Swedroe: What Returns Can Teach

May 23, 2018

Empirical studies have documented patterns of behavior among mutual fund investors that appear irrational or suboptimal. For example, investors chase past performance, reallocating money from funds with poor recent returns to funds with high recent returns, even though it reduces their wealth in the long run. Research has found this behavior holds not only for individual investors, but for pension plans (institutional investors) as well.

Brand-New Research

Geoffrey Friesen and Viet Nguyen contribute to the literature on individual investor behavior through their April 2018 study, “The Economic Impact of Mutual Fund Investor Behaviors.”

The authors examined how the determinants of mutual fund investor cash flows have changed over the 25 years from 1992 through 2016, the economic impact of these changes on investor returns, and what these changes tell us about learning among this group of investors.

Following is a summary of their findings:

  • Expenses are inversely related to measures of a fund’s risk (funds take on more risk to try to overcome higher fees).
  • Individual investors’ return-chasing behavior was highest for the period 1991 through 1995, and then decreased steadily afterward, with the biggest decline in the Great Recession subperiod 2006 through 2010.
  • Investors’ return-chasing behavior essentially disappeared starting in 2011. As investors engaged in less return-chasing behavior toward the end of the sample period, economic performance gaps due to return-chasing decrease to zero.
  • Investors chase alpha, demonstrating their ability to identify funds that have provided higher risk-adjusted returns in the past.
  • Unlike the return-chasing behavior, the alpha-chasing behavior remained relatively stable and significant throughout the entire period, suggesting that investors are keen on chasing alpha.
  • Investors’ focus on alpha is actually more detrimental than their previous focus on past returns, as future alphas are negatively correlated with past alphas at the fund level. Alpha-chasing behavior had the single-largest negative effect on investor returns (24 basis points per year, which is greater in magnitude than the cost of return-chasing behavior, even during the early period when its impact was greatest). A fund that has recently experienced an alpha above its average will likely experience an alpha below its average in the future. Alpha-chasing cash flows will earn an alpha below the fund’s average alpha; when conducted systematically, this strategy will deliver average investor returns below the fund’s average return.
  • The results were relatively consistent between self-directed investors (who are seen as more sophisticated) and those buying funds through brokers (who are seen as more naive, or as “dumb” money).
  • Investor flows have become much more sensitive to expenses and past risk. They take on more market (priced) risks while shying away from a fund’s specific (idiosyncratic) risk.
  • Relative to investing a constant amount across time, timing behavior costs individual investors 10.7 basis points per month.

The authors concluded: “Overall, our results suggest that mutual fund investors have been learning: they are paying more attention to what matters and focusing more on fund risk, expenses and risk-adjusted returns. But when it comes to pursuing superior performance, they may have learned just enough to be dangerous. They know that alpha is important, but cannot effectively capture it.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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