When Picking Mutual Funds, Don’t Be The Dumb Money

By | October 27, 2015

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For the typical retail investor, mutual fund research reveals an uncanny ability to pick the worst fund categories at the worst possible times. The reason has to do with the tendency to base these types of decisions on “gut feeling” or emotion, rather than careful analysis. Investors feel most comfortable climbing aboard overvalued sectors of the fund universe towards the tail end of bull markets, only to flee to safety when stock prices are closer to their lowest. First identified by researchers Andrea Frazzini from NYU and Owen Lamont from 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 retail investors to make questionable decisions. 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 retail 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 behavior provides insight into why retail investors underperform the market. It also reveals how an investor, with a modest amount of additional effort, can improve their performance by avoiding common decision mistakes. Recent performance is the force that drives dumb money losses for many retail investors. This isn’t surprising since mutual fund advertisements and fund prospectuses tend to emphasize how well the mutual fund has performed in the past. Most investors shop for mutual funds the way they would for a toaster or microwave oven. Instead of researching the quality and durability of the product, they use shortcuts – cues of quality such as brand name recognition, an appealing marketing campaign, or a recommendation from a friend or family member. 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. A simple way to break the cycle of mutual fund underperformance is to develop an investment policy in which the 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. 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. 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 emotions are much more likely to succeed in the long run. And a skilled investment advisor can help a client tune out the noise. Scalper1 News

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