The Ego, The Market, and The Mania

Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world. Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows

Industry vs. Dimensional Relative to S&P 500 Index Performance

January 2008–June 2011

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional’s figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor’s Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.

Now consider how mutual fund investors responded to the stock market’s downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.¹

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.² When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.³

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional’s funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund’s net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.⁴ The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.⁵ Therefore, consistently positive net cash flows are helpful to a fund’s expenses, strategy, and performance.

Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional’s stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional’s funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor’s steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund’s strategy, cost management, and returns.

Endnotes:

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day’s end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a “liquidity reserve” for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, “Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns,” Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund’s published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, “Bad Timing Eats Away at Investor Returns,” Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows” (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day’s end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: “On the Run: Examining Patterns in Mutual Fund Redemptions,” Knowledge at Wharton,http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

Disclaimer:

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at www.dimensional.com. Dimensional funds are distributed by DFA Securities LLC. 

Proponents of active management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction. While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s.

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks. Known as the SPIVA scorecard¹, the report analyzes the returns of US-based equity and fixed income managers investing in the US, international, and emerging markets. The managers’ returns come from the CRSP Survivor-Bias-Free US Mutual Fund Database, and the managers are grouped according to their Lipper style categories.²

The graph below features fund categories from the most recent SPIVA scorecard—all US equity funds, international funds, emerging market funds, and global fixed income funds—and shows the percentage of active managers that were outperformed by the respective S&P Indices in one-, three-, and five-year periods. These are only four of thirty-five equity and fixed income fund categories. But a deeper analysis confirms that the active manager universe usually fails to beat the market benchmarks over longer time horizons. Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Over the last five years, about 60% of actively managed large cap US equity funds have failed to beat the S&P 500; 77% of mid cap funds have failed to beat the S&P 400; and two-thirds of the small cap manager universe have failed to outperform the S&P Small Cap 600 Index. Furthermore, across the thirteen fixed income fund categories, all but one experienced at least a 70% rate of underperformance over five years.

In 2009, active funds experienced more success over a one-year period, and proponents typically highlight those results in the SPIVA scorecard. However, one-year results are not consistently strong from year to year, and investors should not draw conclusions from short-term results. Over three- and five-year periods, most fund categories have not outperformed their respective benchmarks.

This poor track record appears in other research, as indicated in the graph below. This study compared the same actively managed funds in the CRSP database to the Russell benchmarks and showed similar results over the three- and five-year periods. Over the past five years, about 65% of all US equity managers failed to outperform their respective Russell Indexes, and 84% of fixed income managers failed to beat their respective Barclays Capital Indices.

Of course, the results of these studies will fluctuate over time, and a majority of funds in a given category might outperform over the short term. But the message is clear:  As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

1.  SPIVA stands for Standard & Poor’s Indices versus Active Funds. The report covers US equity, international equity, and fixed income categories. The actively managed funds are grouped according to Lipper style categories.

2.  The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks listed on the NYSE, Amex, and NASDAQ exchanges. The Survivor-Bias-Free US Mutual Fund Database includes a history of each US mutual fund’s name, investment style, fee structure, holdings, asset allocation, and monthly data, including total returns, total net assets, net asset values, and dividends. All data items are for publicly traded open-end mutual funds and begin at varying times between 1962 and 2008, depending on availability. The database is updated quarterly and distributed with a monthly lag.

Disclaimers

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.

Past performance is no guarantee of future results. This article is provided for informational purposes only and should not be construed as an offer, solicitation, or a recommendation from Dimensional Fund Advisors. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission.

©2010 Dimensional Fund Advisors