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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