Chasing Hot Funds Translates to Diminished Returns, Study Finds

Performance-chasers beware: By the time you get into a hot fund, it's usually too late. In fact, bad timing can diminish your returns by as much as 20%, according to a new study by Financial Research Corporation.

Buying into funds at their high and selling off at lower levels low caused the average mutual fund investor to miss about 20% of a fund's gains over the past decade, according to an FRC study commissioned by Phoenix Investment Partners. And it appears that this kind of fund-hopping is on the rise: FRC also found a dramatic decline in the average holding period for funds. The average fund holding period is now 2.9 years, down from 5.5 years in 1996, according to FRC.

The pursuit of hot mutual fund money is a "disturbing trend" that has "detrimental effects on the long-term financial health of the investing public," says Gavin Quill, director of research studies at FRC and author of the report.

Basing its study on today's average holding period of three years, FRC calculated 10.92% as the mean three-year average annualized return for funds between January 1990 and March 2000. Tracking monthly fund flows and performance, FRC discovered that the actual return that investors received from that fund was 8.7% -- 20% less than the 10.92% three-year mean.

While the study does not break out the results for individual funds, it does for categories. Small-cap growth funds, for example, delivered an average 19% three-year return in the 1990s, whereas the actual return seen by small-cap fund investors -- who tended to get in after part of the run-up -- was 15.6%, meaning they missed 17.9% of the returns, says Gavin Quill, director of research studies at FRC and author of the report.

FRC also looked at fund flows following the best and the worst four quarters for each of Morningstar's 48 investment categories. In the quarters following high returns, an average of $91 billion in net new cash flowed into funds, whereas after funds' worst-performing quarters, they received only $6.5 billion in new money, according to FRC.

"The moral of the study is that investors who make investment decisions ... in pursuit of big stock market gains are more likely to lose out on the long run," said Jack Sharry, president of Phoenix's private-client group.

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