Investors Trail Funds by 1.9% Per Year

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Rick Ferri
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Investors Trail Funds by 1.9% Per Year

Postby Rick Ferri » Fri Feb 04, 2011 7:10 am

In a recently released article entitled “Past Performance is Indicative of Future Beliefs”,Philip Maymin and Gregg Fisher investigate how the aggregated timing of buying and selling by mutual fund investors affects their average returns. Using monthly returns and assets for approximately 25,000 mutual funds over the period November 1995 through October 2010, investors lost about 1.9% due to poor buy and sell decisions.

Here is a fact summary provided by CXO Advisory:

■ Over the entire sample period, for all types of mutual funds, the average fund investor sacrifices about 1.9% annually to poor market timing.
■ This poor timing derives essentially from replacing recent underperforming funds with recent outperforming funds. For example, peak net inflows to bond funds occur after equity bear markets in 2002 and 2008-2009.
■ A model assuming that a one-year “memory” of past returns triggers investor actions effectively explains the bad timing behavior.
■ The study infers that buy and hold investors fared better than those who attempted to time the sale and purchase of funds.

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Postby richard » Fri Feb 04, 2011 7:27 am

If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?

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Postby livesoft » Fri Feb 04, 2011 7:30 am

The market beating group has folks who buy on really bad days.

How do you know which group you belong to if you do not benchmark your portfolio?
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Postby RadAudit » Fri Feb 04, 2011 7:53 am

I like the chart in the cited paper which shows the decomposition of the 15 year annualized return of the S&P 500 of 6.75%:

Inflation - 2.38%
Investor Behavior - 1.91%
Average Tax Cost - 1.63%
Expense Ratio - 0.81%
Net Return to Investor - 0.02%

Let's see - a low cost, broad based index fund held (forever) in a tax sheltered account seems to be a good bet at maximizing real return to an investor. Sounds familiar.
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Postby at » Fri Feb 04, 2011 7:59 am

I guess that part of the market-beating group are the investment bankers, who sell stocks on behalf of corporation via IPOs during market peaks. Also, corporation might conduct, as insiders, share buybacks during market bottoms.

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Postby Rick Ferri » Fri Feb 04, 2011 8:17 am

richard wrote:If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?


Hedge funds, private wealth funds, trading desks, and, ironically, investors using buy, hold and rebalance strategy over the same period added about 1.9% per year over a buy, hold and do nothing strategy.

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Postby xerty24 » Fri Feb 04, 2011 9:23 am

A consequence of this is that financial advisors charging only 1% AUM fees to keep their clients in a buy & hold strategy are providing good value for their customers, even if they do nothing else.

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Postby Trebor » Fri Feb 04, 2011 9:34 am

I would not be surprised if "advisors" as a group do just as bad. Finding a "good" boglehead type advisor probably isn't as easy as it seems.
TINSTAAFL

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Postby xerty24 » Fri Feb 04, 2011 9:50 am

Trebor wrote:I would not be surprised if "advisors" as a group do just as bad. Finding a "good" boglehead type advisor probably isn't as easy as it seems.

Here at Xerty's Financial Non-Management services, you need to submit requests to change your AA 6 months in advance for processing. It's for Your Own Good (TM).

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Postby JW-Retired » Fri Feb 04, 2011 10:06 am

richard wrote:
If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?

Rick Ferri wrote:
Hedge funds, private wealth funds, trading desks, and, ironically, investors using buy, hold and rebalance strategy over the same period added about 1.9% per year over a buy, hold and do nothing strategy.

My quickie googling says that Hedge funds and Mutual Funds have roughly similar market caps of around $2T each. So doesn't that indicate Hedge funds are beating the market by 1.9%?

Of course, with 2 and 20 fees the Hedge fund investors still don't.
JW

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Postby fishndoc » Fri Feb 04, 2011 10:23 am

RadAudit wrote:I like the chart in the cited paper which shows the decomposition of the 15 year annualized return of the S&P 500 of 6.75%:

Inflation - 2.38%
Investor Behavior - 1.91%
Average Tax Cost - 1.63%
Expense Ratio - 0.81%
Net Return to Investor - 0.02%

Let's see - a low cost, broad based index fund held (forever) in a tax sheltered account seems to be a good bet at maximizing real return to an investor. Sounds familiar.

And, the pie chart leaves out trading costs (not part of a mutual fund's stated ER).
So, average investor return is almost certainly negative.
Last edited by fishndoc on Fri Feb 04, 2011 10:54 am, edited 1 time in total.
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Postby richard » Fri Feb 04, 2011 10:34 am

Rick Ferri wrote:
richard wrote:If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?

Hedge funds, private wealth funds, trading desks, and, ironically, investors using buy, hold and rebalance strategy over the same period added about 1.9% per year over a buy, hold and do nothing strategy.

After all the bad things we've heard throughout the years from you and other advisors about hedge funds, etc., we now find they're actually beating the market by a fair margin. One even hears their costs are coming down.

How can buy, hold and do nothing underperform the funds they're invested in? By definition they should exactly match (give or take reinvesting dividends).

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Postby richard » Fri Feb 04, 2011 10:36 am

xerty24 wrote:A consequence of this is that financial advisors charging only 1% AUM fees to keep their clients in a buy & hold strategy are providing good value for their customers, even if they do nothing else.

The cynical would say financial advisors have an incentive to tout papers that show the value of advisors. The Dalbar study is the classic example of the cynical being right.

On the other hand, many need help to avoid self-destructive investing behavior.

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Postby richard » Fri Feb 04, 2011 10:40 am

xerty24 wrote:Here at Xerty's Financial Non-Management services, you need to submit requests to change your AA 6 months in advance for processing. It's for Your Own Good (TM).

I had a similar post last year
viewtopic.php?t=59422&start=0

Your version is much more direct.

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Postby lazyday » Fri Feb 04, 2011 12:46 pm

Maybe the lost 1.9% increases performance for everyone else. Similar to the fee when buying or selling Vanguard's International Smallcap fund: the fee is added into the fund for the other investors.

So if you buy&hold, or if you buy&hold&rebalance, your return is assisted by those investors who buy high and sell low. If they weren't in the market, then returns would be lower.

I'm not sure you need to buy low and sell high, or be a hedge fund, to gain from those who lose to emotional investing.

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Postby rustymutt » Fri Feb 04, 2011 12:54 pm

richard wrote:If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?


Wall street beats the market by taking the extra money from under educated investors.
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Postby rustymutt » Fri Feb 04, 2011 12:56 pm

livesoft wrote:The market beating group has folks who buy on really bad days.

How do you know which group you belong to if you do not benchmark your portfolio?


Simple, looks at how your funds/ETFs have done for the time period compared to your returns.
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Postby peter71 » Fri Feb 04, 2011 1:30 pm

Based on a quick read the article's authors' primary interest is in putting forward a deductive model rather than in empirics.

As a result, there's really only a little bit about the dataset and no split-sample or out-of-sample checks on the 1.91% calculation.

Taking the 24,719 mutual funds from Morningstar data that had at least some assets data and some returns data during the past fifteen years, we calculate the rolling annual fund returns and average investor returns using the calculations described in Appendix A. For each rolling window of 13 months (the first month is required to know the initial asset size), we require complete data on assets and on returns. However, to minimize possible survivorship bias, we only require this complete data on each 13-month rolling window; we do not require funds to have all data for every month for the past fifteen years.


So the basic finding is that, among funds that are at least 15 years old, investors have done 1.91% worse than the funds over a 15 year study period (perhaps because they performance-chased, as I agree many did in the late 90's, but perhaps also because they got liquidated, retired, etc.)

Question: Is this finding highly sensitive to the 15-year study period?
Answer: Yes.
Evidence: See VTSMX investor returns over 3, 5, 10 and 15 year periods


http://performance.morningstar.com/fund ... -US&s=SPYZ

Conclusion of 15-year study: VTSMX investors are idiots! Stupider than average because they trail the fund by 2.19% per annum.
Conclusion of 3, 5 and/or 10-year study: VTSMX investors are geniuses! Investor returns BEAT the fund over all three study periods. And by as much as 1.57% per annum!

All best,
Pete

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Postby grabiner » Fri Feb 04, 2011 11:29 pm

richard wrote:If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?


The investors aren't underperforming the market; they are underperforming the funds. If Fund A gains 20% with a $1B portfolio and Fund B gains nothing with a $3B portfolio, investors switch $2B from Fund B to Fund A, and now Fund A gains nothing and Fund B gains 20%, the market went from $4M to $4.4M, a 10% gain over two years (4.9% annualized), even though both funds reported a 20% gain over the two years (9.1% annualized).
David Grabiner

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Postby asset_chaos » Sun Feb 06, 2011 7:27 am

I am not astonished that market timing of any kind produces poor results in aggregate, but I am astonished that 25,000 mutual funds exist. The web says there are around 19,000 exchange listed companies in the world. More funds than companies seems silly to me.
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Postby pointyhairedboss » Sun Feb 06, 2011 10:37 am

Question: Even if investors behaved rationally, wouldn't they still under perform the market (albeit to a smaller amount)?
Consider:
- Stocks outperform bonds over the long term.
- When rebalancing, investors will typically sell shares from stock funds and into bond funds. Over the long time, the stock funds will continue to outperform, and the investor won't get all the outperformance as they have sold a portion of it.

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Postby richard » Sun Feb 06, 2011 10:46 am

grabiner wrote:
richard wrote:If one group is consistently underperforming the market by 1.9% per year, another group must be consistently beating the market by enough to make everything balance (all investors as a whole must equal the market performance, before costs).

What is the market beating group?


The investors aren't underperforming the market; they are underperforming the funds. If Fund A gains 20% with a $1B portfolio and Fund B gains nothing with a $3B portfolio, investors switch $2B from Fund B to Fund A, and now Fund A gains nothing and Fund B gains 20%, the market went from $4M to $4.4M, a 10% gain over two years (4.9% annualized), even though both funds reported a 20% gain over the two years (9.1% annualized).

The aggregate of all funds should be a good approximation of the market. If there's a major disconnect, then something odd is going on.

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Postby richard » Sun Feb 06, 2011 10:50 am

asset_chaos wrote:I am not astonished that market timing of any kind produces poor results in aggregate,

pointyhairedboss wrote:Question: Even if investors behaved rationally, wouldn't they still under perform the market (albeit to a smaller amount)?
Consider:
- Stocks outperform bonds over the long term.
- When rebalancing, investors will typically sell shares from stock funds and into bond funds. Over the long time, the stock funds will continue to outperform, and the investor won't get all the outperformance as they have sold a portion of it.

Investors in the aggregate are the market. Beating the market is a zero sum game (before costs). Individual investors can easily underperform the market, but it's hard to see how all investors can underperform the market, i.e., all investors (again, before costs).

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Postby lazyday » Sun Feb 06, 2011 1:14 pm

Richard, you could add the word "retail" before the words "investor(s)" to distinguish the rational retail fund buyers from institutional investors.
And don't forget young investors with 100% stock portfolios.


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