- It is well established that many investors tend to purchase "winning" stocks—those that have recently outperformed—and to shun "losers."
- ETF providers evidently take investors' preference for winners into account by predominately launching funds whose underlying indices are outperforming at the time they make new product decisions.
- Strategies that produced excess returns over the prior three years generally behaved like an average investor's portfolio after the ETFs were launched.
Adventurous people who love riding in the gondola of a hot-air balloon would naturally detest plummeting to earth. Similarly, many investors have a pronounced tendency to channel funds to managers, strategies, and stocks with superior short-term returns, while steering clear of those that have been on a losing streak.
Empirical studies have amply documented this widespread propensity to favor winners and shun losers, and behavioral economists have cogently explained it. As long as 30 years ago, De Bondt and Thaler (1985; 1987) demonstrated that investors' partiality toward winners affects market prices. Grinblatt, Titman, and Wermers (1995), along with Wermers (1999), documented that mutual funds are, on average, trend chasers in their stock purchase decisions, and that the trend-chasing behavior is especially common among growth and aggressive-growth-oriented funds. Badrinath and Wahal (2002) found similar results for other types of institutional investors. As recently as this year, Hsu, Myers, and Whitby (2015) showed that, much to their detriment, investors repeatedly transfer assets from underperforming to outperforming mutual funds. This pattern of decision-making persists even though it clearly results in forgone gains or out-and-out losses in the long run (Jegadeesh and Titman, 1993).
What's hot may change abruptly, but investors' penchant for what's hot is steady, because it is sustained by ingrained psychological forces and habitual cognitive biases. Hong and Stein (1999) provided a theoretical foundation in demonstrating that trend chasers underreact to fundamentals at first, and then overreact as their numbers grow. Early trend chasers profit from the initial underreaction; late trend chasers lose money. Some investors are overconfident about their ability to pick stocks or time the market, and in evaluating their own performance, they give most weight to decisions that have proven successful (Daniel, Hirshleifer, and Subrahmanyam, 1998). Others, presumably less self-assured and more in need of social validation, simply follow the emotional crowd, buying the popular stocks and selling the ones that are out of favor (Howard, 2014). Thus, numerous factors contribute to investors' enduring preference for winners.
Over the last 10 years, investors have grown excited about exchange-traded funds (ETFs) as a market-valued vehicle, and, accordingly, providers have launched thousands of them. As Figure 1 shows, ETFs have enjoyed phenomenal growth, with the number of funds expanding by an order of magnitude, and assets under management increasing more than sixfold through 2014.
For a larger view, please click on the image above.
How do ETF providers respond to investors' well-established preference for strong recent performance? Our empirical research supported the common-sense conclusion: Because they bring to market products that investors will want to purchase, ETF providers launch funds with hot strategies. But in the process, our research revealed a striking pattern of investment performance.