Are Individual Investors Destined to Fail?
By Chris Gay
It's axiomatic among financial-service professionals that most do-it-yourself investors are their own worst enemies, always in the grip of some cognitive bias or other leading inexorably toward the worst possible investment decision.
Or are the professionals too pessimistic? True, there is a long history of self-directed investors generally underperforming and sometimes going up in smoke. But there is also recent evidence that, while most of us still do worse than the funds we invest in, we're collectively closing the gap and managing to tame certain value-destroying reptilian impulses.
A Vanguard study released this month, for example, challenges the notion that the rise of the exchange-traded fund-which investors can trade at will, like a stock-would create a culture of day traders who'd throw long-termism to the winds and gamble away their savings. Enthralled by the "ETF temptation effect," the theory went, a self-selected group of active investors would gravitate to ETFs, where they'd chase past performance, run up transaction costs and generally behave like reverse indicators on autopilot.
"ETFs introduce a different type of investor that doesn't exist on the mutual-fund side, and that's the day trader," says Lou Harvey, president of Dalbar, Inc., a Boston analytical firm whose annual "Quantitative Analysis of Investor Behavior" (QAIB) documents the wayward performance of individual investors.
For all that, the Vanguard report ("ETFs: For the better or bettor?") argues that such funds are not weapons of self-destruction, after all. "In general, both ETF and traditional mutual fund shareholders proved to be long-term, buy-and-hold investors," it concludes. The study is based on 3.2 million transactions in more than half a million accounts held in various Vanguard mutual funds and ETFs over four years through 2011.
Some key findings: 62 percent of ETF accounts fell into the buy-and-hold category, which Vanguard defines as an investment held for more than a year and experiencing no more than two investment "reversals" (the first sell after a buy, or vice-versa) in any rolling one-year period. That's lower than the 83 percent scored for mutual-fund holders, but still evidence, says Vanguard, that the temptation to trade is not the threat it was cracked up to be "and is not a significant reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio."
While trading behavior of ETF holders was more active than that of those in mutual funds-27 percent of ETF positions were held short-term, compared with 12 percent for mutual funds-"more than 40% of the variation can be explained simply by correcting for differences in personal and account characteristics between ETF and traditional fund shareholders," reported Vanguard. The temptation effect does explain part of the other 60 percent, the study concedes, though Vanguard's own limits on trading mutual funds, as well as unknowable self-selection effects whose impacts are indeterminate, also matter.
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Vanguard notes, however, that a fund family which attracts more-active investors to its ETFs will likely attract them to its mutual funds, too. The whole point of the Vanguard study, says co-author Joel Dickson, is to document "relative trading activity"-namely ETF activity relative to mutual-fund activity-and to suggest that "the investment vehicle is not the source of that churn difference. Just because it's an ETF doesn't mean an investor's DNA automatically changes."
Dalbar's Harvey agrees. "In contrast with the premise that ETFs encourage stable investors to trade, I interpret the results as ETFs attracting investors who are intent on trading," he says. "The ETF temptation effect is an attractant, not a behavior changer."
In short, ETFs don't kill returns; investors do.
Vanguard, of course, is only one corner of the funds universe, as are ETFs. Since 2006, data provider Morningstar has tracked "investor returns," which are not to be confused with fund returns. If a fund returns 10 percent for some time period, its average investor almost invariably earns less than 10 percent, because he or she tends to get in and out of the fund at the wrong times.
In the five years through May 31, Morningstar's Terry Tian recently wrote, the gap between investor returns and total returns was 1.27 percent for the large-cap blend category, and 1.26 percent in short-term bond category. Over 10 years, the numbers fall to 0.39 percent and 1.02 percent, respectively, Tian wrote. It's worse with alternative funds-essentially those outside the stock-and-bond world. There, investor returns over the five-year period lagged total returns by an annualized 2.25 percent: the funds produced 0.21 percent, while the investor lost 2.04 percent.
And, just in case you're not thoroughly demoralized, let's not forget Dalbar's latest QAIB, which reads like a Harper's Index of investor haplessness. Among its more memorable items:
- The average equity investor underperformed the S&P 500 by an annualized 4.32 percent over the past 20 years.
- In 2011, the average equity-fund investor lost 5.73 percent, compared with the 2.12 percent simply holding the S&P 500 would have generated.
- The average fixed-income investor underperformed the Barclay's Aggregate Bond Index by an annualized 5.56 percent over past 20 years.
- Both equity and fixed-income mutual-fund investors have underperformed the market on a one-, three-, five-, 10- and 20-year annualized basis.
- The average investor in asset-allocation mutual funds (balanced funds, target-date funds and the like) outperformed the average equity investor last year for only the sixth time in the past 20 years.
- The average fixed-income mutual-fund investor has not kept up with inflation on a one-, five-, 10- or 20-year annualized basis.
The reason, thinks Dalbar, is that investors who entered the markets in the 1990s "have now experienced multiple market declines and recoveries and have learned from those experiences. They found that remaining invested has, over the long term, produced positive results."
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