Wow, look! This fund made 522% for the past 10 years or 15.21% per year! The fund manager is top in class and you should invest in this.
It is very typical to be shown an investment performance chart like the above. The fund becomes a convincing ‘buy’ since the manager was able to deliver high returns over a long period of time. But unfortunately, the returns is a misleading one.
Unit Trusts, ETFs and Hedge Funds report their performance using a technique known as time-weighted returns and the reported returns often result in a wrong inference for investors.
You can lose money even in the best performing fund
Peter Lynch is a well-revered mutual fund manager given his track record of an annual return of 29% over a 13 year period running the Magellan fund. It was reported that Fidelity conducted a study (but I couldn’t find the actual report) on the Magellan fund from 1977-1990 and found that the average investor in the fund actually lost money instead of achieving a 29% annual return.
Why so? The study found that whenever the fund suffered a setback, money would flow out, and when it got back on track, money would flow back in, by which time investors would have missed the recovery. In other words, humans have the tendency to get in and out at the wrong time instead of sticking with an investment.
I couldn’t find the actual study so I would assume the stats are exaggerated. Even so, it isn’t difficult to picture or relate to investors’ detrimental behaviour of buying high and selling low. Essentially, every investor will have a different return from another even if they invested in the same fund. Here’s a simplified illustration:
In Money by Tony Robbins, he quotes Jack Bogle (Vanguard founder) on this matter,
when the mutual fund advertises a specific return, it’s not, as Jack Bogle says, “the return you actually earn.” Why? Because the returns you see in the brochure are known as time-weighted returns.
… The mutual fund manager says if we have $1 at the beginning of the year and $1.20 at the end of the year, we are up 20%. “Fire up the marketing department and take out those full-page ads!” But in reality, investors rarely have all their money in the fund at the beginning of the year. We typically make contributions throughout the year…
… And if we contribute more during times of the year when the fund is performing well (a common theme, we learned, as investors chase performance) and less during times when it’s not performing, we are going to have a much different return from what is advertised. So if we were to sit down at the end of the year and take into account the “real world” of making ongoing contributions and withdrawals, we would find out how much we really made (or lost). And this real-world approach is called the dollar-weighted return. Dollar-weighted returns are what we actually get to keep whereas time-weighted returns are what fund managers use to fuel advertising…
… Bogle says: “We’ve compared returns earned by mutual fund investors—dollar-weighted returns—with the returns earned by the fund themselves, or time-weighted returns, and the investors seem to lag the fund themselves by three percent per year.” Wow! So if the fund advertises a 6% return, its investors achieved closer to 3%.
So maybe the better rule of thumb for investors is to half the reported returns by any funds to approximate their true returns. Otherwise, calculating money-weighted returns using the IRR method would be more accurate for the savvy ones.
Funds are not a silver bullet to help investors buy low and sell high
I’ve heard comments from people that DIY investing is hard and most investors would do better buying funds.
I agree with the former but not the latter.
The problem is that investors can still make a lot of mistakes in buying funds. The core problem is that they cannot overcome the human tendency to buy high and sell low. They get in when the funds are doing well and reporting good historical returns, and sell when the funds underperform or lose money.
No fund managers want to have their performance affected by the folly of this human herd behaviour. Using time-weighted returns would remove the impact of the flow of capital in and out of the fund. Thus, the fund performance is almost never the true return of her individual investors.
In order to achieve the time-weighted returns, the investors have to stay invested with the same amount throughout the entire period. How many investors do that in reality?
Investing is a path-dependent activity. How much you buy and sell? When you buy and sell? Every little action makes a significant difference in your investment returns that diverges from other investors.
Bottom line, you need to measure your own returns to truly know how well your investments have grown.
Editor’s Notes: There is a reason we are more biased towards being systematic. Following a well set out procedural checklist eliminates human bias and removes our tendency to invest at the worst of possible times, buying when we should be selling and selling when we should be buying. Trust me when I say that most of us are fools when it comes to the market if left to our own devices. Common sense, as it turns out, is not common. We have, realising this, structured and put in place a program of our own that allows us to invest better with supporting evidence and a firm checklist in mind. If you wish to know how we do it, you can register for a seat here to preview our methods or see more of our case studies here.