Passive investing

The reaserch company Morningstar Inc. published an analysis of US investors’ returns as compared to returns of mutual funds over the last decade (through 31.12.2009). For investors this period was especially challenging. They experienced 4 excellent years, 4 years with dismal returns and 2 years with one digit positive returns. Especially 2008 was critical as the vast majority of investors sold their stakes in mutual funds just to watch the equity funds soar in the following year. Naturally, with their money in money market funds. Consequently, the analysts at Morningstar scrutinized the returns of investors, not those of the funds. They tried to answer the question whether the investors themselves are better at timing the market than the mutual fund managers.

In contrast to analysing the usual, time-weighted, fund returns, Morningtar was interested in dollar-weighted returns. In other words, they took into account the inflows and outflows of money in mutual funds since an investor who buys a fund e.g. in August at falling prices will experience a different return from an investor who buys the same fund in January at rising prices (calculation methodology).

In my opinion, the result could have been expected. Investors fared worse than we would think by looking at the funds returns. The reason are investors’ market timing activities – the attempts to sell before an alleged peak or to buy before or soon after an alleged market bottom. Over the last decade the average investor earned (equity, bond, alternative funds etc together) 1.68% p.a., whereas the average fund returned 3.18% p.a. When it comes to the US equity funds, the average investor return amounted to 0.22% p.a., whereas the average fund in this category earned 1.59% p.a. Better than mutual funds fared investors in foreign equity funds. Probably the worst result achieved investors in global real estate funds – 0.65% p.a. vs 10.74% p.a. for the funds in this category.

In my opinion, investors should hold the funds as long as it was recommended. Generally speaking, if you are buying e.g. equity funds that form a large part of your portfolio, you should hold them for at least 10 years. Do not trade short-term and beware of timing the market. The odds are almost 100% against you. You will be better off holding your investments long-term. The best suited for this are, in my opinion, low cost passively managed index funds.

Source: Morningstar.com.