An article in The Wall Street Journal provides evidence that following both the recent leaders and laggards results in inferior investment performance:

WSJ - Following the Leader

According to these figures, after 20 years investors following the portfolio of the previous year’s top-performing newsletter would end up with only 2.4% of their original investment. Those following the portfolio of the previous year’s worst-performing newsletter would finish with virtually nothing. In contrast, investors in a broad market index would realize a return of over 460% in the same period.

These findings are similar to those of the recurring SPIVA reports, discussed in a previous Alpholio™ post. Mutual funds in the top half of quartile of the population are more likely to revert to the mean than could be expected by chance. On the other hand, funds in the bottom quartile are more likely to continue to underperform, and eventually end up being liquidated or merged with other funds.

The article indicates that merely focusing on lower-risk investment strategies is insufficient. Instead, the investor should extend the observation period:

You would do much better to focus on performance over far longer periods than the past 12 months. That is because, when picking an adviser based on his track record, you implicitly are betting that the future will be just like the period over which that record was produced.

While there is no magical track-record length on which you should always focus, 15 years is a good rule of thumb. The past 15 years—from the beginning of 1999 through the end of last year—encompass two powerful bull markets as well as two punishing bear markets.

As an example of a suitable mutual fund, the article offers the Turner Emerging Growth Fund (TMCGX, investor shares) with the highest annualized return among diversified U.S. equity funds in that long time span. Let’s take a closer look at that fund’s performance.

First, data from Morningstar show that the fund’s 15-year annualized return of about 17.6% was significantly higher than the 10-year return of about 10.6%. This indicates that the fund may have outperformed early on since its inception in late February 1998. Indeed, in the first couple of years the fund generated a return of over 355%, no doubt riding the wave of appreciation of small-cap stocks caused by the Internet boom. While this performance could in theory be repeated, it seems unlikely.

In the next three years through February 2003, the fund generated a cumulative loss of only 21% compared to about 52% of an average small-growth peer. This was another contribution to the high annualized 15-year return. However, the fund failed to beat the iShares Russell 2000 Growth ETF (IWO), a practical implementation of its prospectus benchmark, in four out of six most recent years. This is further illustrated by the fund’s performance relative to its reference portfolio of ETFs since early 2005:

Cumulative RealAlpha™ for TMCGX

The chart shows that all of the cumulative RealAlpha™ the fund generated through mid-2008 was subsequently lost. The fund strongly rebounded only in the second half of 2013. Moreover, the reference portfolio had a lower volatility than that of the fund.

The next chart depicts ETF membership and weight changes in the reference portfolio over the same analysis period:

Reference Weights for TMCGX

The fund could have effectively been emulated by a collection of four ETFs: iShares Russell 2000 Growth (IWO; average weight 63.8%), iShares Morningstar Mid-Cap Growth (JKH; 25.4%), Vanguard Energy (VDE; 7.7%), and iShares 20+ Year Treasury Bond (TLT; 3.1%). Over time, the equivalent position in IWO became even more dominant, which implies that the fund’s characteristics were getting closer to those of its benchmark.

Only time will tell if the fund is able to outperform its reference portfolio on a consistent basis. There is no guarantee that the spectacular performance of early years will be repeated or even that the fund will be in existence in the next 15 years. In addition, as the above charts demonstrated, investor’s returns depend heavily on the timing on the initial investment. Therefore, while following the laggards is certainly not a fruitful endeavor, blindly following the leaders, even those with a long-term record, is not advisable either.


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