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). Disclosures The material contained in this document is for general information purposes only. It is not intended as an offer or a solicitation for the purchase and/or sale of any security, derivative, commodity, or financial instrument, nor is it advice or a recommendation to enter into any transaction.

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