Lou Harvey is talking apples. Wade Pfau is talking oranges. And never the twain shall meet, it seems.
This disparity is the crux of a beef between the two respected industry experts, says Harvey, in an interview with ThinkAdvisor. He is president and CEO of Dalbar, a leading Boston-based financial services market research company. Pfau is a professor of retirement income at The American College of Financial Services and a principal of McLean Asset Management.
When, in March, Dalbar released its “Quantitative Analysis of Investor Behavior 2017,” an annual study that now embraces the last 30 years ending December 30, 2016, findings once again showed that the typical mutual fund investor earns less than funds’ performance reports suggest. QAIB looks at retail investor behavior and returns in equity, fixed-income and asset allocation mutual funds; such investments are the most popular for generating retirement income.
After assessing the report, Pfau wrote a critical article for Advisor Perspectives charging that Dalbar’s “calculations are wrong.” And he warned “the financial services profession to stop using” the study “as a way to market the value of financial advice.”
In the interview, Harvey, who is president of the Fiduciary Standards Board, vigorously defends his methodology. The study examines investor returns, while Pfau takes the perspective of investment returns – two quite different concepts and numbers, Harvey says.
Because Dalbar’s methodology is flawed, Pfau claims, he advocates for a different approach. Singling out equity funds in the article, his rationale is supported by a table, employing Morningstar data, and several graphs.
Pfau insists that since “the quantitative results of the [Dalbar] study do not properly measure the underperformance of investors,” it “unfairly understates investor returns.”
Meantime, here are some of the study’s important findings: In 2016 “the average equity mutual fund investor underperformed the S&P 500 by a margin of 4.70%. While the broader market made gains of 11.96%, the average equity investor earned only 7.26%,” the report shows.
Further, investors’ pattern of behavior in the fourth quarter of last year, “positions [them] to also miss much of the first quarter market returns of 2017,” the study indicates.
That pattern began surfacing last October, when “fearful investors withdrew heavily early in the month and missed the modest recovery in the last week. Withdrawals continued post-election, while the markets raced ahead in November. Fear of a correction drove up withdrawals again in December, so many investors again missed the opportunity. [They] lagged the index by 1.34 points for December,” the study found.
Investors’ propensity to buying high and selling low, together with fund expenses, chiefly account for the lower returns.
Dalbar has conducted its annual QAIB since 1994. Institutions provide the study to advisors at no cost. It’s also available on the Dalbar website for $99. According to Harvey, Pfau publishes no competing study.
In the article, Pfau contends that the correct methodology is one based on internal-rate-of-return. But Harvey holds that the math Dalbar employed is the Securities and Exchange Commission standard for calculating annual investment returns.
Before publication, Advisor Perspectives sent a draft of Pfau’s article to Harvey for comment. After his review, some deletions and other changes were made. Be that as it may, Harvey then fired back a “P.S.,” which was posted below the story. He wrote: “It is utter impudence for your author to take the position that the only valid methodology is that which he espouses.”
ThinkAdvisor recently interviewed Harvey, who spoke by phone from Dalbar headquarters. Notably, this is far from the first time that QAIB’s methodology has been disparaged. But compared to past years, Pfau’s story has generated the loudest hue and cry, Harvey says. Here are excerpts from our conversation:
THINKADVISOR: Wade Pfau’s article about your QAIB 2017 study is headlined: “A Warning to the Advisory Profession: Dalbar’s Math is Wrong.” He charges that the “calculations are wrong” and urges “the financial services profession [to] stop using [the study] as a way to market the value of financial advice.” What do you think of his critique?
LOUIS HARVEY: My assessment is that he had a major problem with the methodology and couldn’t get anybody to pay attention, so the next step is to attack the author – and the blood in the water will attract sharks.
I know that [the story] has gotten a lot of pushback, particularly from financial institutions because they told us. There certainly has been more discussion about it than about the actual findings of the study. Such as: Although the market was pretty robust in 2016, investors got it all wrong and came up with relatively poor performance. Instead, the discussion is that we don’t use an internal rate of return. I mean, this is silly!
That’s the methodology that Pfau says is correct.
If the goal were to measure a time-weighted rate of return, I would agree with him, of course. That’s not what we’re measuring. The methodology we use reflects the investor’s experience. If he chooses to use an internal rate of return, then he should go ahead and use that [in his own study] and see what level of acceptance he gets in the marketplace.
What are you driving at?
If an advisor sat down with an investor and tried to explain the [various ways to measure a fund’s performance], I don’t think they’d get past first base. If they tried to use internal rate of return to market advice, they’d get nowhere, simply because the investor isn’t going to understand it. One of the reasons our study has been so widely adopted is that it’s easily explained so the investor can understand it.
Is there anything valid in Pfau's article?
Yes. If you redesign the objective to be the objective that he talks about, the article is perfectly valid. However, that’s not the objective of our study, which is to measure and describe the investor experience. We’re measuring investor performance. The amount of money an investor makes is not equal to the amount of money that a fund pays. Those are very different numbers. So we’re dealing with apples and oranges. This isn’t advanced math. It’s very straightforward and simple.
For illustration sake, what’s an example of how to look at investor performance?
You invest $1,000 in a fund. The fund comes back and tells the investors, “You’ve earned $100.” The fund will report a 10% return to investors. But when they look at their statements, they only see $80. Why? Because the investor wasn’t invested for the entire time, or the time they went into the fund was wrong, or the time they went out was wrong. What we’re measuring is how the investor actually did.
Have you had criticism of the study before?
For at least 20 years, there’s been noise somewhere along the line. Generally, however, people who understand what the study is doing tend to disregard [the noise]. The noise we’ve gotten because of [Pfau’s] article is probably louder than any we’ve had in the past.
Why do folks question the study?
Critics misunderstand it. It’s not sexy to talk about investor returns. It’s far sexier to talk about how well fund managers have performed: How does Fund A perform vs. Fund B – as opposed to how Ma and Pa on Main Street do.
How have you dealt with brickbats in the past?
By explaining that what we’re fundamentally trying to do is quantitatively measure investor performance. Every time it comes up, [critics] say, “Why don’t you use the time-weighted rate of return approach?” Well, we don’t because we’re not measuring the fund. We’re dealing with the elements of how much money goes in and out of an investor’s fund.
Is the study meant to be a tool for advisors?
It wasn’t designed as that. It’s used far more as an educational vehicle to reconcile for investors why there’s such a difference between their own experience and what the financial institutions – mutual fund companies, brokerage firms – report.
But presumably advisors use or refer to the study in discussions with clients.
That’s certainly one purpose. But it’s developed for and principally used by the financial institutions to develop communications.
Do broker-dealers pass it along to their financial advisors?
Absolutely. All the financial institutions release the complete study or a portion of it to advisors.
As a result of Pfau’s article, do you plan to change anything in the methodology or calculations that you’ll employ for next year’s study?
No [because] we’re going to continue to measure investor performance. Nothing in that article suggests any other method of measuring investor performance.
--- Related on ThinkAdvisor: