The performance of the average mutual fund, exchange-traded fund (ETF) and hedge fund investor lags the performance of their funds.
“The average fund investor loses money by engaging in active investment timing,” says Marco Pagani, Ph.D., Associate Professor of Finance and Interim MBA Director of the Lucas College and Graduate School of Business at San José State University.
Smart Business spoke with Pagani to learn more about the ability of fund investors to time the market.
How is the timing ability of fund investors measured?
Fund performance is computed using time-weighted returns — the geometric mean — which measure the return of a buy-and-hold strategy. This is a strategy that holds a fixed quantity of fund shares without any contribution, known as shares purchase, or withdrawal, called shares sale, during the investment horizon. Such measure is ideal to compare the performance of similar funds over a common time period. The return realized by an investor depends on the performance of the investment selected and the ability to purchase or redeem shares at the most advantageous time during an investment period.
An investor’s performance is measured by dollar-weighted returns, referred to as an internal rate of return, which account for both the investment performance and the investor’s timing ability. By calculating the difference between the time-weighted return and the dollar-weighted return, one can isolate the portion of the overall return solely due to the ability to time investments.
To what extent are returns reduced by poor investment timing skills?
Financial research has shown that the penalty associated with poor timing decisions is significant and present among many categories of investors. Professors Geoffrey Friesen and Travis Sapp in their 2007 article published in the Journal of Banking and Finance show that the average equity mutual fund investment underperforms by 1.6 percent on an annual basis. Similarly, studies performed by Morningstar estimate the timing penalty at around 1.5 percent per year.
Consistent evidence has been found by studying the ETF universe. In a 2013 working paper I co-authored with Dr. Stoyu Ivanov, we estimate that ETF investors lag the performance of their investment by 2.4 percent per year.
In a 2011 article in the Journal of Financial Economics, Professors Ilia Dichev and Gwen Yu found that the average hedge fund investor displays a timing penalty in the order of 3.5 percent per year. The significant penalty associated with the timing decisions of hedge fund investors imply that, even though hedge funds have produced returns higher than the equity market, the returns of hedge fund investors have lagged the performance of the S&P 500 and have only fared marginally better than short-term Treasury securities.
What are the investor or fund characteristics associated with poor timing ability?
It does not appear that the performance of more sophisticated investors displays lower timing penalties. Hedge fund investors, comprising sophisticated individual investors or institutional investors, somehow display the worse timing ability.
With both mutual and hedge funds it seems that negative timing skills are especially concentrated in large funds where more dollars are at stake. Active fund investors show worse timing performance than index mutual funds. In a 2013 working paper I co-authored with Dr. Marco Navone, we found that load mutual funds are associated with larger timing penalties than no-load funds. This is particularly interesting since load funds are often bought or sold through investment professional and brokerage channels.
What should fund investors know?
Investors should not attempt to time the market because it is hazardous to their financial health. To avoid engaging in pernicious investment behavior, investors should follow a predetermined schedule of share purchases or sales motivated by cash flow availability and target portfolio allocation. Trades motivated by market forecasts or emotional reactions should be avoided at all costs. ●
Marco Pagani, Ph.D., is an Associate Professor of Finance and Interim MBA Director of the Lucas College and Graduate School of Business at San José State University. Reach him at (408) 924-3477 or [email protected].
Insights Executive Education is brought to you by San José State University