Why you should avoid the most popular funds

A regular ritual of financial media and investment platforms is to list the best-selling funds each month and every year; I think they provide valuable insights into the trends and fads of the day. Therefore I decided to take a deep dive into the data to see how each fund performed following the year they became a top seller (spoiler alert: very poorly).

Data

Below I listed the best-selling funds in 2012, 2013, 2014 and 2015 and revealed their subsequent performance to the end of 2020. While the data is for UK based retail investors, the results play out the same for overseas funds).

Information is sourced from Hargreaves Lansdown, Morningstar and Trustnet.

I compared the returns to an iShares MSCI World Index fund.

Top selling funds in 2012 and their subsequent performance

Top Selling Funds in 2013 and their subsequent performance

Top Selling Funds in 2014 and their subsequent performance

Top Selling Funds in 2015 and their subsequent performance

Summary of findings

-The most popular funds all have one thing in common, strong recent performance running up to and including the year in which they become a best seller.

-The average total returns of the most popular funds from the year they became a best-seller to 31/12/2020 underperformed a simple MSCI World index fund.

Best-seller returns:

-Average returns from 31/12/2012 to 31/12/2020: 110% vs 205% for iShares MSCI World Index

-Average returns from 31/12/2013 to 31/12/2020: 89% vs 170% for iShares MSCI World Index

-Average returns from 31/12/2014 to 31/12/2020: 79% vs 125% for iShares MSCI World Index

-Average returns from 31/12/2015 to 31/12/2020: 65% vs 100% for iShares MSCI World Index

-5 of the 14 best-sellers in 2012 were emerging market funds, only one was present in 2015. I have no doubt investors were chasing strong past performance of EM markets in the 2000’s (10% per annum vs. 0% for developed markets) hoping it would continue. It didn’t (reversion to the mean!), the MSCI Emerging Markets index has underperformed the MSCI world index from 2010 to 2020, and investors bought EM funds right before a decade long period of underperformance.

-7 of the 14 top sellers in 2013 were equity income funds, the highest of any year, their peak popularity correlated with subsequent underperformance relative to the MSCI World index.

In the year after achieving best-seller status, the equity income sector (measured by Vanguard FTSE UK Equity Income index Acc) produced a derisory 25% return (from 01/01/2014 to 31/12/2020), compared to 125% for the iShares Core MSCI World index Acc, whereas from 01/03/2009 to 01/01/2014, the equity income index outperformed it. Once again investors demonstrated atrocious market timing, buying high and selling low.

-The majority of best-selling funds lagged the index, the exceptions being Fundsmith, Lindsell Train Global Equity fund and AXA Framlington Biotech. Typically to capture their best returns, you would have had to identify and invest in them before they become a best-seller. But studies shows that investors rarely do this, only buying funds after a strong run-up and after being lauded over in the financial press.

My findings are congruent with existing research by S&P Dow Jones Indices (SPIVA scorecard and persistence scorecard), which reveals that 90% of actively managed funds lag their benchmarks over a 10–15 year horizon, and the small minority that do outperform struggle to maintain it.

It’s an unfortunate reality that retail investors are only attracted to fund managers who have outperformed recently, but they typically go on to disappoint. This is consistent with the iron clad rule of investing, which is that sentiment is negatively correlated with future returns, if investors are collectively bullish and expect outsized returns, the opposite more or less is guaranteed to happen.

In conclusion picking funds is hard, and the preoccupation with short-term performance is investors Achilles heel, they (myself included) rely on a 3 to 5 year horizon before selecting a fund. But according to Larry Swedroe, director of research at Buckingham Strategic Wealth, even a ten-year record is random noise.

Can Baillie Gifford avoid the same fate as Invesco?

At present Ballie Gifford is the most popular fund house, with 6 of the 10 most popular funds on Hargreaves Lansdown’s platform being managed by them, an incredibly feat. They are frequently dominating the performance tables and the best-seller lists across all major platforms. After a blockbuster year in 2020, they grew assets under management (AUM) to £324bn as of 31 December 2020, this compares with AUM of £219billion at the end of 2019. Baillie Gifford’s an astonishing success story, but fund managers frequently go through high-flying periods, Invesco did so with the success of their equity income funds and value style of investing, which is currently out of favour.

BG’s growth tilt and focus on innovative companies has paid off handsomely, but the record AUM will place constraints on future performance (higher trading costs, shrinking universe of investable stocks etc). Add in lofty valuations of growth stocks and the odds are against them repeating their past stellar performance.

Takeaway: Appearing on the best-seller lists is a curse, as they tend to be a harbinger of future underperformance; I’ve made a habit of identifying the most popular funds so I can avoid them!

No one has yet to find a way of identifying in advance the small percentage of active fund managers that will outperform, but perhaps that’s the wrong way of going about it, better success may come to those who identify funds that go on to underperform, and those tend to be the most popular ones.

It’ll be interesting to do the same exercise in 5–10 years as I’m sure the same pattern will play out again.