A new study has just shaken one of the biggest investment myths on Main Street.
An analysis of mutual-fund stock trades over the past two decades has thrown into question the rationale that has sent everybody and her grandmother stampeding into low-cost index funds and exchange traded funds.
That rationale: that even skilled fund managers can’t beat the stock-market indices, so there’s no reason to pay someone to try.
Not true, write finance and accounting professors Linda Chen of the University of Idaho, Wei Huang of the College of Saint Benedict & Saint John’s University, and George Jiang of Washington State University, after an exhaustive study of nearly 2,000 U.S. mutual funds’ stock trades by month from January 1998 to March 2015.
Instead, their research found substantial evidence that many skilled money managers are adept at picking stocks. “Mutual fund trades outperform their benchmarks,” they wrote. And, critically, they are good at picking the stocks that are going to beat earnings expectations ahead of time: “[L]arge active trades by mutual funds prior to the month of earnings announcements have significantly positive abnormal returns in the subsequent one-, two- and three-month horizons,” they wrote. That’s true even when you adjust for the major stock market “factors” such as value, stock size, and price momentum, they wrote.
Indeed when you measured this, they found the top 20% of funds beat the bottom 20% by a remarkable 1.27 percentage points a year. And the outperformance is even true when fund managers’ fees were taken into account, they added.
So why doesn’t this show up more in fund investors’ returns? After all, there has been plenty of evidence that, overall, fund returns don’t on average exceed their benchmarks.
A big reason lies in the words “active trades.”
For their analysis, the researchers separated all mutual fund stock trades into two groups.
One group consisted of the trades that managers made simply because they had to, as a result of investors’ money flows into or out of their fund. So, for example, in a hot market the public typically invests more in stock market mutual funds, and the money managers then have to invest that money — with the result that they have to keep buying shares at higher and higher prices, regardless of what they really think is wise.
The second group of stock trades, however, consist of those that the managers made simply because they liked or disliked a stock. These so-called active trades had nothing to do with fund flows. Money managers may have had to liquidate other stocks in order to raise the money to double down on their bets on stocks they liked.
It was these active trades, found the researchers, that drove the fund managers’ outperformance. “[T]he outperformance is largely driven by large active trades,” they write.
In other words, mutual fund managers would do a better job if investors would just leave them alone.
Instead, the public plunges into hot markets, hot funds and hot stocks after they’ve outperformed — and then sells out again when they’ve underperformed. So money managers are forced to keep buying hot stocks even after they’ve risen too far, and to sell them after they’ve fallen too far.
When it comes to investing, we — not the Illuminati or the 1% — are our own worst enemies.
As if to underline the point, the latest report from fund analyst firm Dalbar showed that in 2018, once again, Joe and Joanna Public did the wrong things and underperformed the market. “The average investor was a net withdrawer of funds in 2018 but poor timing caused a loss of 9.42% on the year compared to an S&P 500 index SPX, +0.46% that retreated only 4.38%,” they report.
In other words, the average investor in U.S. stock mutual funds last year did twice as badly as the stock market ... and all because they bought and sold at the wrong times.
Low-cost exchange traded funds and index funds are a response to the long term underperformance of “active,” stock-picking mutual funds. Ironically, though, they seem to address the wrong problem. They do nothing whatsoever to counterbalance the issue of mistiming. Quite the reverse: They’re so cheap and easy to buy and sell that they positively encourage Joe and Joanna Public to trade in and out.
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