In investing, a familiar story keeps playing out: a fund shines with impressive returns, climbs the charts quickly, grabs the media spotlight, and draws in a wave of excited new investors.
But often, this surge in popularity signals the start of a downturn rather than lasting success. Many jump on the bandwagon, only to be let down as the fund’s performance fades.
The idea that popularity guarantees future profits is misleading and can hurt your financial health. Research shows that chasing after the hottest funds usually isn’t a smart move.
The Illusion of Past Performance
Popular funds catch our eye because of their strong recent returns. We naturally trust numbers and feel safer following the crowd. But this comfort can be misleading.
Jeffrey Ptak from Morningstar recently offered some eye-opening insights into this phenomenon. (1) His analysis found that fund categories with the biggest inflows over three years often saw a sharp drop in returns in the following three years.
In more than 80% of cases, these popular funds underperformed the broader market afterwards. This trend holds across different asset types: equities, sectors, and bonds alike.
For instance, equity funds at their popularity peak earned about half the returns of other equity funds over the next three years.
This isn’t a one-off: it's a recurring pattern in the investment world.
Academic Evidence: Popularity as a Contrary Signal
Decades of academic research back up Ptak’s findings. Many studies show that highly popular mutual funds tend to perform worse after their peak:
- Morey (2003): Funds with 5-star Morningstar ratings saw sharp performance drops within three years.
- Massa and Yadav (2010): Funds with strong investor buzz experienced a 3.8% annual drop in risk-adjusted returns, worsening to 5.8% in bubbly markets.
- Greene and Stark (2016): "Trendy" funds consistently lagged behind less popular ones over five years.
- Choi and Zhao (2020, 2021): The link between past and future returns has weakened or disappeared recently.
Simply put, today's hot fund often becomes tomorrow’s disappointment.
The Paradox of Popularity: Why Underperformance Happens
So why does chasing popularity usually backfire? A few factors play a role.
First, recency bias makes us overvalue recent winners, assuming their streak will continue. But short-term returns don’t reliably predict the future. As more money floods popular funds, asset prices get pushed up, limiting potential gains.
Second, herd behaviour causes big inflows that create challenges for fund managers. They might be forced to buy overpriced assets or stray from their strategy, which often hurts returns.
Third, popularity can shift managers’ focus toward marketing and chasing trends instead of sticking to long-term plans. Research shows this often leads to worse performance.
The Hidden Cost of Following the Crowd
Chasing what's popular doesn't just risk lower returns; it also means missing out on undervalued funds that could outperform.
Ptak’s research highlights that top-selling fund categories often lag behind less popular ones within the same asset class after their popularity peaks.
Take sector funds in infrastructure and energy: they drew big inflows but delivered little in returns afterwards, while less popular sectors gained about 10% annually.
Hot Funds That Cooled Down
In the UK, several funds have seen this rise-and-fall pattern:
- Fundsmith Equity: Managed by Terry Smith, it was hugely popular due to strong long-term results but has underperformed the MSCI World Index for four years since 2021.
- Baillie Gifford American Fund: Focused on disruptive growth stocks, it faced big losses when sentiment shifted, with many investors buying at the peak suffering underperformance despite recent recovery.
- Jupiter European Fund: Once a favourite, it has struggled due to regional issues, management changes, and high fees, delivering less than half the sector average.
- T. Rowe Price Global Technology Equity Fund: Attracted investors seeking tech exposure but faltered due to poor stock choices, volatility, management changes, and high fees.
These examples aren’t meant to single out these funds but to illustrate that even popular funds can have rough patches. Chasing past success can be risky.
Follow the Evidence Instead
Rather than chasing the latest popular fund, take a thoughtful, evidence-based approach:
- Choose low-cost index funds, which often outperform actively managed ones over the long term.
- Focus on diversification, risk management, and aligning investments with your overall portfolio instead of reacting to headlines or star ratings.
- Pay attention to valuation - strong recent performance rarely lasts forever.
- Avoid emotional decisions driven by hype or fear of missing out.
- Adopt a critical mindset: don’t avoid popular funds blindly, but assess whether their success is sustainable or already priced in.
Resisting the Siren Song
Popularity in funds often turns out to be a misleading mirage rather than a sign of future success. Morningstar’s data and decades of research tell a clear story: funds at their popularity peak are more likely to stumble later.
This is driven by psychological biases and the challenges managers face handling surges in demand.
So next time a top-performing fund catches your eye, pause and consider the evidence. Long-term success comes from resisting hype, building diversified portfolios, keeping costs low, and investing with patience and discipline, being guided by reason, not impulse.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a freelance journalist and author, and Editor of The Evidence-Based Investor.
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