Hot funds and the curse of ‘self-inflated returns’

That’s because a fund’s returns often don’t depend merely on the behavior of the investments it buys, but also on the behavior of the investors who buy the fund.

Hot money—a sudden influx of cash from people trying to get rich quick—can overheat an ETF and create what new research calls “self-inflated returns." The result, sooner or later, is self-inflicted losses. Fortunately, you can protect yourself with some common sense.

What are self-inflated returns?

They start when a fund generates a burst of high performance. Maybe an “active" ETF run by stock pickers buys a few big winners. Or maybe a passive fund that holds everything in a benchmark tracking one market segment has gotten hot.

In either case, people notice. They buy the fund in droves, pouring in hundreds of millions or even billions of dollars. The ETF’s managers take that cash and pump it into the stocks the fund already owns.

If those stocks are small and thinly traded, the fund’s own buying will drive their prices up. That will raise its return again, attracting even more money from performance-chasers, pushing the prices of the fund’s stocks even higher and drawing in another blast of hot money.

A new study—by Philippe van der Beck, a finance professor at Harvard Business School, and Jean-Philippe Bouchaud and Dario Villamaina of Capital Fund Management, a Paris-based investment firm—looks at how this cycle feeds on itself.

As the researchers put it, “Investors chase their own impact."

The study hasn’t yet been published in a peer-reviewed journal, but I think the findings are solid.

Over the years, many portfolio managers have told me that large inflows at a fund that concentrates on smaller, less-liquid stocks can drive prices up if the fund’s buying constitutes much of the typical daily volume in those stocks.

This self-reinforcing cycle can delude investors into thinking a fund’s return is generated solely by the manager’s skill—when, in fact, it comes largely from the behavior of the fund’s investors themselves. Self-inflated returns can push prices higher and persist longer than you might imagine—although they’re bound to fade eventually.

Part of the study focuses on an ETF whose name the researchers won’t disclose. I’m almost certain that it’s ARK Innovation, the “disruptive innovation" fund actively managed by Cathie Wood that earned one of the highest returns in history when it gained 153% in 2020.

As of October 2019, ARK Innovation had nearly one-quarter of its $1.6 billion in assets in nine stocks. It owned more than 5% of the total shares at each of them. Such larger positions in smaller stocks included 9.9% of genome-editing company Intellia Therapeutics and 5.1% of genetic-testing firm Invitae.

As ARK Innovation’s returns flared up, investors pumped money in. In 2020, its assets ballooned more than ninefold from $1.9 billion to $17.7 billion. As ARK redirected that tidal wave of cash into its favorite stocks, Intellia rose 271% and Invitae 159%.

Sooner or later, though, performance falters, the hot money flees and managers have to dump stocks. That pushes down the prices of those stocks, worsening the fund’s performance and sending even more hot money stampeding out.

ARK Innovation’s assets peaked at about $25.5 billion in mid-2021 and have shriveled to $6.3 billion. The fund has lost an average of 27.9% annually over the past three years. Intellia and Invitae are down an average of 30.1% and 96.9% annually over the same period.

ARK declined to comment.

But its funds aren’t alone. On average, at the biggest, most-concentrated ETFs, 8% of the variation in performance over time can be attributed to what van der Beck calls “an increase in price generated by the funds’ trades as money comes in from their own investors."

The study shows that an ETF whose return is 10% better than average over a given period will increase its inflows by 2%—half of which comes within two months of the reported outperformance.

It also shows that self-inflated returns fade and reverse—but the exact timing is unpredictable.

Chasing momentum feels great on the way up; just ask anybody who bought GameStop at the beginning of this month when online influencer Keith Gill touted the stock again. But knowing just when to jump off is hard; GameStop fell from its peak by almost half in a couple of days.

“Everyone wants to be in on the virtuous part of the cycle, but not its evil twin," says investment analyst Tom Brakke.

Common sense is your best guide.

First, beware of funds that deviate drastically from a broad market index by holding only a few dozen stocks or lots of smaller companies. Those features are the breeding ground for hot returns and the hot money that chases—and inflates—them.

Check whether holdings are “capped," or limited to a fixed proportion of a market index—often somewhere between 2% and 5%. That should prevent the fund, no matter how popular it gets, from pouring too much money into its hottest stocks.

Steer clear of ETFs whose top holdings are heavily sold short by hedge funds and other traders betting on a decline. You can check the short interest in any stock on most market websites or brokerage apps.

Finally, watch out for rapid growth.

When billions of dollars gush into a small fund that just reported big gains, self-inflated returns are likely to follow.

Let other people chase them. In the end, all they’re likely to end up with is self-deflated returns.

Write to Jason Zweig at intelligentinvestor@wsj.com