Copyright 2020 Tom Madell, PhD, Publisher
Nov. 2020. Published Oct. 29, 2020. Updated: Nov. 1
by Tom Madell
One may be tempted to congratulate themselves for having been astute enough to hold one or more funds/ETFs that have shown amazing long-term performance, maybe even near the top of performance charts.
However, I have long advocated in my Newsletter that very high average annualized fund returns over a number of years, rather than being celebrated, should make one think twice about continuing to savor such funds. The outstanding performance likely gives investors confidence that such holdings are solid enough to keep holding them for a long while, or perhaps even indefinitely.
But is it possible that funds with near top-of-the-chart prior returns actually have somewhat poorer prospects than other funds of the same ilk? And does a predominance of high performing funds across nearly all fund categories suggest that fund prices as a whole may have become stretched too far precipitating a severe pullback?
For outstanding funds that one opts to buy and hold, one might expect these funds to do well, both in an absolute sense against the market as a whole, and in a relative sense against their peers, regardless of the market's inevitable ups and downs. But some funds, and/or their average category's performance, can wind up doing so outstandingly well, that they should serve to raise warning bells. In this article, I will explore such a phenomenon and provide rather stark evidence, not mere conjecture, to back up the notion of "overheated" funds and categories turning out to lead to very poor performance over the next five years or so.
Warning bells suggest that enough evidence may have appeared to possibly suggest an undesirable future occurrence. While no one knows what the future will bring regarding stock fund/ETF performance, there are tantalizing clues that perhaps there is such a thing as "overheated" funds and fund categories.
First, I must define what I mean by "overheated." Down through history, stocks have averaged annual returns of about 9 to 10%. While periods have certainly existed when funds returned more than that for a number of years, the longer a large collection of stocks that make up a fund exceed that average, either one (or in some cases, both) of two things appear to be happening: a) the collection of a certain type of stocks have become so popular that investors are willing to put aside typical risk assessment in order to own that collection, or, b) a fund manager is truly skilled in identifying and including those stocks that will indeed exceed fellow-competing funds; a) seems most true, but not exclusively, for index funds, while b) requires expert stock picking skill. An "overheated" fund might be defined as one exceeding the 9 to 10% average annualized return by a large margin for many years running.
In spite of claims made otherwise, we know that no one fund manager or index can successfully outpace the market indefinitely. If a fund manager appears to be doing so, we can likely attribute much of that success to either luck or perhaps just identifying a group of stocks that have captured the investing public's imagination enough, as in a) above, to vault that group into even higher performance than what stocks normally return.
My prior research suggests that an annualized return of nearly double the expected return, that is a return of 15 to 16% or more, achieved over a period of 5 or more years, would qualify a fund or merely its category, as what I call overheated. So the question now becomes once a fund or category has become overheated, does this suggest anything about returns in the future? In particular, does it suggest good returns in the subsequent 5 years, or relatively poorer returns over the period? Or perhaps one might guess it would have no relationship at all to future returns.
Let's briefly look at three examples of nearly all fund categories becoming overheated. In January 2000, 8 of the 9 Morningstar categories (3 x 3 style grid) of funds met the above definition with the S&P 500 index showing an annualized 5 year return of 28.6%! (not a misprint). The only category not meeting this definition was Small-Cap Value. By 5 years later (beginning of 2005), the index was returning -2.3% ann.; the Small-Cap Value category, however, was now returning +16.2% ann. So, ironically, Small-Cap Value itself had now become overheated. By Jan. 2010, Small-Cap Value was now showing a trailing 5-year ann. return of only +0.9%. A rather extreme example perhaps, but illustrating my point that overheating as I have defined it can be a warning sign of potential trouble ahead.
In Oct. 2007, all major categories of international funds met my definition of being overheated, along with 7 of the 9 Morningstar categories. By 5 years later, ann. returns of the average international fund was -5.0% while for US diversified funds it was just +0.2%.
Likewise, in Jan. 2014, all 9 Morningstar categories were simultaneously overheated, most of all Small and Mid-Cap funds, averaging a trailing 5 year return of 20.9% By 5 years later, the average diversified US stock fund was returning an underwhelming 4.8% with Small and Mid-Cap funds averaging only 3.9%.
At the end of 2010, as I reported in my April 2015 Newsletter, (see the page 5 marked there), the 7 top performing specific funds had an average ann. 5 year return of +20.2% while the overall market had done poorly over the period, due mainly to the 2007-2009 bear market.
By 5 years later, the average 5 yr. ann. year return of the 7 funds was -12.5%; by contrast, the average similar return for all diversified US stock funds was +9.1%.
More recently, in April 2015, as also reported in the above link (see the page 7 marked there), some funds were also overheated, or nearly so. At the time, I listed eleven such funds and specifically predicted at that time that those funds were likely to underperform otherwise good funds that were not overheated. The table below shows each of these funds and how they did in the subsequent 5 years (2015-2020). It also shows how the average fund in the same category as each of the funds did.
|Eleven "Overheated" Funds in Spring 2015
Along with Subsequent 5-Yr. Annualized Fund Performance
as Well as Their Category's Performance
|April 2020 5-Yr
|April 2020 5-Yr Ann.
|Vanguard Small Cap Growth
Index Inv (VSGIX)
|T. Rowe Price Mid-Cap
|Fidelity Mid Cap
|Vanguard Mid Cap
Index Inv (VIMSX)
|Oakmark Select I
|Delaware Value A
|Invesco Small Cap
Value A (VSCAX)
|Vanguard Health Care
|American Century Real
Estate Inv (REACX)
|Average Ann. 5 yr. return
for the above funds
and their categories
As the table shows, all eleven funds did significantly poorer over the subsequent 5 years, dropping from a mean of about 17% to 1% annualized. While most stock funds performed poorly over the 5 year period, when compared to the average fund in each of the eleven represented categories, the average ann. return for the overheated funds was approximately 1.8% less. In other words, the overheated funds in 2015 did quite poorly over the following 5 years, even worse on average than their category peers. The results suggest that broad-based fund overheating can serve as a warning of poor fund and entire category performance by 5 years later.
Note: Five year returns between April 2010 and April 2015 were negatively impacted by the coronavirus pandemic-induced bear market that began in Feb. 2020 but had largely dissipated by Aug. A repeat of the of the above analysis between Aug. 2015 and Aug. 2020 showed nearly the identical data trends as shown in the table suggesting that the depressed results were not just a result of the timing of the bear market in the table's results.
Each of the above historical instances should serves as a cautionary flag for investors to be on the lookout for overheated funds and categories in the latest market results.
As of the beginning of this Oct., the following 3 categories of stock funds/ETF can be considered as overheated: Large Cap Growth, Science/Technology, and Gold. Their prior 5 year ann .returns were 18.2, 22.5, and 22.0% respectively.
The following are some particularly overheated funds in these categories and their 5 year performance, as well as those dominated by stocks that are highly weighted in those type of stocks. Of course, there are many other overheated funds, particularly managed funds that include sectors of the market that are currently highly popular with investors today. (5 Year Performance shown as of 10/27/20)
If we can extrapolate past trends from the past 25 years or so (beginning from the run-up of stocks going back to 1995), it makes sense to be cautious with regard to any funds, indexed or managed, that exhibit returns far in excess of what is normally expected.
Of course, this may not apply to investors who are truly able to be buy and hold investors for the next decade or more since down periods for stocks may be able to overcome periods of poor returns when held for the very long run. Nor does it necessarily mean that investors need to rush out of overheated stocks within the next few months or so since the trends we see reported in the development of poor returns may require years to materialize. But investors who are concerned with their fund performances for the next half-decade or so may want to start to reduce or eliminate positions in these highly super-charged funds and their categories in favor of funds that haven't overheated either right now or in the recent past.
Note: Fund 5 year performance can be checked at your fund's website or at morningstar.com .
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