Chasing Performance

The end of 2008 is almost here.  For many investors that will be a welcoming event.  I think it's safe to say that most investors will be more than happy to put this year behind us.  

However, this reminds me of something else that is about to happen.  In January, you will start to see the "Best of 2008" lists.  These are the lists that rank the top performing stocks, ETFs, and mutual funds for 2008.  This happens every year.  Investors see these lists in Money, Fortune, SmartMoney, The Wall Street Journal, The USA Today, and so on.  

Mutual fund investors will often compare these top performers with their own mutual fund holdings and get frustrated.  Acting out of emotion, they will sell their current holdings and "chase" performance by buying the funds on the "top performers" list.  Usually, this is a HUGE mistake.  Here's why: More often than not, today's winners will be tomorrow's losers.  

Here is a case in point: Legg Mason Value Trust (LMVTX).  This fund's manager, Bill Miller, spent nearly two decades building a reputation as one of the greatest mutual fund managers ever.  He consistently outperformed the S&P 500 year after year.  Then, in one year, his track record took a major hit.  Here is an excerpt from an article in yesterday's Wall Street Journal profiling the fund's fall from glory:

A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.

These losses have wiped away Value Trust's years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar.

Here are a few lessons learned from this example:

1. Just because a fund has consistently been a top performer in the past doesn't mean it will always be a top performer in the future.
2. Every great money manager will have a period of underperformance.
3. Investor's who "chased" performance by buying the fund anytime in the past 10 years now have a loss.

There is much more to mutual fund selection than last year's performance.  In addition to performance, there are 3 other P's you must understand about a mutual fund:

• Philosophy - How does the manager approach investing?  Try to understand exactly what the manager is looking for in an investment.   Spend as much time as you can seeking to understand the manager's investment criteria. 
• Process - How does the manager execute his or her philosophy.  What are the steps the manager takes to narrow down the vast universe of investment opportunities?  How does the manager identify the most attractive investments to be included in the fund portfolio?
• People - What is the manager's experience and prior track record?  What is the quality of the research team that supports the manager?