equity mutual funds. Do not apply these conclusions to any other fund category. The results for sector funds (such as precious metals, resources and energy), or foreign regional funds (such as Japan, Far East and Europe) are quite different and will be the subject of a future article.

As usual, this study is based on historical data. The future performance and the conclusions will be different.

Cemil Otar, P. Eng., I.A., CFP, is an independent financial advisor. This article is from Canadian MoneySaver magazine.

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