Who makes money on mutual funds?

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PEOPLE WHO BUY MUTUAL funds solely based on past performance are probably kidding themselves. But that act of mass self-delusion ensures rich rewards for fund managers--even if they're only temporarily successful.

That's the conclusion of two economics professors at the University of Toronto, Michael Berkowitz and Yehuda Kotowitz, who specialize in the study of how compensation affects business behavior. They wondered why so few Canadian fund managers charge their clients extra in return for superior performance.

What they discovered is that successful fund managers don't need performance bonuses because investors, not surprisingly, tend to put their money into mutual funds that have performed well in recent years. These fund managers, in turn, gain market share precisely because of superior past performance and are richly rewarded as their management fees increase with the funds they administer.

But investors, says Prof. Berkowitz, shouldn't be putting their money blindly into funds that already have performed well. Why not? Because if a fund has been a winner for the past three years, it is quite possible that it will be a loser next year. "The investor's motivation is ill-conceived," says Berkowitz, "because the relationship between past and future performance is, if anything, negative."

In other words, Berkowitz and Kotowitz wrote in a recent issue of Canadian Investment Review, Canadian investors have a tendency to act irrationally. But you didn't need two tenured economists to tell you that, did you?

PHOTO (COLOR): BERKOWITZ AND KOTOWITZ: MUTUAL FUND INVESTORS ARE IRRATIONAL

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EDITED BY CHRISTIAN ALLARD