Does it make sense to time the market, or are investors better off adhering to a target mix of assets?

In a recent working paper examining mutual fund buyers’ timing ability, Iowa State University professors Geoffrey Friesen and Travis Sapp provide further evidence that investors are their own worst enemies. The professors studied the difference between time-weighted and dollar-weighted returns.

A fund’s time-weighted return reflects how much investors would have made had they invested in a particular fund at the beginning of a time period and held it without interruption, reinvesting dividends along the way.

The dollar-weighted return measures the returns that inves-tors actually achieve in a particular fund.

As the average fund investor generally doesn’t buy and hold, and because the assets of a fund fluctuate, a fund’s dollar-weighted return will often be significantly different from its time-weighted return. And if, as is typical, investors plough more money into a fund after it has performed well and then sell units after it has performed poorly, the fund’s dollar-weighted return will be a whole lot less than its time-weighted return, the professors maintain.

Looking at monthly returns for 1991-2004 for more than 7,000 equity funds, they found investors’ time-weighted average monthly return to be 0.62%, while the average monthly dollar-weighted return was 0.49%. As a result, those inves-tors making active decisions underperform by about 0.13% a month, or 1.56% annually, relative to the funds they invest in. This performance gap is twice as large for load funds as for no-load funds.

The study’s authors also examined whether investors who were able to identify funds that generated extra return for extra risk also fared equally poorly through suspect timing decisions. The study found the performance gap was largest among the most volatile categories and funds, ranging from 0.25% for aggressive growth funds to 0.03% among income-growth funds.

Oddly enough, the researchers also found that larger, older and more costly funds with big marketing budgets and profiles seem to attract less sophisticated investors, thus increasing this relative performance gap.

As index funds don’t attempt to select securities or time the market, investors in them are generally assumed to be pursuing a completely passive investment strategy. To test this common belief, the authors examined 416 equity index funds. Here, too, they found a performance gap, indicating that some index fund investors may also be trying to time their investments. But compared with the actively managed fund gap, the index investor shortfall is less than half that of non-index funds — 0.05% per month vs 0.13%.

Investors looking to gauge the effects of chasing performance now have a new tool. Chicago-based Morningstar Inc. recently introduced the Morningstar Investor Return, which directly measures the price investors have paid for failing to be patient and disciplined. (This has yet to be introduced in the Canadian market.)

Assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year’s first quarter. If investors added substantial sums of money to the fund after its first-quarter run-up, the investors’ returns for that year would be lower than the fund’s 10% total return. That’s instructive, albeit after the fact, and may help to modify poor investor behaviour, Morningstar maintains.

Although fund companies can’t bear the blame for their inves-tors’ poor timing, they can deploy strategies that result in a better outcome for investors through fund design, the timing of launches and closings, marketing efforts and shareholder communications, Morningstar managing director Don Phillips says.

Advisors can do the same. IE