FUNDAMENTALS
be funding the value premium. Certainly
their trading activity accentuates the
volatility of the value cycle.
The return gap also provides us with two
useful insights.
1. The trend-chasing habit has been
detrimental to the average fund
investor even if he or she invests
in
outperforming
strategies
executed by skillful managers. In
our assessment, a trend-chasing
February 2015
allocation
process,
combined
with cyclical (mean-reverting)
style or strategy performance,
has contributed most appreciably
to the observed return gap. This
interpretation almost surely applies
as well to institutional investors; it
is a public secret that consultants
disapprove of but nonetheless go
along with clients’ penchant for
hiring ”hot” managers only to fire
them after three years of lackluster
results (West and Ko, 2014).
Appendix: Measuring Dollar-Weighted Average Returns
The time-weighted or buy-and-hold return of a value fund is easy to calculate:
The geometric average of its reported returns is what you would have earned
had you bought in at the beginning of a period and never sold.
But what if you
had moved money in and out of the fund? Then you need the dollar-weighted
average return to know what your portfolio actually earned.
Hsu, Myers, and Whitby (2014) examine the dollar-weighted average return of
investors in mutual funds using the CRSP Survivorship-Bias-Free U.S. Mutual
Fund Database. The funds’ stated benchmarks reliably indicate whether they
should be classified as value or growth and small-cap or large-cap.
Using the
methodology set forth in Dichev (2007), the authors use the funds’ external
cash flows (that is, the aggregate contributions and distributions) and the
reported returns of each portfolio of mutual funds to calculate the internal
rate of return. By definition, this equates to the dollar-weighted return, and it
represents the return the average investor actually achieves—the investor’s
bankable return.
Endnote
1.
The dollar-weighted return, which takes into account the timing, direction, and magnitude of contributions and withdrawals, is the return the
investor actual receives. The buy-and-hold or time-weighted return,
which is used in performance reporting, eliminates the impact of client-
2.
Financially
less
sophisticated
investors—those who are attracted
to active growth funds with high
expense ratios—experience the
greatest return gaps over time.
Thus
consultants and financial advisors
may wish to help put into place an
investment governance structure that
discourages clients from tactically
allocating their positions unless they
are financially very educated and
demonstrate the ability to overcome
the behavioral bias for trend-chasing.
initiated cash flows. If an investor buys a fund and holds it, making no
contributions or withdrawals during the measurement period, then the
dollar-weighted return equals the time-weighted return.
References
Basu, Sanjoy. 1977.
“Investment Performance of Common Stocks in Relation to
Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis.” Journal
of Finance, vol. 32, no. 3 (June):663–682.
Dichev, Ilia D.
2007. “What Are Stock Investors’ Actual Historical Returns?
Evidence from Dollar-Weighted Returns.” American Economic Review, vol. 97,
no.
1 (March):386–401.
Fama, Eugene F., and Kenneth R. French. 1992.
“The Cross-Section of Expected
Stock Returns.” Journal of Finance, vol. 47, no. 2 (June):427–465.
Hsu, Jason C.
2014. “Value Investing: Smart Beta vs. Style Indexes,” Journal of
Index Investing, vol.
5, no. 1 (Summer):121-126.
Hsu, Jason C., Brett W. Myers, and Ryan J.
Whitby. 2014. “Timing Poorly: A
Guide to Generating Poor Returns While Investing in Successful Strategies.”
Available at http:/
/papers.ssrn.com/sol3/papers.cfm?abstract_id=2560434.
West, John, and Amie Ko.
2014. “Hiring Good Managers Is Hard? Ha! Try
Keeping Them.” Research Affiliates (November).
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