Rats! My Mutual Fund Did Real Well Last Year

Consider this problem: you walk through the local grocery store and spot a Money magazine. Right there, in bright gold 48 point font, you see that the mutual fund you picked several years ago is now listed as “One of the Best.”

You congratulate yourself. You’re a mutual fund picking expert. You’ve been happy with your returns, but the validation you get from seeing your pick publicly confirmed by such a prominent publication is even better.

And then, like clockwork, the fund’s returns start to stall.

What happened?

The ‘mutual’ in mutual fund began to work against you.

One definition of ‘mutual’ – and the one used in the fund industry – is ‘shared interest’.

In this case, you began to ‘share’ the fund’s management with other investors…all those hyperactive folks who read about your fund on the cover of a magazine and bam, next day, moved all their money over there.

Mutual funds have certain rules that they must abide by. One is that they can only have a certain percentage of their assets in any one investment. And as the new money flows into a mutual fund, the manager has to invest all of that new cash.

What does he do? Well, once he exhausts putting money towards his ‘great’ investment picks (the ones you made out on so well on in years past), he has to move down a notch to his ‘really good’ investment picks. Then the ‘good’ ones. Then his “ok” ones. Then the blaze lackadaisical. Or something. The point is that all those new investors can quite literally begin to dilute the performance of your mutual fund.

And this ‘shared’ downside to mutual funds doesn’t come into play just when there’s good news about the fund.

If a fund or even the overall market experiences a short-term downwards blip for whatever reason, the herd investors often run for the hills. This forces that mutual fund manager to liquidate investments to pay out all that cash. And for you, my dear long term investor, this is bad. It’s actually exactly what you don’t want to happen – selling when prices are down. Nobody makes money that way.

So whether good news or bad news, when it comes to mutual funds, you’re often stuck in the same boat as a lot of other investors that you probably wouldn’t want to be with…if you’d only had the choice.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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