Jump Around: The Inconvenient Truth of Investing
by Matt Dunn
Many of us are old (or young) enough to remember the 1992 party anthem “Jump Around” by the American hip-hop group House of Pain. There is a recurring behavioral theme amongst market participants whereby mutual fund investors have a tendency to ‘Jump Around’ and switch from one fund/strategy to another as they seek the next manager who will outperform the market. The typical pattern is to switch from a manager who has just underperformed to the ‘star’ fund manager who has recently posted strong results in hopes that this will continue after they have invested. However, there is compelling academic evidence that this “Jump Around” strategy will invariably land the average investor squarely in the “House of Pain”, with very underwhelming future investment returns. This can become self-perpetuating as the investor then repeats the mistake (and compounds the damage) by making another switch to try and make back their losses. The industry term for this is ‘chasing performance’.
There is another related phenomenon where instead of switching between fund managers the investor tries to rotate their capital in and out of equities to avoid the pullbacks and participate in the rallies. This behavior is called ‘market timing’. In their attempt to ‘buy low and sell high’, most investors end up doing the opposite, eroding their capital in the process.
The inconvenient truth of market timing and chasing performance (aka “jumping around”) is that it is a one-way ticket to the ‘House of Pain’.
The Objective Research
Here are some independent research sources that have done a good job of quantifying the impact these behaviors have on realized investment performance.
1. DALBAR is an independent research firm generally regarded as the authority on measuring and analyzing the returns that ‘average’ fund investors1 actually realize. The analysis shows that the average investor consistently and significantly underperforms the benchmarks. Over the last 20 years to the end of 2018, the average equity investor has earned 3.88% vs the S&P 500 at 5.62%. The average Asset Allocation (aka ‘balanced’) fund investor earned 1.87%, less than the inflation rate of 2.17% over the same 20 years. These investors literally became less wealthy, mainly due to market timing & chasing performance. CWB M&P clients can download a copy of the 2019 DALBAR report through a link in the "Jump Around: The Inconvenient Truth of Investing" email delivered to them. If you are not a current client, contact us and we will send you a copy.
2. Richard Bernstein Advisors, an investment firm in New York, compares ‘average investor’ returns with various asset classes, market sectors and broad indices. The results are eye opening, as over the most recent 20-year timeframe the average investor has underperformed most asset classes, including cash (T-bills). Click here for a copy of RBA’s report (“Investing by the rear-view mirror”).
Source: Richard Bernstein Advisors LLC., Bloomberg, MSCI, Standard & Poor’s, Russell, HFRI, ICE BofAML, DALBAR, FHFA, FRB, FTSE. Total Returns in USD. *Average Investor returns are represented by DALBAR’s investor returns which represent the change in total mutual fund assets after excluding sales, redemptions and exchanges.
3. An October 2017 article in the Wall Street Journal “The Morningstar Mirage” examines the reality behind the very influential Morningstar mutual fund ratings (one to five stars). The key findings were:
- Half of the funds that attained a five star rating held it for only three months before performance weakened;
- The average rating for five star funds over the next three years was three stars;
- The Morningstar fund ratings had a significant correlation to the amount of new money that investors poured into particular funds.
This is anecdotal evidence of investors chasing performance.
What Does this Mean for our Clients?
We use an ‘active management’ style to invest money. Simply put, this means that we run investment portfolios that seek to outperform their benchmarks by holding securities in different weights than the benchmark, and sometimes holding securities that are not in the benchmark. For example, if Royal Bank is 6% of the S&P/TSX total return index and we hold a 3% weight in Royal Bank , then we are ‘underweight’ Royal Bank by half. We also hold mortgage lender Equitable Group which is not in the benchmark at all. This makes our portfolio ‘different’ than the benchmark, and the degree of this difference is measured by a statistic called ‘active share’. An active share of 0% means there is no difference between the portfolio and the benchmark, they hold identical securities in identical weights; this is what an ‘index fund’ will look like. An active share of 100% means the portfolio is completely different than its benchmark. Active management also allows us to manage risk by not confining the portfolio to only securities that are included in the index.
The active share in CWB McLean & Partners equity portfolios run between mid-60% for Canadian Equity to low 90% for our Global & International Equity pools. We use a relatively high degree of active management. We believe that in order to outperform a benchmark, we must do something different than the benchmark and the more your portfolio resembles its benchmark, the harder it will be to outperform it.
The flip side to this style of management is that there will certainly be periods of time where the portfolio underperforms its benchmark as the market is slow to recognize the value we see in certain stocks that we have ‘bought low’, and are planning to ‘sell high’ later once the real value is priced in by the market. This is the key to long-term outperformance, and an investor must be willing to underperform in the short run in order to outperform in the long run. Some of the most successful investors of the last hundred years have regularly ‘underperformed’ the market. A sample of 22 of the most successful long-term investors shows that on average they underperform the market one out of every three years.2 This list includes Peter Lynch, Charlie Munger and even Warren Buffett who underperformed on average once every six years. Buffett’s Berkshire Hathaway has underperformed the S&P 500 over the last five years, with an annualized total return of +7.98% versus the S&P 500 at +10.26%.
All of us may feel an ordinary human urge to ‘Jump Around’ during these periods of underperformance, and also when the headlines start to take on a negative tone regarding the potential for a recession or pending bear market. The latter can encourage attempts at market timing. The truth is that market corrections are impossible to predict with accuracy. They are by definition surprises, and the market-timer must make two successful decisions: when to get out and when to get back in. This is extremely difficult to achieve with any level of consistency, and investors are far more likely to damage their long-term returns, as the DALBAR data shows clearly, and end up making an unplanned visit to the “House of Pain”. Keeping a long-term perspective, with a diversified portfolio, and a team of advisors to provide counsel & direction, is your best way to avoid this.
1 DALBAR database measures 30 years of mutual fund data, and calculates the ‘average investor’ return as the net change in mutual fund assets after backing out sales, redemptions and exchanges. The return calculated would include capital gains (realized & unrealized), dividends, interest, management fees, trading costs, sales charges, fund expenses and any other costs. This is deemed to be what the ‘average investor’ would have earned for that time period, and it captures well what impact investor timing of mutual fund buys and sells has on their returns. DALBAR then compares the ‘average investor’ return figure to the relevant equity & fixed income benchmarks.
2 Source: "Excess returns - A comparative study of the methods of the world's greatest investors " book presentation by Frederik Vanhaverbeke.