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FRC Study Confirms Investors Chase Fund Returns to Their Detriment

Man on Coin Stack

Bad news from Financial Research Corporation: fund investors chase returns like a mule with a carrot dangling in front of its nose - and it's hurting them in the long run.

"Our research shows that accelerating redemption rates and declining holding periods are entrenched problems that have been worsening for more than a decade," says Gavin Quill, Director of Research Studies at Financial Research Corporation (FRC) and author of the study. "It will take a concerted effort by financial professionals and individual investors alike to reverse this disturbing trend and to undo its detrimental affects on the long-term financial health of the investing public."

In a study commissioned by Phoenix Investment Partners, FRC found that mutual fund investors had 20% lower returns, on average, over 3-year periods during the last decade. In particular, FRC noted that from January 1990 through March 2000, the average fund's 3-year return was 10.92%, while the actual return to investors was 8.7%.

Somewhere along the line, the creed for many mutual fund investors in the 1990s became, "Buy high, sell low."

Investors have also been redeeming funds at a faster clip lately - the average holding time period for a mutual fund is currently 2.9 years, compared to 5.5 years four years ago in 1996. Essentially, holding periods have decreased as the markets have gone up.

Implied holding period (years)*

*Implied holding periods are based on redemption rates. For example, if an investor has a 25% redemption rate, a quarter of assets are redeemed each year, and over a four-year period all assets will be liquidated.[/:Author:] [:Date:]Source: Financial Research Corporation[/:Author:]

And there was more bad news for individual "do-it-yourself" investors. When FRC examined the data, it found that funds sold through an investment advisor had less redemption than funds directly marketed to individual investors. According to FRC, fund redemption for individual self-directed investors averaged 18% in 1996 and moved up to 30.5% in 2000. Redemption rates for investors who purchased "wholesale" funds through advisors was 13.8% in 1996 and 25.4% in 2000. Phoenix Investment Partners interpreted the widening redemption gap to mean that investors with advisors are better coached to ignore market fluctuations and stick to their long-term investment plans.

Additionally, FRC found that investors truly do chase hot-performing funds and sectors - and usually jump on the bandwagon after funds have peaked. Over the 1990s, FRC concluded that, on average, $91 billion in new cash flowed into funds after they experienced their best-performing quarters. Conversely, $6.5 billion in new cash went into funds after they had their worst-performing quarters. FRC examined performance chasing - which it defined as higher net flows into mutual funds after their best-performing quarters - in 48 Morningstar categories, and found it to be the case in 42.

This evidence lends credence to a common phenomenon in the investing world: fund has record-breaking year/quarter, media attention and advertising hypes fund, fund manager speaks on CNBC, cash flows into fund, fund returns to earth leaving most of its new investors holding the bag.

"The moral of the study is that investors who make investment decisions based on emotion, not logic, in pursuit of big stock market gains, are more likely to lose out in the long run," said Jack Sharry, President of Phoenix Investment Partners' Private Client Group.