Fund flows are explained by short-term recent performance.

There is a near perfect correlation between a fund’s recent performance and the flow of assets. A fund with strong recent performance, typically experiences strong inflows. Conversely, when performance was poor it suffers outflows. This is evident in a vast body of surveys that were done. It is true for both retail and institutional investors.

We say we are long-term investors, but can we manage the evidence?

DALBAR (QAIB) has been studying investor behaviour for decades. They track what effects investors’ decisions to buy and switch funds over time. The results consistently show that the average investor earns less – in many cases much less – than mutual fund performance reports would suggest.

People love to chase “what’s working now”.

An extreme example of this behaviour is Ken Heebner’s US-based CGM Focus Fund (a diversified stock mutual fund) that gained 18% annually for the period 2000 to 2010. The S&P 500 was flat over the same period. It was the top performing fund for that period. Unfortunately, investors were not around to enjoy much of those gains. According to Morningstar the average investor in fund lost 11% per annum over this period.

How is this possible?

The fund surged 80% in 2007. In 2008 $2,6 billion of investments flowed into the fund. That year the fund dropped by 48%. In 2009 when the fund was up around 11% investors had already pulled $750 million from the fund. This is a classic example of buying high and selling low.

It is explained by investor behaviour buying a fund after a strong run and selling as it hits bottom. The investors’ dollar-weighted returns incorporate the effect of the in-and-out cash flows and the timing thereof. The funds time-weighted returns are the result of being invested for the full period.

The same happened to investors invested in the Fidelity Magellan Fund. Peter Lynch is the legendary investor who managed the fund between 1977 and 1990, churning out an annual return of 29%. You would reasonably expect investors to have done well, but this did not happen. According to Fidelity Investments, the average Magellan Fund investor lost money during Lynch’s tenure there.

A very recent example is Cathie Wood’s ARK Inovation ETF (ARKK). Since 2014 ARKK returned 23.5% annually compared to the S&P 500’s 14.6% for the same period. Most of ARKK’s returns occurred between 2019 and the ETF’s all-time high registered on February 18, 2021. Over that period, ARKK returned 203% compared to a 24% return for the S&P 500.

We have seen this before.

At its peak, billions of dollars herded into ARKK just as performance turned south. From February 18, 2021 through January 7, 2022, the ARK Innovation ETF has lost 43% of its value while the S&P 500 has gained 21%. ARKK’s ETF flows indicate the average investor in the fund is underwater.

“The ARRK Innovation ETF has returned 346% since its inception but no value has been created due to flows’ poor timing,” – Vincent Deluard (StoneX startegist).

Investors make emotional decisions based on recent events, changing their stance repeatedly at the most inopportune times. This behavioural gap is a severe drain on long-term performance.

A well-conceived investment plan must be paired with the conviction to stick to it. Moving in-and-out of investment managers is usually not a manager problem. It is rather an indication of a portfolio structuring problem, or a lack of suitable upfront work done. The investor needs to stay focussed on their long-term objective.

Chasing performance by buying recent “winners” and trying to time the market usually leads to vastly inferior performance.

 

Resources

DALBAR – Quantitative Analysis of Investor Behaviour

Forbes.com – How Investors Are Costing Themselves Money

Michael Cannivet – Cathie Wood’s Rollercoaster Performance Offers A Familiar Lesson About Volatility

The above article was written by Marius Kilian.