The Suckers at the Investment Table
Michael McDermott, from the movie “Rounders,” played by Matt Damon
New research confirms that institutional investors, such as mutual funds, outperform the market before fees, and they do so at the expense of retail investors. That is bad news for retail investors and for investors in active mutual funds, who underperform after fees.
A large body of evidence, including studies such as “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” “Asset Managers: Institutional Performance and Factor Exposures,” “Yes, Virginia, there are Superstar Money Managers” and “Behavioral Biases in the Corporate Bond Market,” has found that institutional investors (such as mutual funds) have sufficient stock-picking skills to generate gross alpha – the stocks and bonds they buy go on to outperform and their sales go on to underperform (before fees). Given that outperformance is a zero-sum game in terms of gross returns, those institutional investors must be exploiting some other group of investors who are generating negative alphas even before considering investment expenses.
These findings are entirely consistent with those from research on the performance of retail investors, including “The Behavior of Individual Investors” and “Industry-Based Style Investing.” The research finds that the stocks and bonds individual investors buy go on to underperform and the ones they sell go on to outperform – demonstrating that retail investors are “dumb money.” The study “Attention Induced Trading and Returns: Evidence from Robinhood Users” found this to be especially true when retail investors “herd.”
Junqing Kang and Shen Lin contribute to the literature on the performance of institutional versus retail investors with their August 2021 study, “Spot Fishes at the Table: Tracking Retail Investors and Mutual Funds Return.” Their focus was on how institutional investors deliver excess returns in the Chinese stock market. Through characterizing trading synchronicity (the coincidental occurrence of events) between mutual funds and retail flows, they studied the asset-pricing implication of mutual funds’ ability to track retail investors. They used stocks’ shareholder numbers (SHG) to measure the flows of small retail investors and constructed two intermediate measures based on the correlation between growth of SHG and either the holding (i.e., quarterly holding-based synchronicity, HSQ) or trading (i.e., quarterly trading-based synchronicity, TSQ) of mutual funds. They defined trading synchronicity (holding against retail investors, or HARI; and trading against retail investors, or TARI) by negative value of moving average of either HSQ or TSQ over a four-quarter rolling window.
Their data sample included daily and monthly transaction data, quarterly accounting and shareholder information for all common stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Since the shareholder numbers of stocks were first disclosed in the first quarter of 2003, the sample period was 2003-2020. The variables they analyzed included market beta, market equity, value, institutional ownership, abnormal analysis coverage, stock price, abnormal news, top 10 abnormal daily volume, top 10 daily return, quarterly return and idiosyncratic volatility. Following is a summary of their findings:
- Some mutual funds track retail investor trades and then exploit the cash flow information, trading against them, to deliver excess returns.
- SHG negatively predicted future returns.
- Funds with low trading synchronicity significantly outperform other funds with high trading synchronicity.
- There was a stronger negative relationship between TARI and opposite trading among stocks with a higher liquidity.
- Both HARI and TARI positively predicted mutual funds return: The long-short portfolio earned a CAPM alpha of 4.1% per year for HARI and 2.2% per year for TARI. After adjusting for four factor exposures (market beta, size, value and abnormal turnover), both HARI and TARI earned annualized excess returns above 4%, with t-statistics above 2.6.
- Their findings were robust to different weighting schedules, subsamples and rebalancing schedules.
Their findings led Kang and Lin to conclude that by exploiting the irrational behaviors of retail investors, institutional funds obtain excess gross returns. Unfortunately for fund investors, the same large body of evidence demonstrates that while mutual funds generate gross alpha, their total expenses exceed gross alpha, resulting in negative alphas for their investors. For example, Russ Wermers, author of the study, “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” found that on a risk-adjusted basis, the stocks active managers selected outperformed their benchmark by 0.7% per year. However, their total expenses – not just the fund’s expense ratio, but trading costs and the cost of holding cash as well – more than eroded the benefits derived from their stock-selection skills, leaving investors with net negative alphas. What economists call the “economic rent” was going to the scarce resource (the ability to generate alpha), not to the plentiful resource (investor capital). That occurred, just as economic theory predicted.
Warren Buffett famously warned investors that if you cannot value businesses “far better than Mr. Market, you don’t belong in the game. As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” The evidence makes clear that, on average, the patsies are retail investors. That makes trying to outperform the market through individual security selection or market timing a loser’s game for individual investors – just like at the roulette wheel, while it’s possible to win, the odds are so poor that you shouldn’t play. However, it’s also a loser’s game for actively managed fund investors.
The evidence from the annual S&P Indices Versus Active (SPIVA) Scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks, shows that regardless of the asset class, year after year a large majority of actively managed mutual funds underperform and that there is little to no persistence of outperformance beyond the randomly expected. In addition, studies such as “The Selection and Termination of Investment Management Firms by Plan Sponsors” have found that while pension plan sponsors hire investment managers after those managers earn large positive excess returns up to three years prior to hiring, post-hiring excess returns are indistinguishable from zero; and if plan sponsors had stayed with the fired investment managers, their returns would have improved. In other words, while fund managers have sufficient skill to exploit retail investors and generate alpha, they don’t have sufficient skill to overcome all their costs. Thus, fund investors are the losers in that game of active investing, and the fund sponsors are the winners.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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