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Upgrader funds always follow the leaders
Top mutual funds are usually worth chasing, so much that one fund family simply buys the best in each category and holds them until something better comes along.
By Timothy Middleton
Nobody knows why, exactly, but hot mutual funds tend to stay hot long enough that you can make money chasing them. And now theres a tiny family of mutual funds that do this for you.
Sponsored by DAL Investment, publisher of the NoLoad Fund*X newsletter, the four funds target both stock and bond funds, ranked by their risk. Three are brand new. The fourth, FundX Upgrader (FUNDX), was launched last fall. In the second quarter, when the S&P 500 Index ($INX) plunged 13.4%, Upgrader went down only half as much, 6.6%.
Mark Hulbert, whose Hulbert Financial Digest has tracked the newsletters recommendations for decades, says that since 1989, it has delivered the best risk-adjusted returns of any investment newsletter, and the second-best returns overall. Its one of the better performers, he says.
The Fund*X strategy is to identify the hottest funds over the last one month to 12 months and to own them until their performance begins to lag. That can happen in as little as three months, but above-market performance can persist for more than a year.
Our goal is to be in the funds that are doing well now, says Janet Brown, president of DAL, editor of the newsletter and lead manager of the mutual funds. (She also is a current entrant in our Strategy Lab.) Lately, that's been value funds such as Clipper (CFIMX) and Yacktman (YACKX), but three years ago it was technology funds.
Differing risk classes
NoLoad Fund*X, the newsletter, groups mutual funds into four categories, from Class 1, most speculative stock funds, to Class 4, which are total return funds, including bond and real estate portfolios. (FundX also has a Class 5 for bond funds, which it ranks by overall performance but not with its proprietary scoring methodology.)
FundX Upgrader mainly invests in Class 3 funds, which the newsletter terms higher-quality stock funds. Hulbert has tracked their performance since 1980. In those years, the Class 3 funds the newsletter recommended advanced an annual average of 18.6%, compared with a 13.2% rise in the Wilshire 5000 ($TMW.X), or total market index, as of June 30.
The existing mutual fund puts 70% to 80% of its assets in these funds, with the balance coming opportunistically from the other classes, mainly Class 1 and 2. These more aggressive categories have not done as well historically: Class 1 has lagged the market with average gains of 12%. Class 2 gains have averaged 17.1%, Hulbert says.
Our system works by far the best with Class 3 funds, Brown says. They have the best long-term performance because you dont suffer the kind of losses in them that the speculative funds suffer. We dont recommend upgrading in the most aggressive funds.
But if you want to, you can. In July, DAL launched FundX Aggressive Upgrader (HOTFX), FundX Conservative Upgrader (RELAX) and FundX Flexible Income (INCMX). The aggressive fund will limit itself to classes 1 and 2. The conservative fund will draw almost entirely from Class 3. The income fund will invest principally in bond and balanced funds.
Letting winners run
DAL tracks hundreds of mutual funds. Despite the NoLoad Fund*X name, they include many load funds, such as Pimco Total Return (PTTAX). As institutional money managers -- DAL manages about $700 million, mostly for wealthy individuals -- the company can invest in institutional and other share classes that dont charge a load.
The funds are grouped into classes by their risk characteristics, which include such familiar measurements as beta, standard deviation and downside performance. Each month, all the funds are compared against the others in their class based on the average of their 12-, six-, three- and one-month returns.
These time periods were selected by DAL more than 30 years ago because it works, she says. Weve tested it every way. When the tech bubble burst in March 2000, for example, and market leadership pivoted to value from growth, she found that ignoring the 6- and 12-month numbers did not identify the new market leaders better than the existing system.
That surprised even me, she says. Intuitively she had thought that such a sudden lurch in leadership would be discovered by focusing strictly on one- and three-month returns, but that didnt produce better returns in her tests, she says.
The top five funds in each class that Browns system turns up are featured on the cover of the newsletter as recommendations. In the August newsletter, the Class 3 funds, in addition to Clipper and Yacktman, are PBHG Clipper Focus (PBFOX), American Century Equity Income (TWEIX) and FAM Value (FAMVX).
Readers are encouraged to own funds until they slip from their perch. Historically, funds have remained at the top of their class an average of seven months, but Hulbert says that recently, changes have occurred as often as every other month.
Why the good get better
In the history of what economists call the persistence of performance, annual changes were long considered the norm.
Mark Carhart, co-head of quantitative strategies at Goldman Sachs Asset Management, was among the first to document persistence of mutual fund performance while a finance professor at the University of Southern California.
One-year returns seems to be the right window, if you are only going to look at past performance, he says. For some reason if you go beyond a year, there is mean reversion, or return to average. If you go too short, theres so much noise you dont have enough information, he adds.
However, other scholars recently have come to different conclusions. A good performer one quarter tends to persist the next quarter, says Jeffrey Busse, assistant finance professor at Emory University's Goizueta Business School.
The reason for hot hands is, however, not understood. It could be sheer luck, as was true when leadership switched to value stocks from growth, and suddenly made stars of long-neglected funds, notably Yacktman.
But it could also be self-perpetuating to some extent. That is, hot money follows hot hands, and when fund managers put it into the same stocks they already own, they push up those shares prices. Rival managers who copy the leaders moves then could push prices higher still.
For Brown, why performance persists is of less interest than the fact that it does. Its just momentum, she says.
Several attributes make the new mutual funds more appealing than just following the newsletters recommendations. For one thing, DAL can access more portfolios, including closed funds, than individual investors. For another it doesnt have to pay redemption fees, which brokers such as Charles Schwab increasingly are imposing on funds held less than six months.
But since the funds tack an expense ratio of as much as 1.5% on top of those of the underlying funds, you pay steeply to do so. Particularly in the world of income investing, fees matter a good deal. Since the newsletter returns dont factor in such fees, they arent a reliable guide to how the funds can be expected to perform.
That said, Class 3 funds have beaten the market historically by so much that the RELAX portfolio might really allow you to do that, and still outperform the indexes.
At the time of publication Timothy Middleton owned the following securities mentioned in this article: PBHG Clipper Focus Fund.
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