It is an unfortunate fact of investment life that, even after transaction charges and other costs are taken into account, investors can end up making lower returns than the very fund in which they have placed their money. This additional drag, we should quickly add, has nothing to do with bad practice on the part of any fund managers and everything to do with bad timing on the part of many investors.
Before we look into why this should be, let’s flesh out the idea with some figures from the 2014 edition of Credit Suisse’s highly regarded Global Investment Returns Yearbook. Over the last 20 years, it notes, shareholder returns from the S&P 500 index averaged 9.3% a year while the impact of charges meant the annual return for the average actively managed fund was 1.0 to 1.5 percentage points less.
The average return investors earned, however, turned out to be another 1.0 to 2.0 percentage points less than that of the average actively managed fund – meaning the return many investors actually saw was some 60% to 80% that of the market. According to Credit Suisse, the key to understanding this shortfall is the distinction between ‘time-weighted’ returns and ‘asset-weighted’ returns.
“The time-weighted return measures the performance of the fund over time based on net asset value,” explains the yearbook. “The asset-weighted return incorporates not only the performance, but also the money going in and out of the fund.” Anglicising the simple example it offers, let’s say on 1 January 2012, you buy 100 shares of a fund with a net asset value per share of £10 – so a total outlay of £1,000.
Over the course of the year, the fund's net asset value increases to £20 a share, thereby doubling your money. Suitably thrilled, on 1 January 2013 you shell out another £2,000 to buy 200 more shares but over the next 12 months things do not so go well and the fund’s net asset value per share drops back down to £10, which is where we came in.
So how did fund do over the two years and, more importantly, how did you do? Well, since the fund ended up at the same price it started, its time-weighted return is zero. However, taking into account the timing and size of your own pair of investments, your asset-weighted return is a much more uncomfortable –27%.
Had you chosen to use a straightforward ‘buy-and-hold’ strategy, there would have been no nominal gain or loss and your return, like the fund, would have been zero. But since you got excited on the back of your success over the first year, you ended up losing £1,000 of your total £3,000 investment because of your second purchase after the fund had doubled its net asset value.
Back in reality, if you did happen to be the sort of person who is inclined to invest more money as markets rise and take it out as they fall, you would by no means be alone. As you can see below, in the first of two interesting charts on the subject from the Credit Suisse yearbook, investors tend not to be so great at picking when to move in and out of the market.
Source: Investment Company Institute and MSCI - February 2012
What is more, if you look at the difference between time-weighted ‘buy-and-hold’ returns and asset-weighted returns, which is what is going on below in the second chart, you will see there are some markets – most glaringly Italy, but also France and Japan – where investors would appear to be very fickle when it comes to dipping in and out.
Source: Ilia D. Dichev, “What Are Investors’ Actual Historical Returns? Evidence from Dollar-Weighted Returns
The Credit Suisse yearbook then poses the question: “How do we sidestep this behavioural bias of buying high and selling low?” Towards the end of its own answer, it notes: “The lesson should be clear. Since year-to-year results for the stockmarket are very difficult to predict, investors should not be lured by last year’s good results any more than they should be repelled by poor outcomes.”
For many investors, as we have seen, this is clearly easier said than done, so to Credit Suisse’s conclusion that “it is better to focus on long-term averages and avoid being too swayed by recent outcomes,” The Value Perspective would add its own exhortation to think hard about when you are putting money into the market and, when you are considering a fund’s historic returns, do not ignore what the valuation was at the start of the period under review and what it is today.