Why Following Hot Mutual Fund Managers Doesn’t Work

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During the winter of 2007, Jim Cramer, in his television show and his book, Stay Mad for Life: Get Rich, Stay Rich (Make Your Kids Even Richer), was highly recommending 1) to follow his technique for picking your own stocks and 2) if an individual could not devote the time to picking his/her own stocks, to put your money in the care of a fantastic money manager at a mutual fund.
Since I knew that I didn’t have enough time or desire to devote to picking my own stocks, I decided to go with option 2 above.
The most highly recommended fund manager by Jim was the CGM Focus Fund’s manager, Kenneth Heebner. Jim’s advice was something along the lines of “buy this fund and stick with it as long as Ken Heebner is running the show.”

Since this was in my learning, naive days, I followed Jim Cramer’s advice and bought this mutual fund in a Roth IRA account.

This was probably one of the stupidest things I have done financially to date. Let’s analyze why.

Why was this such a mistake? It was recommended by Jim Cramer, after all.
This was a mistake because it basically violates every rule of set forth in My Personal Finance Journey.

  • First, it is an actively managed fund. And, as we have found in many financial books (A Random Walk Down Wall Street, for example), 70% of actively managed mutual funds fail to beat the market index averages.
  • Second, the expenses ratio/fee for owning the CGM Focus fund is 1.23%.
  • The CGM Focus Fund cannot keep all of it’s money invested in equity at all times due to the fact that it has to maintain reserves to redeem shares when investors buy and sell shares. This decreases returns for investors.
    • For example, CGM keeps >1% of it’s assets in cash vs. Vanguard’s Total Stock Market Index which maintains 0.31% in cash.
    How has the CGM Focus Fund performed relative to the S&P500 Index?
    • Over the past 10 years…
      • CGM Focus Fund has increased 120% vs. the S&P500 which has decreased 30% overall.
    • Over the past 5 years…
      • CGM Focus Fund has decreased 30% vs. the S&P500 which has decreased 15% overall.
    • Over the past year…
      • CGM Focus Fund has decreased 2% vs. the S&P500 which has increased 15% overall.
    • Since I bought the CGM Focus Fund
      • My holdings have decreased 22% overall. Wonderful!
      • During this same time period, the S&P500 indexed decreased 19%, beating the CGM Focus Fund. Remember, this is even before considering the expense ratio of the CGM Focus fund further diminishing returns.
    Even though the CGM Focus Fund has clearly been one of the best performing funds of the past decade, the more recent returns are not very promising, and seem to further make a case against Jim Cramer’s advice of following a wise mutual fund manager.

    Why following recent “hot” fund managers does not work
    The topic of whether or not superior past performance will indicate superior future performance is continuously being debated.

    Moolanomy.com recently put out a good piece discussing several reasons why past performance will not be the same going forward. See the link below for more information.

    Moolanomy.com – How Important Is Mutual Fund Historic Performance?

    Recently, while reading the book by Jerry Tweddell titled, Winning With Index Mutual Funds, I came across a brilliant and very complete section about the reasons why “hot” mutual funds do not perform well in the future. The key findings are listed below.

    • The top 20 best performing mutual funds from 1982-1992 fell to an average rank of 142 out of 309 funds in the period 1992-2002. This is basically reverting to average performance.
    • When a fund becomes successful, publicity increases, causing more funds to pour in to the fund.
      • All too often, this creates the situation of the mutual fund manager having more money than good ideas. This can even put pressure on the manager to purchase additional stocks that he or she is not as enthusiastic about.
      • An increase in funds also means that the fund will need to bring in more personnel to handle additional workload. This can create additional people-management problems that the mutual fund manager must handle, distracting him or her from investment analysis.
      • Success also increases the chances that a fund manager will be hired away to another firm or start their own business all-together. This increases the chance of turnover in the mutual fund.
      In my opinion, these are definitely interesting findings. However, I wonder how this increase in popularity, funding, and success affected our all-star, Kenneth Heebner. Let’s investigate that scenario.
      First, we need to know when Heebner’s CGM Focus Fund was made popular by Jim Cramer’s book, Jim Cramer’s Stay Mad for Life: Get Rich, Stay Rich (Make Your Kids Even Richer). Looking at Amazon, it appears that the book was published December 4th, 2007. Great! We have our beginning date.
      • Since the published date, the CGM Focus Fund has decreased 54%, compared to the S&P500 index which has decreased 26%.
      What’s even more interesting to note is the price changes that can be seen on the Google Finance screen shot at the link below.

      As you can see, Jim Cramer recommended the CGM Focus Fund when it was FAR outperforming the S&P500 index (in 3Q-4Q 2007). However, almost immediately after his book was published, the price decreased dramatically.

      While there may have been other factors involved in this price decrease, it is interesting how it looks like a classic case of being doomed by your own success, as discussed by Tweddell in his book.

      Should I sell out of my and rollover to a Roth IRA With Vanguard?
      Given all of the evidence against owning actively managed funds, the question that remains in my mind is, “Do I sell my actively managed CGM Focus Fund and rollover my Roth IRA with CGM to a Vanguard IRA?”

      This will be the topic of future post. So, keep your eyes out for it! On the way soon!

      How about you all? Do you all own actively managed funds? How have they performed compared to the market indices? Are you thinking of selling out of them?

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      1. Thanks for reading Brooke! Have you had success with actively managed mutual funds?

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