Sympatico MSN Finance, Canada
06-01-07
Does market timing ever work?
By Gordon Powers
June 04, 2007
Most mutual fund companies discourage rapid, short-term trading because it drives up costs for other investors. But they haven't banned it altogether. They should though.
n fact, they'd be doing everybody a favour since study after study provides further evidence that investors are their own worst enemies. We know this by studying the difference between time-weighted and dollar-weighted returns.
A fund's time-weighted return reflects how much investors would have made had they invested in a particular fund at the beginning of a time period and held it without interruption, reinvesting dividends along the way. The dollar-weighted return measures the returns that they actually achieve in a particular fund. This gap accounts for the disconnected feeling many people experience when trying to match up their fund statements with the performance numbers they see in ads.
Consider, for instance, someone who buys 1000 shares of a company at a price of $10 a share. A year later, the share price is up to $20, and he then buys 1000 more shares. The market pulls back, as it sometimes does, and by the end of the next year the price has fallen back to $10.
A buy-and-hold investor who bought at $10, held the stock for two years, and then sold at $10 would have broken even – ignoring inflation. But someone who tried to time the market actually did much worse. Over the two years, that poor soul invested $30,000 in the stock but only ended up with $20,000, losing out because most of his money was invested right before the stock dipped.
Does any of this sound familiar?
Since the average fund investor generally doesn't buy and hold, and because the assets of a fund fluctuate, a fund's dollar-weighted return will often be significantly different from its time-weighted return. And if, as is typical, investors plough more money into a fund after it has performed well and then sell units after it has performed poorly, the fund's dollar-weighted return will likely be a whole lot less than its time-weighted return.
In fact, according to the University of Michigan's Ilia Dichev, dollar-weighted returns have actually been consistently lower than time-weighted returns through the entire history of the stock market. Going back to 1926, he found that the return differential was roughly 1.5% a year on average for 19 major stock markets around the world.
More recently, Iowa State University professors Geoffrey Friesen and Travis Sapp looked at monthly returns over 13 years for more than 7,000 equity funds. They found investors' time-weighted average monthly return to be 0.62%, whereas the average monthly dollar-weighted return was only 0.49%.
That means those investors making active decisions underperform by about 0.13% a month, or 1.5% annually, relative to the funds they invest in. This performance gap is twice as large for load funds as for no-load funds since their higher fees eat up more of the available returns.
The researchers also examined whether more savvy investors who were able to identify funds that generated extra return for extra risk also fared equally poorly through suspect timing decisions. The study found the monthly performance gap was largest among the most volatile categories and funds, ranging from 0.25% for aggressive growth funds to a modest 0.03% among balanced funds.
And they didn't stop there. As index funds don't attempt to select securities or time the market, investors in them are generally assumed to be pursuing a more conservative, passive investment strategy. To test this common belief, the two professors examined a bunch of index funds. Here, too, they found a performance gap, indicating that some index fund investors may also be trying to time their investments. But compared with the actively managed fund gap, the index investor shortfall is less than half that of non-index funds.
Oddly enough, the researchers also found that larger, older and more costly funds with big marketing budgets and profiles seem to attract less sophisticated investors, thus increasing this relative performance gap and suggesting that fund companies may actually be somehow contributing to this ineffective behaviour.
Investors looking to gauge the effects of chasing performance for themselves now have a new tool at least. Chicago-based Morningstar Inc. recently introduced the Morningstar Investor Return measure, which directly reflects the price investors have paid for failing to be patient and disciplined. This feature has yet to be introduced in the Canadian market but will likely show up here eventually.
Although fund companies can't bear the blame for their investors' poor timing, they can deploy strategies that result in a better outcome for investors through fund design, the timing of launches and closings, marketing efforts and shareholder communications, Morningstar suggests. The firm's current favourite? DFA Funds, a relative newcomer to Canada that the firm lauds for its advisor education programs and emphasis on longer-term portfolio construction.
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