Chasing Performance Is a Loser’s Game
These truths are held to be self-evident:
* Investors should buy low and sell high.
* Investors should not be propelled by panic.
* Investors should not assume that past performance guarantees future results.
At least that’s what everybody advises. New Morningstar research shows that what fund investors actually do is another matter.
Take PBHG Growth Fund. The average dollar in that fund made just 13% annually during the last five years, not the 22% investors would have made by systematically investing throughout the period, nor the 31% return listed in the fund ads or newspapers--that’s based on a single lump-sum investment at the beginning of the period.
What accounts for this? It’s a classic case of buy high, sell low. From 1992 through ‘95, the fund quietly built a superb record, though its cash inflows were moderate. (See graphic.)
In early ‘96, when the fund’s three-year average annual gain of more than 30% placed it on many a leaders list, the money started rolling in. Nearly $2.5 billion poured in through June, just in time for the fund’s 10% slide in July. Inflows dropped sharply. Then, in early ‘97, after the fund had suffered some down months and shareholders started bailing, there was a strong second-quarter rebound. So much for self-evident truths.
Clearly, emotion has a way of interfering with reason. That’s why dollar-cost-averaging--investing a set amount of money in certain funds at set intervals--can be such a good idea.
Sure, it’s possible to make more money with a lump-sum investment, assuming you have it all at the beginning of the period. But it’s also possible to make less money.
A person who invested a lump sum at the start of PBHG’s ’96 growth spurt and held on through the third quarter of ’97 would’ve gained 1.7 percentage points more per year by dollar-cost-averaging through the period.
Although few funds have cash flow stories as dramatic as PBHG Growth’s, Morningstar found that investors across all fund types have paid a price for being fickle.
To determine how much the average fund investor has forfeited, we examined quarterly cash flows in and out of each fund over the last five years and calculated a dollar-weighted rate of return for the average shareholder.
In the dollar-weighted measure, performance in periods when there are more fund assets counts more than performance in periods when there are fewer fund assets.
We then compared this return with that of a hypothetical investor who, using dollar-cost-averaging, would have invested the same amount every quarter. In this measure, performance later in the period counts more than earlier performance. (See “What Could Have Been” chart.)
Across all fund types, investors’ actual dollar-weighted returns lagged the dollar-cost-averaging returns by an average of 0.65 percentage point annually over the last five years. The damage was greater with aggressive equity funds.
In the small-growth category, for example, investors have surrendered 1.8 percentage points annually during the last five years by chasing performance rather than dollar-cost-averaging. The price tag over the volatile trailing three-year period has been 2.8 points.
These figures understate the plight of investors who move money around in search of greater returns. The cash flows examined include the stable flows from 401(k) plans and other dollar-cost averagers, which mute the negative effects of the erratic cash flows.
The lesson: Don’t chase performance. It’s a loser’s game.
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Buy High, Sell Low
A dramatic example of investors chasing past performance and then leaving a fund just in time to miss another upswing can be seen below in the PBHG Growth Fund. Note that the largest amount of new investor money came in the first two quarters of 1996, which was the end of a long period of stellar performance. By the first quarter of 1997, money was actually leaving the fund--just in time to miss two more strong quarters.
The bars, using the left scale, show quarterly net cash inflows and outflows.
The fever line, using the right scale, shows cumulative percentage return since 1992.
(please see newspaper for bart chart information)
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What Could Have Been
This chart illustrates how most of the money in these funds over the last five years did not benefit from the funds’ full performance in that period.
Below are the 10 Morningstar 500 equity funds with the largest spread between actual annualized dollar-weighted investment returns and hypothetical dollar-cost-averaging returns over the last five years.* Investors cashing out of the fund at the wrong time account for the difference. However, Franklin Rising Dividends is an odd bird, with consistent negative cash flows since 1993, in the same period it had a long, strong rally.
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5-yr annual Fund return shortfall Category Franklin Rising Dividends -12.5% Mid-cap value PBHG Growth -8.5 Mid-cap growth Seligman Comm. & Info. -7.3 Specialty-tech Rob. Steph. Value + Gr. -6.6 Large growth Crabbe Huson Special -6.5 Small blend FAM Value -6.1 Small value Evergreen -5.8 Mid-cap blend Oakmark International -5.5 Foreign stock Franklin Growth -5.5 Large blend T. Rowe Price Gr. St. -5.2 Large blend
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Category definitions in Morningstar fund tables.
Source: Morningstar Inc.
