How Performance Chasing Hurts Investment Returns

No matter how frightening a roller coaster ride gets, you’d never unhook your harness and jump out of the cart halfway through it.

Unfortunately, in a sense, that’s what many investors do in their portfolios. When a fund vastly underperforms expectations, there’s a strong temptation to sell out of it and funnel the proceeds into a fund that's a better performer. Finance experts call this “performance chasing” or “market timing”, and it’s about as good for long-term investment returns as jumping out of a rollercoaster after the first big dip. The numbers don’t lie.

PERFORMANCE CHASERS’ DILEMMA

Monitoring the monthly cash inflows or outflows of a fund is one way to gauge when investors are buying and selling. Using this data point, it’s possible to calculate how the average investor fared in a fund over time – the research firm Morningstar calls this a fund’s investor return. This differs from the total return for a fund, which measures its performance over time, regardless of fund inflows and outflows. By tracking both measures of return, it’s possible to contrast the performance of investors attempting to move into and out of a fund at the right time with investors who just buy a fund and hold it.

So, who came out on top?

According to a study by Vanguard, the results, as you can see in the chart below, are clear: Across funds in all major asset classes from 2002 to 2016, average investor returns trailed returns of the very funds they were buying and selling in and out of. This suggests that investors, on average, poorly time their purchases and sales of mutual fund shares. Cutting losses and chasing gains tends to be detrimental to long-term success.

“It would be nice to win all the time, but that’s an unrealistic expectation,” says Nicolas Brown, a senior research consultant at Northwestern Mutual. “From a historical perspective, it is extremely rare for a mutual fund manager to consistently be in the top quartile of their peer group year after year. It is something that we hardly ever see, yet this is what some investors look to achieve with their fund allocations.”

PERFORMANCE CATCH-22

When you invest in an actively managed fund, you expect the higher fees to translate into above-average returns. But here’s the catch-22: To achieve above-average returns, a fund manager’s strategy needs to differ from the market – it’s impossible to beat the market if you simply mirror the market. In some years, a manager’s strategy pays off and the fund outperforms its benchmark. Some years, however, the fund manager’s bets may significantly underperform the benchmark. Why? Because they are going against the grain with their investment decisions.

“Everyone wants outperformance, but if you can’t tolerate periods of underperformance, a highly active fund may not be the best solution for your portfolio,” says Brown. “In most instances, you can’t achieve intermediate to long-term outperformance if you're unwilling to risk underperforming in the short-term.”

Brown says it’s important to allow breathing room for a manager’s strategy to play out over time. Generating outsize returns doesn’t happen over the course of a single year; instead, it might take several years for a strategy to reap rewards. Periods of underperformance should be expected, because history shows very few fund managers beat their benchmark consistently. However, selling or buying on short-term price performance is a common mistake and, as the data show, a costly one over time.

“We commonly see mean reversion with mutual fund returns. Funds that have outperformed for some time see their returns fall back to normalized levels; funds that lagged competitors reverse course as their performance improves,” says Brown. “All too often we see investors switch from a fund that is underperforming to a fund with upper-quartile performance, only to see the fund they sold outperform the fund they just bought.”

Investors who rotate in and out of funds tend to miss those outsize, mean-reverting movements to the upside because they buy too late or sell too soon.

Now, we’re not saying a fund’s poor performance isn’t a sign of a flawed strategy. Rather, past performance is just one of many factors to weigh when making an investment decision. When Brown and colleagues look at funds to invest in, for example, they regularly check in with managers for updates about their performance and investment choices. How does the management team arrive at its investment decisions? Does the fund perform better in certain market environments? What’s the tracking error to its benchmark? There are many factors, in addition to performance, that impact whether a fund is worthy of investment.

“We believe it is crucial to give active managers time to prove their worth, and it should be expected that there will be periods when a manager will underperform,” says Brown. “This can be difficult to endure but is necessary if one is in search for above market returns.”