Buttonwood: Big is not always beautiful THE stockmarket is bewildering. So it is hardly surprising that investors turn to professional fund managers for help. But when they do, they face a paradox. Since the market is dominated by professional managers, the average fund manager will earn the index return, minus costs. Since the index does not reflect the impact of costs, investors are doomed, on average, to underperform the market. The answer is to pick a fund manager who is better than average. But although you know which managers have beaten the market in the past, you cannot know which will do so in the future. Or can you? Some studies have found that strong mutual-fund performance can persist for 2-3 years, long enough for small investors to take advantage. And a recent survey* by Simon Evan-Cook of Premier Funds suggests that British retail investors may do better than the averages suggest. That is because conventional benchmarks average the performance of all funds in their sectors, regardless of their size. As a result, a fund with just £1m of funds under management has the same weight as a fund with £1 billion. But the experience of the average investor is clearly driven more by the performance of the largest funds. Weight the funds by size and you get a different perspective. In the five years to June, the conventionally calculated average return of emerging-market funds was 23.9%, well below the index return of 27.4%. But the asset-weighted return was 32.2%. Mr Evan-Cook suggests that the fixed costs of fund management weigh more heavily on small funds. Big funds achieve economies of scale. So should investors simply focus on the largest mutual funds? Unfortunately, this simple rule is not the answer. Mr Evan-Cook's data show that, in some sectors, the asset-weighted average returns were worse than those of both the index and the conventional average. Other studies have suggested that increased fund size can sometimes lead to lower returns, particularly when the fund invests in illiquid securities such as the shares of small firms. A large fund finds that its buy-and-sell decisions have a big impact on market prices, hurting returns. Investors are dogged by another paradox. Assume for a moment that outperformance is entirely due to luck but that retail investors do not realise this. They look at the five-year records of funds and pile into the ones which have beaten the index. Those funds suddenly expand in size and, over the next five years, half of them beat the market as well. Over time, and purely by chance, you will have a small number of large outperformers. Eventually, however, those funds will have a bad year and investors will desert them. So their worst period of performance will occur at the moment when most money is invested in the fund. Sure enough, a 2006 study by Morningstar, a research firm, found that the asset-weighted returns of American mutual-fund investors were generally worse than the reported sector average. A prime example was the technology sector where, at the time, the ten-year average annual return was a respectable 6.4%. But because most retail investors had piled in at the peak of the dotcom bubble, the asset-weighted return was minus 4.2% a year. How to reconcile these data with the academic finding that fund managers can still persistently outperform? One answer could be "momentum," the phenomenon that sees the best-performing stocks of one period continue to outperform over subsequent months. In a recent article in Central Banking Journal, Paul Woolley and Dimitri Vayanos of the London School of Economics explain momentum as follows. Investors select fund managers on the basis of their recent performance. Those managers take the cashflows and invest them in their favourite stocks. By definition the favourite stocks of top-performing fund managers will already have done well; the new buying pressure means they will continue to do so. As a result such fund managers will keep outperforming. Eventually this outperformance comes to an end. The momentum effect seems to reverse after 2-3 years. When it does fund managers rush to sell the stock. The effect is both to drive the share price down further and to damage the performance of the previously successful managers. Woe betide the small investor who gets sucked into investing in the "star" fund at just that moment. As someone once said, past performance is not a reliable guide to future returns. Sources "Lies, Damned Lies and Sector averages," by Simon Evan-Cook Does Mutual Fund Size Matter? The Relationship Between Size and Performance," by Edwin Elton, Martin Gruber and Christopher Blake "Liquidity, Investment Style and the Relation between Fund Size and Fund Performance," by Xuemin Yan How Much Does Size Erode Mutual Fund Performance? A Regression Discontinuity Approach," by Jonathan Reuter and Eric Zitzewitz Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organisation," by Joseph Chen, Harrison Hong, Ming Huang and Jeffrey Kubik "Taming the Finance Monster," by Paul Woolley and Dimitri Vayanos, Central Banking Journal, December 2012