The Power Of Passive Investing

April 20, 2011

Mutual Fund Flows Show Bad Timing
Mutual fund companies regularly report new purchases and sales of their funds, making it possible to track investors’ buying and selling habits. This information is available to the public through a number of databases.

Studies of fund ?ow data over the decades suggest that fund investors are chronic trend followers. They invest more money in funds that have recently performed well and take money out of funds that have recently performed poorly. This behavior can be characterized as a buy-high sell-low mentality. These bad habits of fund investors show up in individual portfolios as a timing gap between what could have been earned in a strategic asset allocation strategy and what investors actually earned using a tactical asset allocation strategy. This gap represents a cost to active investors.

Mutual fund ?ow data is the subject of many articles in the ?nancial media. The story of these articles is almost always the same: “Fund investors are poor market timers.” They then quote a new study highlighting the knife wounds that fund investors in?ict on themselves from their trend-following behavior. Some studies have concluded that fund investors lose several percent per year from poor market timing.

Mutual Fund Turnover Rates
We live in a rent-a-fund society. Investors typically hold onto their mutual funds for about the same time period as they hold onto a leased car or truck. That’s about three years. They then tire of the funds or become dissatis?ed with performance and follow the next bright idea. Mutual fund holding times tend to increase during a bull market and decrease during a bear market. Figure 1 illustrates the turnover rate for equity funds and bond funds for U.S. investors.

Exchange-traded fund (ETF) data isn’t included in Figure 1, and for good reason. The ETF industry has astronomically high turnover rates because these products are used extensively by traders and institutional investors as hedge vehicles. Some funds average turnover rates of several hundred percent per year. There are also highly leveraged ETFs that are speci?cally designed to be held for only one day or less.

High turnover among ETFs isn’t necessarily a bad thing. It keeps hedge funds and active traders out of traditional open-end funds and away from long-term investors. They also create liquidity in the individual securities that lie inside open-end mutual funds and that lower trading costs.

Figure 1

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