Ferri: Avoid Being An Out-Of-Style Investor

Chasing investing styles is chasing performance, and investors shouldn't do it.

Beating the market using mutual funds isn’t easy. The hope of finding fund managers who steadily beat their benchmarks may seem like a worthwhile venture, but the only people who seem to earn steady profits from active mutual fund strategies are companies selling products. A persistent “performance gap” exists between investor returns and the returns of the funds they invest in.

I talked about the performance gap in my 1999 book, Serious Money. At the time, DALBAR measured the gap for U.S. equity fund investors to be about 7 percent annually relative to the return of the average equity fund, and more than 9 percent annually versus the S&P 500.

This gap still exists, although it has been whittled down somewhat due to the greater use of low-cost index funds and exchange-traded funds. DALBAR’s 2014 annual Quantitative Analysis of Investor Behavior (QAIB) measured the performance gap for U.S. equity fund investors at 4.2 percent annualized over a 20-year period ending in 2013. DALBAR also reported the S&P 500 had a return of 9.22 percent annually, while the average U.S. stock mutual fund investor earned only 5.02 percent.

DALBAR’s QAIB results have always been the subject of criticism. Some people believe the methodology overstates the problem. Even if this were true, other sources confirm the existence and persistence of a performance gap.

Morningstar found U.S. equity fund investors trailed the average U.S. equity fund return by 1.66 percent annualized over a 10-year period ending in 2013. The firm reported that all funds combined had a performance gap of 2.49 percent during the same period. This was an increase over 2012 data.

DALBAR blames about half the performance gap on “psychological factors” resulting in bad investor behavior. They blame the other half on practical reasons such as not having money to invest and needing money for other purposes. A breakdown of these factors is explained in this 2013 QAIB study.

This article attempts to answer this question: What, exactly, are active fund investors doing wrong?

A hint can be found in two recent Vanguard studies on mutual fund investing. The first, Quantifying the Impact of Chasing Fund Performance, estimates the damage investors inflict upon themselves by selecting funds based on past performance. The second, The Active-Passive Debate: Market Cyclicality and Leadership Volatility, examines how changes in market leadership affects style returns.

Taken together, these studies point to the core of the problem: Active fund investors appear to be missing the concept of style investing. They naively buy a fund because it outperformed for a few years, without considering its style, only to catch subpar performance on the regression back to an opposing style, which causes them to sell their existing fund and buy the opposing style. The process becomes a vicious circle and the basis for a persistent performance gap.

Had active fund investors understood the cyclicality of investment style as outlined in the Vanguard paper, they may have remained with one style for the long term and would have been better off for it. Better yet, had investors switched to a total market index fund, they wouldn’t have to worry about styles going in and out of favor.

Style can be defined on two axes: large companies versus small companies; and value stocks versus growth stocks. There is a constant tug of war among these styles, and trying to time them is futile. Figures 1 and 2 illustrates the difference in annualized three-year moving averages between these two opposing styles. Russell Indexes are used for this analysis.

Figure 1: Three-year annualized rolling return difference based on company size

Source: Russell Investments courtesy of DFA Returns program through August 2014

Figure 2: Three-year annualized rolling difference in return based on fundamental style

Source: Russell Investments courtesy of DFA Returns program through August 2014

Vanguard’s Quantifying the Impact of Chasing Fund Performance estimates that fund turnover occurs about every three years and DALBAR data confirms this estimate. I found the three-year rule to be fairly accurate when I was working in the brokerage industry during the 1990s. An active fund investor will give a fund manager about three years to “show his stuff.” If the manager does not perform over the three-year period, then investors are ready to move on.

The problem with the three-year rule is that style shifts are unpredictable, as depicted in Figures 1 and 2. The “bad behavior” portion of the performance gap can be largely explained as style chasing. Investors who have not yet become familiar with investment styles are prone to change styles often, and at the wrong time.

Quantifying the Impact of Chasing Fund Performance makes a strong case for picking one style and sticking with it through thick and thin. This results in a better outcome for active fund investors. Figure 3 from the Vanguard study offers these results.

Figure 3: The performance gap occurs across styles by chasing fund performance 2004–2013

Source: Vanguard: Quantifying the Impact of Chasing Fund Performance, calculated by Rick Ferri

Fixing the problem isn’t easy because style naivete is encouraged by the active fund community. The S&P 500 is a predominantly large-cap index. Yet it’s easy to find many fund managers who consistently overweigh mid- and small-cap stocks while comparing their performance to this large-cap index. When mid- and small-cap outperform the S&P 500, fund companies tout the superior stock-picking ability of their managers.

The fund companies may argue that their outperformance has nothing to do with style; that it’s all management skill, and investors should seek the best managers for their funds. But that’s not true. Leading researchers find that most performance is random after style biases are factored out. See Luck Versus Skill in the Cross Section of Mutual Fund Returns, by Eugene F. Fama, University of Chicago, and Kenneth R. French, Dartmouth College.

The Vanguard study used in Figure 3 suggests that sticking with a style through a complete economic cycle is a better strategy than buying styles that have recently outperformed. Of course, this assumes investors are aware of styles.

A better catch-all solution is for investors to ignore style and buy a total market index fund. By default, this captures all styles all of the time. One fund to consider is the Vanguard Total Market Index Fund (ticker VTSMX). Morningstar ranks VTSMX in the top 18 percent of its category for the past 10 years. Said another way, an index fund tracking the U.S. stock market outperformed 82 percent of surviving active funds.

VTSMX will never be the top performer in every style. That’s technically impossible. But it does provide investors with their fair share of market return. Ironically, VTSMX’s 9.61 percent investor return through August 31, 2014, is higher than the 8.82 percent total return over the same 10-year period. This means investors have stayed with the fund over the long term, and that’s what makes fund investors money!

For a full list of relevant disclosures, click here.

Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.