The Hot Hand Vs. Passive Investing

Do individual investors chase hot managers of funds? It would appear so. Is there a tendency to jump ship when an investment or manager lags? That also
appears to be the case. Let's look at Morningstar Domestic Stock Manager of
the Decade, Bruce Berkowitz, and his fund, the Fairholme fund.

The Fairholme Fund recorded a 14% annualized return from inception through
the end of December 2010. The fund in 2011, however, landed at the bottom of
the barrel in the large value category , losing -32.4%! Since the fund has run
into heavy headwinds, investors have fled in droves and the fund has shrunk from over $18 billion to less than $11 billion in assets. These investors that sold
have locked in their losses.

Lest you would think this is an isolated case, let's look at one of the most
highly touted managers, Ken Heebner, and his fund, CGM Focus. According to
a recent article by Max Magee on Tickerspy(http://www.tickerspy.com/newswire/?p=1284), the Wall Street Journal listed CGM Focus as Stock Fund of the Decade. Its track record has been incredible this past decade. Manager Ken Heebner led this fund to an 18.2% annual gain ina de cade for which the S & P 500 was in the red, placing him tops among all domestic equity fund managers during the last decade ending December 2010, besting the S & P 500 index and Russell 1000 by 20 percentage
points.

Since it has had such a good return, shouldn't you have put this in your portfolio?
Not so fast! First of all, with an average turnover ratio of 333%, you could have ended up with a huge tax liability, as in 2007, when CGM Focus declared a distribution of $9.91 a share or 18% of the funds end of year share price.

Still want to chase these returns? Lest you think you can handle this volatile
fund, let's see what actual CGM Focus investors made. According to Morningstar,
most of the fund's investors did not make 18.2% compounded, not even close. The average CGM Focus investor earned a negative 11% annually over the past decade!
That translates into a total loss of 68.8% for the decade. This kind of return
over an entire decade will definitely hamper your investment goals.

How could this happen? Well, let's take a quote from an interview with Mr.
Heebner. " A huge amount of money came in right when the performance of the fund was at a peak,” says Mr. Heebner, the funds manager since inception. “ I don't
know what to say about that. We don't have any control over what investors do."

This herd behavior of investors and how they goof things up for themselves is
a huge lesson and must be recognized and understood in order to be avoided. So
what did investors in the CGM Focus fund do in 2011? They bailed out just like
the investors in the Fairholme fund. More than $630 million dollars have been pulled out from the fund, leaving less than 2 billion in assets. These shareholders must not have been satisfied with a return of -26.3 in 2011.

Investing in a hot performing managed fund is a losing game for the average investor. Investing exclusively in individual stocks adds significant risks, if there are too few holdings. A far better approach would be to consider broad based, low cost, passively managed exchange traded funds(ETF's) for the bulk of a portfolio. As core holdings, this approach takes the hot or cold streak of the manager out of the equation.