Sentimental Fools: Pity the Poor Mutual Fund Investor

One solution is to create high performing funds through the process of incubation. About a quarter of all new mutual funds are initiated privately by a fund family. A farmer watching over a batch of eggs knows that chance variation will result in a few particularly healthy chicks. Likewise, chance variation in performance of securities held within incubated funds leads some to outperform during the incubation process. The underperformers are then discarded and the incubated funds are introduced to investors and their high returns featured to attract investor attention.

Richard Evans of the University of Virginia finds that new incubated funds outperformed other non-incubated funds by 3.5% before being sold to the public. Incubated funds garner much more investor attention than non-incubated funds and receive much higher investor inflows. However, once these funds leave the incubation stage they subsequently don't perform any better than non-incubated funds. And since incubated funds are also included in mutual fund return databases, their artificially high performance in the incubation stage increases the dollar-weighted investor performance gap of 0.84% annually. 

Selective promotion of established high performing funds is also an effective method of attracting investors. Prem Jain of Georgetown University and Joanna Wu of the University of Rochester examine which individual funds are more likely to be advertised by fund families. Unsurprisingly, funds that have recently outperformed the market are far more likely to be advertised than funds with average performance. 

However, these funds tend to underperform the average fund after they have attracted the new investor cash. And the now disappointed investors begin to look for ways to shift their investments into another winning fund, contributing to a vicious cycle of dollar-weighted performance gap.

The subsequent underperformance of high-flying funds can also be attributed to investor sentiment. Periodic excess performance within sectors favored by emotional investors can lead to high firm valuations. This over-optimism contributes to the underperformance of growth stocks, and in particular stocks that are small and whose value is highly speculative. More money flowing into overvalued sectors leads to disappointing long-run performance for fund investors when the party ends and values fall back to reality. 

Seeking Safeguards

A simple way to break the cycle of mutual fund underperformance is to develop an investment policy in which an investor maintains a diversified portfolio that reallocates periodically as market values change. This naturally works against investor sentiment by increasing investment in bonds when stock prices are rising and reducing one's bond allocation when stock prices have fallen.

Azi Ben-Rephael of Indiana University and his co-authors estimate monthly shifts between bond and stock mutual funds and find that investors consistently do the opposite—they shift to bond funds when equity values drop and back toward stock funds when equities rise in value. I use the monthly calculated shift in equity funds during the two significant equity bear markets of 2001-2002 and 2007-2009. In both cases, mutual fund investors move sharply toward bonds after stock prices have fallen. Investors appear to be unwilling to follow a disciplined long-run investment strategy by maintaining their portfolio risk exposure in a down market.

Since poorly timed mutual fund sales are more harmful than poorly timed purchases, these flights to safety can have a significant impact on long-run portfolio performance. An advisor can act as a voice of reason when client are tempted to give up on their stock investments. Two recent studies conducted at Texas Tech University show how an advisor can help an investor stay the course.

The first study surveys investors just after the most recent great recession. Respondents were asked whether they shifted their portfolio toward cash in the previous year. Those who had an advisor were significantly less likely to shift assets to cash, but individuals who had both an advisor and a written financial plan were twice as likely to maintain their portfolio allocation during the recession. If a client sits down with an adviser and develops a plan that focuses on long-run goals rather than short-run performance, it can be easier to convince him or her to be patient during periods where they may be tempted to cash out.

Including an investment policy statement inevitably leads to a discussion of the importance of rebalancing during good times and bad, allowing a client to anticipate portfolio volatility and follow a smart money strategy.

The second study uses a database of daily tweets been advisors and their clients constructed by the social media aggregator Arkovi. These tweets represent real time advisor/client contact and illustrate the potential of social media in helping manage client market anxiety. We identify conversations that include the mention of an S&P 500 corporation. When the price of an S&P stock increases, so does the frequency of advisor/client tweets. Tweet frequency also increases when prices fall. When prices fall below 3% in a day, however, tweet frequency spikes as investors look for advice. Investor anxiety appears to increase significantly when prices fall enough to force them to pay attention. This is the time when anxious clients want feedback from their advisor. Immediate communication gives the advisor an opportunity to calm an investor down when he or she is most likely to make an investment mistake.

Advisors and Client 'De-Biasing'

Reducing the impact of sentiment-driven trading mistakes may be a significant source of value provided by advisors. However, advisors compensated based on transactions have an incentive not to talk a client out of shifting assets among mutual funds. A study by Santosh Anagol of Wharton found that "de-biasing" a client—for example, explaining the need to resist the urge to shift equity investments into bond funds during a recession—is difficult for both buyer and seller. While an advisor who has an incentive to maximize long-run assets will argue against a sentiment trade, receiving additional compensation from each new asset sale removes the temptation to disagree with a client's misguided preferences.

Friesen and Sapp found that sentiment-driven underperformance on load funds was twice as large (1.92% per year) as the performance gap on no-load funds (0.96%). Incubated funds are also significantly more likely to be load funds. This is consistent with other studies that suggest that the mutual fund universe can be split between funds that are sold through the broker channel and funds that are bought through a direct channel. It is far easier to sell a privately incubated fund with significant recent excess performance, than it is to sell a fund with average performance. This is so even if neither fund is actually more likely to outperform in the future.

It would be tempting to conclude that bad investor timing is primarily the result of inexperienced investors making bad choices, but a recent study by Ilia Dichev of Emory University and Gwen Yu of Harvard found that dollar-weighted returns on hedge funds are between 3% and 7% lower than time weighted returns. This is more than twice the dumb money difference observed in mutual fund investments. Since hedge fund investors are primarily institutions and extremely wealthy individuals, apparently even the professionals can get caught up in the excitement of investing in hot funds. 

Whether novice or professional, it is easy for an investor to fall into the trap of chasing returns of attention-grabbing funds. The good news is that investors who avoid relying on their emotion are much more likely to succeed in the long run. And an investment advisor can help a client tune out the noise.