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In Practice: A Strategy That Loves Performance-Chasers

For every rash trade, there's an investor profiting on the opposite side. Here's a portfolio that capitalizes on poor investor behavior.

Jeffrey Ptak, 12/16/2010

This article first appeared in the December 2010/January 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

In the last In Practice article, we analyzed the risk-adjusted performance of mutual funds that use tactical asset allocation. Our research showed that, as a group, such funds had not acquitted themselves very well. Though a small subset performed impressively, the bulk fell short; their near-and long-term risk-adjusted returns were comparable, at best, to a passive mix of stocks and bonds (represented by Vanguard Balanced Index Fund VBINX).

What last issue's piece didn't address was whether that also called the validity of opportunistic investing into question. That is, can an investor consistently execute a strategy that doesn't hew to a fixed asset allocation? The short answer, based on our research, is yes--we think there's a way, and it's right under financial advisors' noses.

The Investor Returns Gap
Advisors have a tough job. Their clients are bombarded with stimuli, which can make it hard for them to focus on long-term goals in a dispassionate way. Instead, clients are prone to emotions like fear and greed, and they focus on the short term. In investing terms, this behavior expresses itself as performance-chasing. Clients tend to chuck their losers and bear-hug recent winners.

We can quantify the harm clients do themselves using Morningstar Investor Returns, which measures the return of the average dollar invested in a fund. For example, the median investor returns gap (a fund's stated return minus its investor return) for all stock funds was 82 basis points annualized for the five years ended Sept. 30. Put another way, investors in the typical stock mutual fund cost themselves nearly a percentage point of returns by mistiming their purchases and sales. Therein lies the opportunity.

For every rash or impulsive decision to chase performance, there's an investor on the opposite side of the trade--the individual or institution that's buying on weakness, or selling into strength. In that sense, the investor returns gap isn't just a cautionary tale of returns that clients have frittered away. It's also a measure of the excess returns that cooler heads have been able to bag at their expense.

So what if we tried to systematically buy what investors were selling and avoid the areas they were embracing?

For years, Morningstar's director of mutual fund research, Russel Kinnel, has been running a hypothetical "buy the unloved" strategy for the Morningstar FundInvestor newsletter. The gist of the strategy is to invest in fund categories that have suffered the heaviest asset outflows. Generally, the strategy would have been profitable to investors who followed it.

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