The Power Of Passive Investing: More Wealth With Less Work,” by Richard Ferri, hit shelves in December 2010. The book, which includes a foreword by Vanguard founder John Bogle, makes the argument for buy-and-hold index investing based on numerous academic studies, while offering guidance on how to construct low-cost portfolios with index-based investment vehicles.
Chapter 8, “Active and Passive Asset Allocation,” addresses the issue of “timing” by comparing the approaches of so-called tactical asset allocators and passive investors. It is excerpted below.
ACTIVE AND PASSIVE ASSET ALLOCATION
A key facet of the active versus passive debate goes beyond mutual fund selection into the timing of purchases and sales. Asset allocation is how and when an investor diversi?es among different types of investments in a portfolio. An investor following a tactical asset allocation strategy attempts to beat the market by changing asset class weights using market valuation forecasts or price trends. In contrast, an investor following a passive or strategic asset allocation strategy holds a fixed allocation among several broad asset classes in their portfolio over the long term. Passive asset allocation strategies have proven to be a more effective long-term solution for investors.
Tactical Vs. Strategic
Many investors try to achieve superior returns or reduce risk in their portfolios by varying the allocations among the asset classes at the right times. This method is commonly referred to as tactical asset allocation. To be successful, an investor must rotate money into mutual funds that represent asset classes or market sectors before the superior performance occurs and out of the sectors prior to poor performance. These tactical shifts in allocation can be large or small depending on an investor’s strategy and conviction.
Market timing strategies are a zero-sum game in the marketplace. The ?nancial markets don’t earn any more or any less return just because one person is buying and another is selling. If one investor buys in at the right time it means another investor must have sold at the wrong time.
There is academic precedence that points to measurable losses for investors who frequently trade their accounts. Using recent ?ndings from behavioral ?nance and survey data involving a large sample of online brokerage clients, Arvid Hoffmann, Hersh Shefrin and Joost Pennings found that nearly all equity trading strategies produced lower returns than the markets. Trading based on technical analysis (or charting) was the worst strategy. The raw net results of using trends and other chart patterns to predict returns was negative 0.92 percent per month. Trading based on ?nancial news, intuition and professional advice was the second worst, with a raw net return of negative 0.65 percent per month.1
Many mutual fund investors are also poor market timers. They have a long history of trend-following behavior, similar to the trend-following behavior that Hoffmann, Shefrin and Pennings noted in their study. Fund investors shift money into asset classes that have recently gone up in value and take money out of asset classes that have recently gone down in value. Buying high and selling low has never been a good way to invest. I estimate these tactical asset allocation errors cost investors about 1 percent per year.
Strategic asset allocation is a better strategy. Asset class weightings are set based on investors’ personal needs and only change when their circumstances change. This ?xed allocation of asset classes is maintained religiously through regular rebalancing back to asset class targets regardless of market conditions.
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.
Flow Of Funds Studies
Any analysis of mutual fund cash ?ows will uncover interesting information about how and when mutual fund investors make decisions. It provides a chronology of trading decisions made before the fact (ex-ante), which can then be compared to market outcomes (ex-post).
One use for fund ?ow data is a measurement of market timing skill among fund investors. This is done by studying changes in in?ows and out?ows among asset classes and then comparing this data to future moves in the markets. The overwhelming evidence shows from these analyses that people don’t have timing skill. In fact, frequent changes in asset selection hurt portfolio performance by a signi?cant amount.
Flow of funds studies go back several decades, with the early studies ?nding that investors chase top-performing funds. One study from 1978 titled “Is Fund Growth Related to Fund Performance?” found that investors disproportionally added to top-performing funds over a 10-year period from 1966 to 1975.2 A similar study conducted in 1992 concluded that investors responded more strongly to high performance in aggressive actively managed funds by purchasing more of them than less aggressive funds.3
Fund ratings were also a factor in fund-chasing decisions. The Boston Globe and the Wall Street Journal both reported in 1995 that about 97 percent of new investments that year went into mutual funds that had previously been awarded four or ?ve stars by Morningstar. A 2001 study found that an initial Morningstar ?ve-star rating results, on average, in six months of abnormal ?ows (53 percent above the normal expected ?ow). The authors of that study also found signi?cant abnormal ?ow in the case of rating changes, with positive ?ow for rating upgrades and negative ?ow for downgrades.4
The Federal Reserve Bank of Atlanta conducted its own study and found that “mutual fund investors use raw return performance and ?ock disproportionately to recent winners but do not withdraw assets from recent losers.” The Federal Reserve report noted that because of this behavior, “mutual fund managers have an implicit incentive to alter the risk of their portfolios to increase the chances that they are among the winners.”5
ETFs tend to be used by people who are more active traders than traditional mutual fund investors, and this leads to more mistakes. Cash ?ow studies show extremely poor market-timing results by active ETF investors. TrimTabs Investment Research, a consolidator of mutual fund ?ow data, concluded that equity prices tend to fall after equity ETFs rake in large sums of money and rise after equity ETFs post heavy out?ows. Regression analysis suggests the probability that equity ETF ?ows are a contrary leading indicator of equity prices is more than 99 percent. This means the ?ow of ETF money predicts market changes with high accuracy—in the opposite direction!6
One mutual fund cash ?ow study after another has consistently shown the same performance-chasing phenomenon. Fund styles with superior performance and high fund ratings raked in the most money, and this usually occurs close to the time when these investment styles peak in performance.
Institutions Are Also Trend Followers
Performance chasing isn’t limited to individual investors. Pension fund committees exhibit similar behavior, although not to the same degree. Amit Goyal and Sunil Wahal examined the selection and termination of private investment managers by 3,400 pension plans between 1994 and 2003. Plan trustees showed a tendency to hire investment managers after they delivered positive excess returns. However, these new managers failed to deliver returns better than the managers who were terminated for poor performance.7
In a more recent study, Jeffrey Busse, Amit Goyal, and Sunil Wahalu used a new, survivorship bias-free database to examine the performance and persistence in performance of 4,617 active domestic equity institutional products managed by 1,448 investment management ?rms between 1991 and 2008. Controlling for the Fama-French three factors and momentum, the trio found no distinguishable alpha in the data.8
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.
The most recent Dalbar study covering a 20-year period ending in 2009 found that equity mutual fund investors had average annual returns of only 3.2 percent while the S&P 500 averaged 8.2 percent, and ?xed-income fund investors had average annual returns of 1.0 percent, while the benchmark Barclays Capital Aggregate Bond Index averaged 7.0 percent.
Dalbar found a nearly 5 percentage point gap between equity funds and fund investors, and a 6 percentage point gap between bond funds and fund investors. These are extremely large shortfalls for investors. Are individual investors and advisors really that bad at timing the markets? The data compiled to date suggests they are.
Market Timing Gaps
A bear market in stocks tends to happen about every ?ve years and lasts about a year and a half. Studies on investor behavior show that people act very differently during down markets than they do in up markets. Basically, they’re scared in bear markets and brave during bull markets.
The Dalbar Guess Right Ratio measures how often and when the average investor makes smart decisions to get in or out of the stock market in general. This ratio also shows how often the average investor realizes a short-term gain by either buying or selling mutual funds before a market rises or falls. A reading above 50 percent is positive and a reading below 50 percent is negative. Figure 2 illustrates the Guess Right Ratio through 2009.12
Ironically, investors are right about the stock market’s direction in more years than they are wrong, as shown by the disproportionate number of years when the ratio was over 50 percent. However, when investors are pessimistic, they dump stocks. The wrong years tend to occur in the recovery after a bear market, and investors miss the rebound.
In a Gallup Poll of investors taken on March 4, 2009, just a few days before the market bottom, only 18 percent of investors believed the stock market would show a sustained recovery by year end; 27 percent thought it would take two years, 25 percent said three years; 19 percent said longer. About 2 percent said the stock market would never recover.
Only 18 percent of the investors surveyed in the Gallup Poll guessed right. The S&P 500 gained 67 percent from its intraday low on March 9 until year end.
Morningstar weighed in with a comprehensive study on dollar-weighted versus time-weighted returns. They calculated the 1-, 3-, 5- and 10-year time-weighted returns and dollar-weighted returns through 2009 for open-end mutual funds based in the United States.
The Morningstar study found signi?cant de?ciencies in investor timing decisions. U.S. equity fund investors experienced a negative 1.4 percent gap in return over 10 years while bond fund investors experienced a negative 1.3 percent gap over the same period. In aggregate, the timing gap was negative 1.5 percent across all asset classes and sectors.13 Figure 3 illustrates the difference in major asset class returns for the period.
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.
Investors who lose with their tactical asset allocation strategies indirectly provide excess returns to investors who religiously rebalance their strategic allocation. This occurs because rebalancing naturally forces investors to sell some amount of their better-performing investments and buy more of their worse-performing ones. Although it seems counterintuitive to do this, over time, rebalancing increases portfolio returns and lowers risk.
Strategic asset allocation and regular rebalancing provides what is widely referred to as the only free lunch on Wall Street. It’s a nice thought, but every economics student knows there’s no such thing as a free lunch, especially on Wall Street. Any extra gain in one person’s account means a loss in someone else’s.
The loser in this case is the investor who believes sector rotation strategies and market-timing decisions can beat the market. That investor loses about 1.5 percent return annually according to Morningstar and a lot more according to Dalbar. This loss amount from trading mutual funds is controversial. My opinion is that investors lose at least 1 percent per year from these activities.
Assume three investors each start to invest in January 2000 with a portfolio of 45 percent in U.S. stocks as represented by the S&P 500, 15 percent in international stocks as represented by the MSCI EAFE Index, and 40 percent in bonds as represented by the Barclays Capital Aggregate Bond Index. One investor uses tactical asset allocation in an attempt to beat the markets and underperforms them by 1 percent annually. The second uses a buy-and-hold strategy and lets the portfolio sit over a 10-year period, thereby earning market returns. The third investor rebalances every year for 10 years and thereby outperforms the tactical asset allocator and the buy-and-hold investor. Figure 4 illustrates the outcomes.
The rebalanced portfolio in Figure 4 picked up an excess compounded return of 0.9 percentage points over the market portfolio that wasn’t rebalanced during the last decade. This occurred because rebalancing is a natural way to sell high and buy low without having to make a market prediction.
The rebalancing bene?t varies with market conditions. The bene?t was high in the past decade because the markets were volatile. Over the long term, the bene?t tends to be about 0.3 percentage points net of trading costs.15
This excess return earned from strategic asset allocation represents a real wealth transfer that takes place in the marketplace. This return is enough to make up all the fund fees and trading costs that index fund investors incur, leaving these investors with very close to market returns. You can’t do much better than that.
Putting It All Together
Figure 5 quanti?es four portfolio management choices and is overly generous to active investors. Investors who use low-cost index funds and ETFs and strategic asset allocation earn market returns. Investors using actively managed mutual funds lose about 1 percent over index funds, and investors who employ tactical timing strategies lose another 1 percent. Investors who use both active funds and a tactical asset allocation strategy are expected to underperform an all-index fund strategic allocation strategy by about 2 percentage points per year.
Disciplined passive investors are smart-money investors. They follow a long-term strategic asset allocation strategy based on their needs and ?ll their portfolios with low-cost index funds and ETFs to represent those asset classes. They don’t mistakenly believe that they have the skill to pick outperforming funds and know they don’t have the timing skill to rotate in and out of different asset classes and sectors.
Many investors use both a strategic allocation and a tactical allocation. This strategy has been called core and explore, core and satellite, barbell, core plus and a variety of other names. The idea is to place part of the portfolio in a strategic asset allocation using index funds and ETFs, and then play with the remaining part of the portfolio using tactical asset allocation.
I call these combined strategies core and pay more because that best describes the outcome. The cost of the explore side is more expensive than the core side, and there’s no reason to believe that the active management results will be any better simply because there is less of it. Investors will likely earn market returns for their passive positions in index funds and below-market returns in that portion using tactical asset allocation.
Investment returns for a passive strategic asset allocation are much more likely to earn superior returns than those earned from tactical asset allocation strategies. The nuances of strategic and tactical asset allocation strategy go beyond the scope of this exploration.
A high percentage of new money ?ows into asset classes, sectors and styles that have had recent high returns. This trend-following behavior likely results in a loss of more than 1 percent per year in investors’ portfolios. For active fund investors, the timing gap loss is in addition to the shortfalls from the actively managed funds they buy.
Passive investors outperform those who attempt tactical asset allocation. Through regular rebalancing, passive investors bene?t from the mistakes of people who follow the crowd into past outperforming sectors. A passive strategy using index funds and ETFs that is followed religiously provides investors with the highest probability for investment success.
This article was lightly edited to reflect the editorial conventions of the Journal of Indexes.
Copyright © 2011 by Richard A. Ferri. Reprinted with permission of John Wiley & Sons, Inc.
1 Hoffmann, A. O. I., Hersh M. Shefrin, and Joost M. E. Pennings, Behavioral Portfolio Analysis of Individual Investors, Working Paper Series, June 24, 2010.
2 K. Smith, “Is Fund Growth Related to Fund Performance?” Journal of Portfolio Management 2 (1978): 307–328.
3 Richard A. Ippolito, “Consumer Reactions to Measures of Poor Quality: Evidence from the Mutual Fund Industry,” Journal of Law and Economics 35 (1992): 45–70.
4 Diane Del Guercio and Paula Tkac, “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows,” (working paper, Federal Reserve Bank of Atlanta, March 2001).bnotes.indd 249 10/19/10 1:25:16 PM
5 Diane Del Guercio and Paula Tkac, “The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds versus Pension Funds” (working paper, Federal Reserve Bank of Atlanta, November 2000).
6TrimTabs Investment Research, 2010.
7 Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” The Journal of Finance 63, no. 4 (August 2008): 1805–1847.
8 Jeffrey A. Busse, Amit Goyal, and Sunil Wahal, “Performance and Persistence in Institutional Investment Management,” The Journal of Finance 65, no. 2 (April 2010): 765–790.
9 Del Guercio and Tkac, 2000.
10 Edwin Elton, Martin Gruber, and Christopher Blake, “Participant Reaction and the Performance of Funds Offered by 401(k) Plans” (working paper, New York University, 2006).
11 Swensen, David F. Swensen, “Pioneering Portfolio Management,” 2nd ed. (New York: Free Press, 2009), 172.
12 DALBAR, Inc, “QAIB 2010 Quantitative Analysis of Investor Behavior,” 2010.
13 Russel Kinnel, “Bad Times Eats Away at Investor Returns,” February 22, 2010.
14 Andrea Frazzini and Owen A. Lamont, “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns” (working paper, NBER, August 2005).
15 Richard A. Ferri, “All About Asset Allocation,” 2nd ed. (New York: McGraw-Hill, 2010).