Wishing upon a star won't ensure a mutual fund's astral performance

The allure of a star is nearly irresistible, and mutual fund investors are not immune. Investors are drawn to mutual fund families that boast a stellar performer, and the less luminous funds in the family benefit from a spillover effect resulting from their proximity to the headliner. This benefits fund managers, who are compensated based on assets under management, but the presence of a star in the portfolio does not necessarily mean that all of the funds in the family will do well for investors. Research by a W. P. Carey School of Business finance professor concludes that an investing strategy that consists simply of hitching onto stars is naive.

What's the value of a star? In the mutual fund industry, the answer to that question depends on who you are — an investor or a fund manager — and what strategy was employed to raise the star to its heights. Finance Professor Vikram K. Nanda of the W. P. Carey School of Business and co-authors at the University of Michigan investigated what impact a stellar performer has upon the funds that make up its family.

After examining the performance of all diversified equity funds in the U.S. for a seven-year period in the 1990s, the researchers discovered that the sibling funds in families boasting stars do indeed reap increased cash flows thanks to their proximity to a glamour fund. In fact, families with a star will experience 4.4 percent more new money growth annually compared to fund families with no star.

The findings were reported in their paper, "Family Values and the Star Phenomenon." The reason? Investors attracted by the headliner may figure that if the company hit big with the star, it will do the same with the star's investment siblings. Comparing two families of mutual funds, both of them offering a fund with a 7 percent annual return, Nanda finds that investors who own stocks in both will put more money into the fund that has a star in the family.

Fund managers, whose compensation is based on the assets they manage rather than fund performance, benefit from the spillover. This is powerful incentive for managers to come up with a star. But investors would be wise to look around the star at the other funds in the family. The nature of the sibling funds and their quality is a valuable clue as to the overall ability of the fund managers, not only to launch a high flier, but also to generate good returns for investors.

Probability versus vision

For this study, Nanda and co-authors Z. Jay Wang and Lu Zheng worked with data from the Center for Research in Security Prices, using information from 278 diversified U.S. equity funds. The average family studied had 6.83 funds and managed $450 million. Nanda divides mutual-fund families with star performers into two categories:

• Those that follow widely diverse strategies among the funds, indicating a gambling approach, and
• Those which exhibit signs that managers are sharing information and pursuing a coherent strategy.

The first group tends to be distinguished by a high level of variability between the funds; the second is marked by much less differentiation. It's safe to assume that all mutual-fund managers want to post profits on their picks, but these two groups have markedly different investment approaches, Nanda says. Management at star-anchored families following the diverse set of strategies is less likely to use its investment research, and does not share information between fund managers.

Instead, Nanda discovered, they tend to invest in businesses and sectors that are different from the current star. This is a gambling strategy that amounts to making bets on which investments will increase the probability of producing stars. For example, assuming that oil stocks move in an opposite direction to the market for gold, a family that is actively seeking to produce stars may well have one fund that takes a large position in oil stocks while another takes a similarly large position in gold mining companies.

This increases the chances of one of the family funds being star performer — even if the other performs poorly. Such a star performance is not an indication of investment skill — quite the opposite, in fact. Glitter-loving fund-family managers figure they're "better off gambling on the attraction status of the star" and taking extreme opposite positions to find new stars. "That is the negative consequence of following the star approach — it encourages taking extreme positions," Nanda adds.

Once a star rises, other funds in the family garner the benefits.

"Say that only the one or two stars in a family actually attract the big money. The funds in the star's family, despite their lower performance, also attract more funding, thanks to the star," he explains. This leads to more oppositional positioning as the family searches for its next star. Overall, however, the study showed that a strategy of assembling a family of widely different funds in the hopes of stumbling on a star is associated with lower average performance. These families underperform the market by 3.6 percent per year, according to the study.

The approach of managers in the second group, the ones who share data and follow a cohesive approach, create families that usually show a low level of variability among the members. That's because they are following a cohesive strategy and are basing their decisions on analysis. In other words, these funds are managed with skill and analysis — not by chance. Compared to the gamblers, these managers are less likely to produce a high-flying fund. But when they do launch a star, it is attributable to investing ability, and in the end, the returns for investors are better.

Blinded by starlight?

Nevertheless, investors continue to be impressed by stars. Investors with money in several funds within a star-anchored family may pull out of a dog fund after noticing how bad returns are, but rarely withdraw from the star or its other sibling funds. Dazzled by the star, they ditch the dog and continue investing in the rest of the family, hoping for another star.

Discussing this investor behavior, Nanda says, "people have limited attention," and tend to be impressed by fund marketing that trumpets star performance and ignores the dogs' results. Which environment is more likely to give birth to new star performers? The gambling families who chase the glitter. In his study, Nanda notes "that the probability of creating a star fund is most consistently affected by cross-fund return standard deviation." But this strategy tends to result in short-term, rather than long-term stars, he states.

Bottom line: "Stars attract more than dogs lose" for mutual-fund families. "Stars are critical to the mutual-fund business. The question is, how far are you willing to go to get a star, and does it help the individual investor?" Nanda says. Star-seeking fund families bring in more money overall, but investors reap higher returns, long term, on their investment with the analysis-based, lower-differentiated funds, he found.

Investors thus should be cautious of families "running funds taking very different positions in stocks and industries. Step back, compare, and decide which family is likely to be playing the gambling strategy," he suggests. "If a family lacks a common investment approach, that is a form of gambling, whether explicitly or implicitly."