The investing world is awash in simple mechanical strategies that promise prosperity. But they all suffer from a fundamental problem: They’re well suited to robots, but humans control the cash.
Finding a sound strategy is less than half the challenge for most people. If they can’t stick with it, then it’s not very useful.
Consider the behaviour of index investors who follow one of the simplest methods around. In its core form, passive investors buy a broadly diversified portfolio composed of low-fee index funds, or exchange-traded funds, and then sit tight for the long term.
Index fund pioneer John Bogle champions just such an approach. He brought low-fee index funds to a wide audience when he worked at Vanguard and, since retiring, he continues to inspire indexers worldwide.
Because Vanguard’s clients are steeped in the buy-and-hold ethos of low-cost indexing, it makes them a good group to study. That’s why I decided to examine the returns of the Vanguard family of index funds, offered to U.S. investors, over the past 15 calendar years.
I’m not interested in raw returns. Instead, I want to see how well investors timed their moves into, and out of, the funds. To do so, I compared each fund’s return to that of its average investor.
You’re probably already familiar with how fund returns are determined. They’re calculated by assuming an initial investment and subsequent reinvestment of any distributions. They don’t include any additional cash flows.
Investor return is a little more complicated. It accounts for any money that flows into, or out of, a fund while it’s held.
As you might imagine, the two can be substantially different. For instance, Vanguard’s 500 Index Fund (VFINX), which tracks the large cap S&P 500 index, gained an average of 4.58 per cent annually over the past 15 years, but its investors only gained 2.67 per cent a year. The difference of almost two percentage points per year indicates that the fund’s investors tended to buy high and sell low.
The accompanying table shows the returns offered by Vanguard index funds with 15 year track records, based on data from Morningstar.com. (All of the funds were required to have both fund returns and investor returns.)
Cast your eye to the last column which highlights the difference between investor and fund returns. Investors bested the funds in nine cases and trailed in 21. Overall, investors trailed their funds by an average of 59 basis points a year.
At first glance, many indexers don’t seem to follow a strict buy-and-hold approach. Even worse, they tend to fail at market timing. On the other hand, such results are hardly out of line – and perhaps a bit better – than those seen from active investors in other studies.
You should also notice the most extreme results were generated by stock funds. Perhaps more surprisingly, bond fund investors didn’t fare particularly well. Instead, the lowly balanced fund generally provided the best match between fund returns and investor returns. It’s one reason why low-fee balanced funds are relatively well suited to new investors.
I hasten to add that you shouldn’t focus too much on the particulars of the data in the table. Such findings tend to vary dramatically depending on the time period considered. In addition, factors beyond simple market timing enter into the picture. As a result, the timing evidence should be viewed as being suggestive rather than definitive.
But, based on similar work covering different periods, I think the general trend is reasonably clear. It’s hard to stick with simple investment approaches and the urge to tinker with them can gum up the works.
A closer look at Vanguard
Sources: Vanguard.com, Morningstar.com. Average 15 year annual returns ended Dec. 31, 2013 shown