Funds receiving a flood of new investor capital in a short period of time doesn’t bode well for future performance, with new research from Morningstar showing that this hypergrowth often erodes excess returns over a few years.
In analyzing the past and subsequent performance of 568 funds that saw hypergrowth in assets over a 12-month period, Morningstar’s managing director Jeffrey Ptak found that funds seeing hyper-inflows were more likely to have outperformed than lagged their broad benchmark by a margin of roughly two-to-one. All told, the average rolling 36-month excess return was around 3.6 percent per year, which means that these funds typically had their growth spurt when they were handily outperforming — a trend that would reverse after the rapid inflows.
“Funds that see hypergrowth in assets tend to disappoint,” Ptak told Institutional Investor, with performance eroding from when “they were receiving the torrent of inflows.”
While there is a myriad of reasons for why this happens — the surge in capital could overwhelm a strategy that can’t be scaled, for example — Ptak says the biggest drivers come down to “luck and style.”
“It’s being in the right place in the right time,” he said. “You’ve got a strategy that catches a tailwind and investors take notice, then bring a lot of assets in. Then that stylistic tailwind dissipates or even reverses into a headwind, which reverses returns.”
A quintessential example of this hypergrowth pattern is Cathie Wood’s ARK Innovation Fund, which surged after the Covid pandemic boosted holdings like Teladoc and Zoom. This in turn led to a massive influx of capital in a short period of time — only for the fund’s performance to fall precipitously, leaving investors with large dollar-weighted losses.
“They came in at the tippy top, and as we saw, performance fell off a cliff and the shareholder base rode that down,” he said.
Other recent and “less extreme” examples of hypergrowth funds that followed this pattern include Wood’s ARK Genomic Revolution ETF and Global X Lithium & Battery Tech ETF, which outperformed their broad market benchmarks by at least 5 percentage points per year over the three years ended Aug. 31, 2021, only to underperform in the following three years.
An inability to deploy the excess capital can also be a problem for overwhelmed funds. When an investment strategy becomes saddled with more assets than its managers know what to do with, the strategy can no longer navigate “certain nooks and crannies of the markets,” Ptak said.
While Ptak concedes that there’s nothing wrong with a fund catching on, he warned that investors should be acutely aware of what’s driving this newfound popularity, and if its success is sustainable (an aggressive strategy, for example, may not work in unforgiving markets). He suggests that investors should at least temper expectations of future performance, since Morningstar found in most instances that excess returns against a broad market index eroded after a big influx of capital.
