In an article for RegisteredRep.com, hedge fund guru Joel Greenblatt takes a look at why so many mutual funds fail to beat the market averages over the long haul, and offers tips for how the “little guy” can beat the market.
One big thing that hurts mutual fund performance, Greenblatt says, is fund fees, which can chop 1% to 2% off of your profits. Another problem, he says, is that the quest to accumulate assets (which funds want because it leads to more money made in fees) often can hinder performance. “To get big and take large positions, fund managers tend to go for big, well-known stocks,” Greenblatt writes. “But, there can be big advantages to looking at smaller companies. These companies are often too small for large investment funds to buy and for Wall Street firms to spend money on doing research. Less competition from other buyers and less available Wall Street research often mean a greater opportunity to find bargain-priced stocks among these lesser-followed small-capitalization companies.”
Greenblatt says successful investors like Warren Buffett wish they were still able to take advantage of small-cap bargains. And, he says, by the time you’ve heard of a successful fund, it’s probably so big that it can no longer benefit from such small stocks.
Another factor that hinders fund performance: portfolio size. Many fund managers, Greenblatt says, tend to put together funds with dozens of stocks that end up mirroring their benchmarks. That’s because, while holding a more concentrated portfolio gives you a better chance to beat the benchmark over time, it can also lead to short-term underperformance, which many investors can’t handle. “Even a very talented manager who makes excellent stock picks over the long term can trail the market averages for years at a time. In fact, this is almost a certainty with a concentrated portfolio,” Greenblatt writes. “Yet the reality is that a manager who significantly underperforms the market averages for two or three years has a good chance of losing most of his or her investors. … And no investors means no business!”
Investors don’t help matters. They tend to focus on the funds with the best recent performance, Greenblatt says. He points to some studies that show chasing recent performance often leads to future underperformance. “Investing with the managers who have performed the best and attracted all the money is probably a great way to win the last war, just not a great strategy for beating the market going forward,” he writes.