Contrarian Strategies Work
(For Some) In Mutual Funds

Summary: Chasing returns in mutual funds is likely to lose you money - but it's good business for people who can trade against you.

The Basis of Contrarian Investing

Contrarian investing has been popular for many years. Contrarian investors buy when the majority thinks it's time to sell. Contrarian investors sell when the majority thinks it's time to buy.

The basis of contrarian investing is that, in bull markets, traders usually bid stocks higher than the underlying fundamentals can justify. Similarly, in bear markets, traders usually sell down stocks to lower prices than the underlying fundamentals can justify.

Contrarians buy and sell in the opposite direction to the popular flow, in the expectation that the price trend will reverse soon.

This style of investing, however, can be very risky. The famous British economist John Maynard Keynes once said,

"Markets can remain irrational far longer than you or I can remain solvent."

Many would-be contrarians have discovered the truth of Keynes' statement and have lost heavily betting against the markets.

Not everyone who goes against the flow, however, loses money.

Contrarian Flows in Mutual Funds

When it comes to investing in mutual funds, individual investors have a marked talent for doing the wrong thing.

The average individual investor tends to follow - probably unwittingly - a momentum strategy. They buy mutual funds that have performed well in the recent past. This is because it's only the successful funds that are advertised. Less successful funds are left to plod along unloved and starved of publicity.

Since much of the out-performance or under-performance of mutual funds is a matter of chance, it's unlikely that this year's "hot" mutual funds will stay hot for long. This year's hot funds will, however, get a bigger share of investors' money than under-performing funds will. The flow of money into hot mutual funds can be described as "dumb money".

There is evidence now that corporations are benefiting from trading in the opposite direction to that taken by smaller, "dumb" investors.

Andrea Frazzini, of The University of Chicago, and Owen A. Lamont, of Yale, published a paper in 2006; Dumb money: Mutual fund flows and the cross-section of stock returns (pdf file).

The authors found that when large flows of money enter a mutual fund, the fund managers need to use that money to buy more of the stocks in the fund. This can push the prices of these stocks up. The companies whose share price is rising then issue more shares at elevated prices. Companies are therefore able to profit by issuing and selling shares for more than their true worth. Investors who buy into a hot mutual fund lose money when the shares fall back to realistic prices.

Companies follow a contrarian strategy, selling their own stock when there is buying pressure from dumb money flowing into hot mutual funds.

How Can I Benefit From This Information?

How should you use Frazzini and Lamont's report to your own advantage?

The main lesson is that, if you buy into hot mutual funds, your investment is likely to under-perform the market in the longer term. If you're investing with a longer-term perspective, it makes sense not to buy into hot mutual funds!

It's also worthwhile recording several other longer-term conclusions from Frazzini and Lamont's report:
  • Value stocks have higher average returns than growth stocks. Hence buying stocks with low price/earnings ratios is a better bet in the long run than buying stocks with high price/earnings ratios.
  • The corporate sector tends to sell growth stocks and buy value stocks. (Companies can do this by issuing more shares when their shares are overvalued and by buying back their own shares when they are undervalued.)
  • Individuals, using mutual funds, tend to buy growth stocks and sell value stocks.