“My financial advisor retired,” said Joan Smith, “so I hired another advisor to manage my money.” I changed Joan’s name to protect her identity, but plenty of investors will relate to her story.
“My new advisor put together an entirely different portfolio, compared to what I had before,” Joan told me by email. “On January 12, 2021, he put my $412,000 into several mutual funds.”
By mid-May, it had fallen to $401,000. That’s a drop of 2.7 percent. “I know that markets can fall,” she said, “but my portfolio fell during a 5-month period when stocks went up.”
Joan was right. Between January 12th (when she invested that money) and May 14, 2021, Vanguard’s U.S. stock market index (VTSMX) gained 8.77 percent. Vanguard’s International Stock Market Index (VGTSX) gained 4.27 percent. Vanguard’s Global Stock Market Index (VTWAX) gained 6.78 percent. Bonds didn’t fare as well. But even Vanguard’s Total Bond Market Index (VBMFX), which dropped 1.69 percent, beat Joan’s portfolio over the same measured period.
That’s why Joan was asking, “What’s going on?”
I wanted to tell Joan that five-month performances are rarely worth measuring. But I saw a glaring red light when she sent me her portfolio statements. Her advisor selected funds based on their past performance.
At first brush, this sounds smart: Pick funds that have beaten their peers over a 1-year, 3-year, 5-year or 10-year period. Common sense says they should keep winning. But unfortunately, it doesn’t work like that. As proven by the SPIVA Persistence Scorecard, actively managed funds that perform well during one measured time period typically stink the next.
That’s why Joan’s portfolio smells. She owns six actively managed funds and one ETF. All seven funds had beaten their peers (often by a lot!) before Joan’s advisor selected them. But since Joan bought them, they have all underperformed their respective benchmark peers.
The Virtus KAR Small Cap Growth fund (PXSGX) is one such example. According to Morningstar, it posted a spectacular 10-year average annual return of 19.61 percent. In 2019, it gained 40.26 percent. In 2020, it soared another 43.28 percent. Impressed by these returns, Joan’s advisor made this her largest equity holding on January 12, 2021. But since Joan bought the fund, it dropped 6.32 percent to May 14, 2021. Meanwhile, Vanguard’s U.S. stock market gained 8.77 percent over the same time period. In other words, the U.S. stock market index thrashed Joan’s largest stock market holding by more than 15 percent over just five months
Joan’s six other funds aren’t any different. They destroyed the returns of their peers (and their benchmark indexes) before Joan’s advisor selected them. But after she bought them on January 12, 2021, they all underperformed their actively managed category peers and their benchmark indexes to May 14, 2021.
They include the Delaware Diversified Income fund (DPFFX); the Columbia Convertible Securities fund (COCRX); the Guggenheim Total Return Bond (GIBIX); the Hartford Strategic Income fund (HSNYX); Invesco QQQ Trust (QQQ); and the Loomis Sayles Global Allocation fund (LSWWX).
Buying funds based on their past performance is like choosing a lottery ticket based on last week’s winning numbers. If you have a financial advisor, odds are high that your advisor likely does the same. But don’t slash their tires or hurl insults. In most cases, they don’t know any better. For example, when a financial advisor studies to become a CFP (Certified Financial Planner), the course material doesn’t warn them against chasing past performance. Nor does the course material explain that, over time, low-cost index funds beat most actively managed funds. Couple that with the fact that advisors often earn commissions when they recommend actively managed funds. That’s almost never the case with index funds, which is why so few advisors recommend them.
If it’s any consolation, advisors buy actively managed funds for their own accounts too. One 15-year research study published in The Journal of Finance, explains that the typical advisor underperformed an equal-risk adjusted benchmark of index funds by about 3 percent per year. On a compounded basis, that’s about 55 percent over just 15 years. To do that, they bought actively managed funds and chased past performance.
Instead of continuing to hold a handpicked collection of last year’s winning funds, Joan could fire her advisor. She could then switch her IRA to one of Vanguard’s all-in-one portfolio funds. If she wants a financial advisor, she could hire one through Vanguard, or hire any number of firms (such as AssetBuilder) to build her a portfolio of low-cost DFA [index] funds. Such funds and advisors would charge a lot less than she’s paying now. And Joan’s portfolio would align with an evidence-based strategy that doesn’t drive her account by looking through a rear-view mirror.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas