Investors: Often Their Own Worst Enemy

The NYT small business blog by Jeff Brown wrote about the S+P SPIVA report I blogged about on August 20. It pointed out that the active management advocates found solace in one part of the report (my bolds, my comments in bold italics):

Still, the active-management boosters won’t cry “uncle,” falling back on a variety of arguments.

Lending some support to their view, S.&P. noted that on an “asset-weighted” basis, managed funds matched or beat their benchmarks in “most categories except mid-caps and emerging markets.” This analysis takes into account the amount of money investors have in each fund. A few large managed funds that beat the benchmarks can therefore pull up the managed-fund results, even if the average managed fund has trailed the index when assets are not taken into account.

To managed-fund advocates, this means investors are good at picking market-beating funds. But it may also mean that funds with lots of assets can afford to spend money — their investors’ money — to lure even more investors.

To managed-fund advocates, this means investors are good at picking market-beating funds. But it may also mean that funds with lots of assets can afford to spend money — their investors’ money — to lure even more investors.

Marketing on the basis of recent performance can be a dirty trick, drawing investors in too late to share in the big gains. Morningstar, the market-data firm, has worked hard to get insight into this problem, trying to distinguish investor’s actual gains and losses from apparent returns indicated by changes in fund share prices — the figures typically used in marketing materials. By looking at cash flows in and out of individual funds, Morningstar has detected a widespread pattern of investors chasing past results, pouring money in after a fund has done well and taking it out after the fund falters.

The average investor therefore does much worse than the investor who buys a block of shares and hangs on through thick and thin

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Brown points to an interesting aspect of investing in actively managed fund that leads investors to succumb to many of the pitfalls recognized by those that study behavioral finance.

Investors who favor managed funds are more susceptible to this kind of self-destructive behavior because fads change fast. The whole idea of using active managers is to hitch your wagon to a hot stock-picking team, and a fund that loads up on a hot market sector — Internet stocks, for instance — can tumble when that sector falls out of favor, driving the active-management investor elsewhere.

In other words if an investor buys into the belief that there are genius fund managers that can beat the market through sector rotation, stock picking or market timing then they will be in constant search for the next "genius". As soon as their genius manager "under[erforms they will be off in search of the next genius. And how will they pick that genius ? based on the only data available to them = past performance. Yet we know that past performance is not a good predictor of future performance. So the believer in active management (as evidenced by the morningstar data) will constantly be buying funds high and selling low. Of course that doesn't stop Morningstar (and various other magazines websites and newsletters) from constantly publishing list of acte funds to "buy now" or "must dump now".

The same can be said of investors that believe they can consistently beat the market by market timing or shifting in and out of individual stocks. Their belief in these strategies will lead to overtrading often based on chasing past market performance.

as Charles Ellis wrote long ago: It's a Loser's Game.