The previously mentioned study done by the Federal Reserve Bank of Atlanta also looked at pension fund ?ows and found that trustees do act differently than individual investors in one regard. For pension funds, it is whether a manager beat a benchmark that’s important. For individual investors, it’s the magnitude of outperformance.9
Pension trustees who oversee employee-directed retirement accounts such as 401(k) and 403(b) plans are tasked with selecting funds for the plans. The investment committees for these plans exhibit a strong preference for past top-performing mutual funds. One recent study shows that as trustees change fund options, they tend to choose funds that outperformed in the past, but after the change, the new funds performed no better than the underperforming dropped funds.10
Large university endowment investment committees also exhibit performance-chasing behavior in their asset allocation decisions. Developed international markets posted equity returns of 24 percent over a three-year period ending in 2006 and emerging markets posted returns of 36 percent while the U.S. equity markets posted returns of only 13 percent. In response, college endowments boosted their allocation to foreign markets from 14 percent in 2003 to 20 percent in 2006.11
Investors who jump on a trend expecting to see above-market returns more often ?nd themselves standing in the slow lane at the checkout counter. The consequences of this losing tactical allocation strategy are clearly evident in the portfolios of individual investors and many institutional investors.
Measuring The Timing Gap
The timing gap is consistent, predictable and measurable. But before you can appreciate this, a brief explanation of performance calculation methods is required.
Flip through the mutual fund section of your local newspaper or look at any website to ?nd the performance of your favorite mutual fund. The result you see is a time-weighted return of the fund. This is an internal rate of return number that assumes no cash ?ows into or out of the fund. It’s used strictly for comparing the return of the fund to the return of an appropriate index.
Time-weighted returns assume that $100 is invested in a fund at the beginning of a period and remains invested throughout the period. The calculation is the same regardless of the time period. It doesn’t matter if the returns are year-to-date, 1 year, 5 years or 25 years.
A fund’s time-weighted return rarely re?ects the actual return of an individual investor because it doesn’t account for the money that investors add to the fund or deduct from the fund. These additions and withdrawals from a fund over time create real dollar profits and losses for investors. These real pro?ts and losses are known as dollar-weighted returns.
The shortfall in return caused by tactical asset allocation is a timing gap that can be measured by comparing mutual fund cash ?ows to the subsequent performance of sectors and markets. A negative return from timing occurs when money is shifted out of a poorly performing asset class that subsequently outperforms or ?ows into an asset class that subsequently underperforms.
Dalbar Studies The Performance Gap
Early attempts to measure the timing gap began in 1994 with Dalbar, Inc. The ?rm was commissioned by the active mutual fund industry to investigate the differences in holding times between load funds and no-load funds. The theory put forth by the fund companies was that investors stayed invested longer in load funds than they did in no-load funds, thus giving the load fund investor higher returns. The fund companies hoped to use this information to counter the criticism they were receiving for selling funds with high sales commissions.
The Dalbar study did show that load fund investors held onto funds longer than no-load investors, but this ?nding wasn’t what made this study famous. Dalbar revealed huge timing gaps for both load fund investors and no-load fund investors. These gaps were so large that they astonished the investment industry. Some people tried to discredit the study by pointing to ?awed calculation methodologies. However, even when new calculation methods were used, the gaps remained sizable. It appeared that the Dalbar study was onto something important.