Mutual fund investors exhibit remarkable skill when selecting mutual funds – remarkably awful, that is.
This track record is notable since many professional fund managers have difficulty achieving investment performance that differs consistently from the market. For the average investor, however, net flows into mutual funds reveal an uncanny ability to consistently select the worst fund categories at the worst possible times. Investors feel most comfortable investing in overvalued sectors at the tail end of bull markets, and flee to safety when stock prices are their lowest.
First identified by researchers Andrea Frazzini and Owen Lamont, now respectively at NYU and Harvard, the poor timing ability of fund investors has come to be referred to as the “dumb money” effect.
Emotion, limited attention, misguided perceptions and inexperience lead investors to sentiment-driven investment. This tendency to invest more in funds with high positive sentiment (for example tech stocks in the 1990s), and to pull out of funds with high negative sentiment (for example liquidating stock funds in 2008 and moving to bond funds), has led fund investors to lose on average about 1.5% annually, according to a 2007 analysis by Geoffrey Friesen of the University of Nebraska and Travis Sapp of Iowa State.
Understanding investor sentiment provides insight into why most fund investors underperform the market. It also explains how an advisor can help an investor improve their performance by avoiding sentimental pitfalls.
Frazzini and Lamont identified stocks that received excess inflow and outflow from mutual fund investors between 1980 and 2003. If investors were dumping large amounts of money into tech stock funds in 1999, they tracked the impact that these flows had on the percentage of stock held by retail mutual fund investors. If a large amount of money flowed into the stock via retail mutual fund investment, they shorted the stock. They went long on stocks that saw large outflows of mutual fund investor cash. In essence, they wagered that both positive and negative mutual fund investor sentiment were wrong.
Betting against investor sentiment resulted in a riskless excess return of 10% per year if held for a three-year period. A sophisticated investor could simply observe the stocks favored by less sophisticated small investors and profit from their misdirection.
A number of mutual fund researchers have noted that the average fund investor has not performed as well as the average fund. Friesen and Sapp compared time-weighted to dollar-weighted fund return and found that the biggest performance gap occurred within the more speculative fund categories prone to investor sentiment. Aggressive growth funds saw a performance gap of 3% per year, while income-oriented fund categories had the smallest gap.
The largest performance gap was highest within the funds that achieved the greatest risk-adjusted performance. This may be because fund families are most likely to advertise smaller funds that have outperformed in order to attract new investor cash, and these subsequently underperform.
While chasing positive return was harmful, outflows from mutual funds were even more destructive. Buying the wrong funds cost investors 6 basis points per month, but selling at the wrong time reduced fund investor returns by 15 basis points.
Recent performance is the force that drives dumb money losses from sentiment investing. This isn’t surprising since mutual fund advertisements and fund prospectuses tend to focus on illustrating how well the mutual fund has performed in the past. Most investors shop for mutual funds the way they would for a cantaloupe. Instead of sniffing and tapping the fund fruit, they try to find cues of quality such as fund family name recognition, a famous fund manager, a fund objective that sounds appealing and past performance.
Past performance is the easiest characteristic to compare and most compelling since it is ultimately what an investor is looking for in a fund. A grocery shopper sniffs the cantaloupe to determine how it is going to taste and a fund investor looks to past performance as an indicator of better future performance. The difference is that the fund investor never seems to recognize that the nice-smelling mutual fund tastes worse when they get home and take a bite.
Yale researcher James Choi and his co-authors David Laibson and Brigitte Madrian of Harvard investigated how an average investor uses information on a mutual fund prospectus using identical S&P 500 index funds with different fund initiation dates. In addition to the prospectus, they gave respondents in different groups a “cheat sheet” that summarized differences in fund fees, and another that spelled out how the objective of all funds was to mimic the S&P 500. Samples of both employees and Wharton MBA students (with average SAT score at the 98th percentile) consistently focused on the obviously irrelevant fund performance rather than on fund fees even when presented with information that should have helped them make better choices.
Brad Barber of UC Davis and Terrance Odean of Berkeley blame return chasing on the limited attention span of individual investors. According to their investor attention hypothesis, most of us have limited time to devote to researching mutual funds. We can either invest a huge amount of time and effort into learning how to evaluate and select funds, or we can simply invest in ones that capture our attention. The fact that mutual fund investors are attracted by the shiny funds does not serve them well in a market where sentiment can drive the value of securities too high or too low.
Marketing mutual funds to investors who overemphasize recent returns means that fund families need to make sure that they have individual funds in sectors with high recent performance. Since mutual funds can only invest within a universe of investments whose return is by definition average, this presents a challenge.