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Rekenthaler Report

In Praise of the Dead (Investors)

Fidelity's "study" rings true, whether it exists or not.

Do Less, Make More
Google "Fidelity dead investors" and you'll see a number of stories come up. The Conservative Income Investor informs that when conducting an internal performance review of customer performance from 2003 to 2013, Fidelity learned that those with the best returns were "either dead or inactive." Hedge fund manager Mohnish Pabrai refers to that study in a speech. In June, Moneyvator.com upgraded the finding's status to public, writing that Fidelity had "released a study" to that effect.

Well, maybe. My Fidelity contact has not heard of such a thing, nor has Morningstar's Fidelity Canada contact. Suffice it to say that none of these citations came linked to the original source. (Such is the Internet.)

However, the general notion is sound. As William Sharpe explained decades ago, and institutional investors have learned to believe fervently (no split infinitives here!), investing is a zero-sum game. One side wins on a trade, the other does not. More trades lead to more costs, which must be overcome by notching more than one's share of wins. Sure, that can happen. But for a great number of investors, on average? Highly unlikely. Even if Fidelity's retail customers trade as well as professionals, and are not beaten in aggregate by portfolio managers, as a group they don't figure to overcome the friction caused by trading costs.

Penny Wise
My argument, for this half of the column, is not about making bad trades. I don't believe that retail investors make worse trades, in aggregate, than do professional portfolio managers.

Part of the reason for that statement is basic math. If active mutual fund portfolio managers, who control a large amount of professionally managed stock assets, break even as a whole after their funds pay operating expenses and trading costs (which they do), then it would seem that professional management does not register a plus sign on the ledger. If that is true, the amateurs cannot score a minus. The game sums to zero.

The other part of the reason is that this subject has been tested directly. When Berkeley professor Terry Odean published his landmark study of retail investing results in the 1990s (to the sighs of one of my business school professors, who said "I sure wish I had that database"--Odean had somehow talked a large discount-brokerage firm into giving him the information, with the customers' names redacted), he found that performance aligned neatly with costs. The highest traders had the worst results, which roughly equaled the market performance minus the costs of their trades. Those who barely touched their accounts enjoyed nearly the market results.

(One of Odean's side discoveries was that women fared better than men. Again, the reason was due to trading volume. The average woman in the broker's database outgained the average man by 1 percentage point (100 basis points) per year--a hefty sum indeed. That's because the women traded 45% less often than did the men. To be sure, the ladies still lagged the dead, but among the living, they appear to be the superior investing gender.)

So far, I have been discussing stock-for-stock trades (or bond-for-bond). That lesson seems straightforward: The decision to swap one equity tends to be damaging even if well informed. Retail investors, as with professional managers, will generally do best if they lie on the couch when the urge strikes, and get up only when it leaves. This holds particularly true for taxable accounts, where the odds become brutal for the active trader, unless he enjoys the luxury (of sorts) of having capital losses that he can harvest to offset the trading gains.

Pound Foolish
Now I turn to the part about bad trades. Although retail investors make competitive stock-for-stock trades before considering costs, they do not do so with their asset-class switches. This too has been tested. Over the years, Morningstar has measured the future performance of fund categories, and compared that with current sales/redemption activities. Regrettably, the best-selling categories tend to underperform in future years. And the categories that suffer the most redemptions often rebound--a trend sufficiently pronounced that Morningstar's Russ Kinnel periodically publishes articles entitled "Buy the Unloved."

It is tempting to write that this is where professional managers come to the fore. But I am not sure that is true.

At least when measured very broadly, professional managers appear to also buy asset classes high and sell them low. The Ford Foundation, infamously, convinced many endowment funds in the late 1960s that they were invested too conservatively--just in time for the severe 1973-74 bear market. More recently, the average institutional fund let its stock allocation ride through the mid-2000s, then transferred some of those assets to alternative investments following the 2008 crash. While they are grateful for those alternatives this year, they left a lot of money on the table during the previous half decade.

(This raises the question: If both retail and institutional investors err with their tactical allocations, who is getting that right? Not the dead; they don't move. I don't have an answer for that, nor have I ever encountered somebody who does.)

Also, there is once again an empirical test available. We can examine the results of tactical asset-allocation funds, which of course exist to move into and out of asset classes. Those funds have no particular record of success. (As always in this article, I write as a general rule: If you manage a tactical fund that is the exception to the rule, bully for you.) In fact, they have been among the more disappointing categories among mutual funds, springing to life and attracting assets after the 1987 and 2008 crashes, then lagging during the subsequent recoveries. Ironically, investors particularly mistime their purchases of the very fund category that exists to be a superior timer.

Thus, the lesson for asset-class trades is even more severe than for stock trades. The problem this time is not costs, as funds may freely be traded without transaction fees, but instead the moderate probability that the trade will be ill-considered. If all asset-class swaps were made for truly strategic reasons, such as rebalancing or adjusting the portfolio based on changing goals/risk tolerance, then the average asset-class switch would not be a mistake. It would be an even chance. But many ostensibly strategic trades are actually tactical moves in disguise. Gold goes up for several years, it attracts favorable headlines … so let's add some gold to the portfolio. Now is the time. See, there is that word time.

The dead have their drawbacks. They make for dull company, and when the dishes need washing, they are never around. As investment mentors, however, they have their merits. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.