Research Affiliates: Woe Betide The Value Investor

March 09, 2015


Why might growth investors do so much worse? Apparently the same investors who tend to chase high-flying growth stocks are also the ones who chase high-flying growth managers—in both cases to their own detriment. It is possible that growth mutual fund investors are less financially sophisticated on average; the evidence that value strategies outperform growth is widely taught in business schools and professional credentialing programs.

Perhaps, then, less sophisticated investors are more vulnerable to their natural trend-chasing instinct and, therefore, to cognitive errors and behavioral biases that show up in their trading. Similarly, it seems reasonable to suppose that investors in high expense ratio funds are also likely to be less financially sophisticated. It would be unsurprising if investors in high expense ratio funds suffered more from poor timing decisions. Indeed, this is exactly what Hsu, Myers, and Whitby (2014) find. Table 3 shows that investors in funds with the highest expense ratios experience a dollar-weighted return fully 4.01% less than their respective funds' time-weighted return. Investors in funds with low expense ratios experience a better (but still bad) shortfall of 1.34% due to their trading in and out of the funds.


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In contrast, value investors, index fund investors, and institutional fund investors tended to do better, in terms of the return gap they experience. This is intuitive in light of our interpretation on investor sophistication. We emphasize that, on average, all mutual fund investors underperform the buy-and-hold return; the gap between their actual dollar-weighted returns and the funds' reported time-weighted returns is always negative on average. Our research indicates that the more sophisticated investor groups—for example, value and institutional fund investors—just display a smaller-than-average return gap.

In Closing
There is an enormous gap between mutual funds' time-weighted rates of return and the dollar-weighted returns that investors actually receive. Although numerous researchers have carefully documented this phenomenon, the investment industry has largely ignored its most significant implication. If value investors are losing money in mutual funds, then it seems most unlikely that value investors' transactions will arbitrage away the value premium. In fact, it is rational to suspect that the average trigger-happy value investor may be funding the value premium. Certainly their trading activity accentuates the volatility of the value cycle.

The return gap also provides us with two useful insights.

  1. The trend-chasing habit has been detrimental to the average fund investor even if he or she invests in outperforming strategies executed by skillful managers. In our assessment, a trend-chasing allocation process, combined with cyclical (mean-reverting) style or strategy performance, has contributed most appreciably to the observed return gap. This interpretation almost surely applies as well to institutional investors; it is a public secret that consultants disapprove of but nonetheless go along with clients' penchant for hiring "hot" managers only to fire them after three years of lackluster results (West and Ko, 2014).
  2. Financially less sophisticated investors—those who are attracted to active growth funds with high expense ratios—experience the greatest return gaps over time. Thus consultants and financial advisors may wish to help put into place an investment governance structure that discourages clients from tactically allocating their positions unless they are financially very educated and demonstrate the ability to overcome the behavioral bias for trend-chasing.

Appendix: Measuring Dollar-Weighted Average Returns
The time-weighted or buy-and-hold return of a value fund is easy to calculate: The geometric average of its reported returns is what you would have earned had you bought in at the beginning of a period and never sold. But what if you had moved money in and out of the fund? Then you need the dollar-weighted average return to know what your portfolio actually earned.

Hsu, Myers, and Whitby (2014) examine the dollar-weighted average return of investors in mutual funds using the CRSP Survivorship-Bias-Free U.S. Mutual Fund Database. The funds' stated benchmarks reliably indicate whether they should be classified as value or growth and small-cap or large-cap. Using the methodology set forth in Dichev (2007), the authors use the funds' external cash flows (that is, the aggregate contributions and distributions) and the reported returns of each portfolio of mutual funds to calculate the internal rate of return. By definition, this equates to the dollar-weighted return, and it represents the return the average investor actually achieves—the investor's bankable return.



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