The Power Of Passive Investing

April 20, 2011

Broad asset classes see higher cash in?ows after the markets have performed well and out?ows after markets have done poorly. A deeper analysis shows that the biggest contributor to these performance gaps likely comes from sector rotation within asset classes; in other words, market timing.

Morningstar divides mutual funds into dozens of sectors, styles and industries to analyze dollar-weighted performance across the spectrum of fund categories. Investors fared poorly from their timing in most categories. Here are some 10-year results:

  • Large-cap growth funds had returns of negative 2.2 percent, while investors in those funds had returns of negative 2.7 percent.
  • Small-cap value funds earned 8.8 percent, while investors in those funds earned only 7.1 percent.
  • Precious metals funds had the highest return of 18.6 percent, while investors in those funds earned only 15.9 percent.
  • Diversified emerging markets funds performed well with returns of 9.0 percent, while investors beat that average with a return of 9.9 percent.
  • U.S. taxable bond funds outperformed investors by about 1.3 percentage points.
  • Municipal bond funds beat investors by 1.6 percentage points.
  • Emerging markets bond funds earned 2.8 percent more than investors did in these funds.

The returns of mutual funds outperformed the returns of investors in most categories. In aggregate, investors hurt their performance by more than 1 percent per year. This is the penalty that active investors incur by thinking they can be successful market timers.

Dumb Money Vs. Smart Money
Investors who chase past performance are referred to by academics as dumb money. This is a “quiet” term because no academic is going to say publicly that these investors are dumb. Yet, mention this term at an analyst conference and everyone in the room knows exactly what it means. There are many investors, both individuals and institutions, that herd into sectors, strategies and asset classes based on the belief that past superior performance will continue into the future, and for no other reason.

An interesting paper by Andrea Frazzini and Owen Lamont outlines how smart money capitalizes on the way dumb money invests. First, the study explains why investors have a striking ability to do the wrong thing by sending their money to mutual funds that own stocks that do poorly over the subsequent years. Second, they develop a trading strategy based on this behavior to predict future stock returns. In a nutshell, doing the opposite of what most people believe will be pro?table can lead to excess returns.14

Smart money attempts to take advantage of dumb money mistakes whenever possible. Recall the grilling of Goldman Sachs’ trading desks by Congress in the spring of 2010. They decided to reduce their positions in subprime mortgages because they thought a lot of dumb money was buying. The ?rm is still in business today because they won that bet. However, this strategy doesn’t always work.

There have been many occasions when betting against dumb money hasn’t worked out. Long Term Capital Management thought they were betting against dumb money by purchasing Russian bonds as others were dumping them in 1998. Russia ultimately defaulted on its foreign debt obligations. This led to insolvency for Long Term Capital Management and put the country on the verge of a ?nancial market meltdown. In order to avoid the crisis, the president of the New York Federal Reserve had to orchestrate a bailout by several leading Wall Street ?rms.

How The Dumb Money Gets Divided
Tactical asset allocation is a zero-sum game. When someone underperforms the market it means someone must have outperformed before fees and expenses. The grand total dollar-weighted return for the average investor in all funds over the past 10 years was a 1.68 percent annualized return compared with a time-weighted 3.18 percent for the average fund according to the Morningstar study. So, where did this 1.50 percent go?

Much of it went to brokers, brokerage ?rms and their trading desks. Another portion went to a handful of talented money managers who skillfully separate investors from their money. Finally, believe it or not, a portion went to investors who develop a passive strategic asset allocation strategy and rebalance asset classes annually.


Find your next ETF

Reset All