Top fund’s shareholders missed the party
Reprinted courtesy of MarketWatch.com
Published: July 23, 2014
To read the original article click here
One of the most fascinating mutual funds to watch over the past 15 years has been CGM Focus Fund.
I disagree with most of the things this fund does. I don’t recommend it to anyone. And yet sometimes CGM Focus CGMFX, +1.12% is an amazing performer.
How do you evaluate a fund that:
- Typically owns fewer than 25 stocks;
- Has sometimes generated great returns for investors who stick with it through good times (sometimes very good) and bad times (sometimes very bad indeed);
- At the same time has consistently lost money for its typical shareholder;
- Currently has one of the best records in the industry for the past 15 years;
- Currently lags 99% of funds in the first half of this year and for the past three-year and five-year periods?
This is a tough question. The search for the answer leads to some valuable lessons.
One lesson is about beating the market — a popular quest that I try to discourage. I’ve never found a manager or a fund that consistently beats the market, although many certainly try.
CGM Focus Fund is for investors who believe that a smart manager can beat the market by picking stocks. As you can tell from the statistics I cited, sometimes this fund succeeds, while at other times it fails miserably.
A second lesson is about what investors do when performance switches from red-hot to ice-cold – and then reverses course. This is known as “investor behavior,” and it’s been a focus of study over the years by Christine Benz, personal finance director at Morningstar.
She found, not surprisingly, that a hot fund can attract buckets of money from eager investors who perhaps believe they have finally found a manager with “the magic touch.”
But when the hot numbers turn cold, that money can leave just as quickly.
This in-and-out behavior results in an interesting divide between two ways that can be used to measure the returns of a fund.
- The first, used by mutual funds themselves, is known as the “fund return.” This is calculated, quite logically, on the assumption that an investor began a period with, for example, $10,000 and didn’t add or withdraw anything throughout the period.
- The second, called “investor return,” takes into account all the additions and withdrawals that investors actually made in a given time period. In effect this measures the returns that typical investors actually achieved.
For an extreme example, imagine this hypothetical scenario: Investors learn in June that a fund has been red hot, doubling in value since January. Suddenly the fund is flooded with new investments totaling tens of millions of dollars. Then, for whatever reason, the fund’s performance takes a nose dive in July, August and September.
To nobody’s great surprise, thousands of suddenly disillusioned investors start pulling their money out. Most of them wind up selling in October and November for less than they paid in June.
The fund may wind up with a gain for the whole year; but the average investor in the fund probably had a much smaller gain — or perhaps even a loss.
In a nutshell, that is the difference between fund return and investor return.
Back in 2009, Morningstar’s Christine Benz looked at the reported returns and investor returns for CGM Focus, which had produced off-the-charts performance for years. She calculated that in the 10 years ended July 31, 2009, an investment of $10,000 would have grown to $51,633.
But when she studied the fund’s investor returns, she found that an initial $10,000 investment would have shriveled to $1,585.
The fund could legally report a 10-year gain (not annualized) of more than 400%. Actual investors, on the other hand, lost more than 84% of their money in that same 10 years.
This discrepancy, while it is extreme, isn’t limited to this fund. It’s typical of investor behavior in general, as a research company named DALBAR has reported over and over.
Over 10 years, this difference between $51,633 and $1,585 was all due to investors’ performance chasing while they repeatedly mistimed their purchases and sales, Benz wrote.
As this shows, impatient investors who are intent on beating the market can turn a mutual fund manager’s superb 10-year performance (17.8% annualized) into awful returns for themselves (annualized losses of 16.8% over 10 years!).
I recently wondered if anything had changed with CGM Focus. Here’s some of what I found:
- In the 15 years ending July 2, 2014, the fund had one of the best records in the industry, an annualized return of 14.1%. That puts CGM Focus in the top 1% of its fund category.
- In the most recent periods of six months, three years and five years, CGM Focus was in the bottom 1% in its category.
- In the most recent one-year period, the fund was in the bottom 13%.
Without question, this fund is in the habit of taking big risks with its shareholders’ money. CGM Focus holds only 23 stocks. It turns the portfolio over at an annual rate of 291%. According to Morningstar, the fund recently leveraged its equity investments by 33% and its bond investments by 44%.
The future, of course, is unknown. CGM Focus could be a star performer over the next 15 years (at least for investors who are willing and able to stick with it through thick and thin). Or it could remain in the bottom ranks of all funds.
One thing that’s clear is that investors won’t get the fund’s favorable long-term returns unless they are willing to overlook very significant periods of severe underperformance. Based on the thousands of investors I have worked with over the years, I think that is too much to reasonably expect.
My advice regarding this fund is to ignore it. You can do better.
If I were given the choice between CGM Focus and a small-cap value index fund, my decision would be a no-brainer. I’d take the small-cap value fund in heartbeat.
Another important lesson from CGM Focus is that there’s sometimes a big difference between the sales pitch and the reality. The sales pitch (perfectly accurate, by the way) can be superb long-term fund returns. The reality (also perfectly accurate) is that actual investor returns are much lower.
I think many investors will continue to be attracted by the sales-pitch returns. If (and it’s a very big “if”) the fund continues to do very well over the very long term, perhaps a few of those investors will reap the rewards. But I’m very confident in predicting that this fund will continue to disappoint its shareholders much more often than it delights them.
Ironically, this won’t be the fault of the fund. It will be the fault of impatient investors who don’t understand what they are doing. I hope you and the rest of my readers will avoid this trap.
Richard Buck contributed to this article.
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