Friday, December 28, 2007

For Higher Returns, Fire Your Broker?

Studies of money flowing into and out of mutual funds suggest that investors tend to buy high and sell low. They put lots of money into funds that have had a hot streak while selling funds whose value has sagged. In real life, investors in a fund with an average annual return of 9% may be lucky to make 7% or 8%.

According to Investor Timing and Fund Distribution Channels, a study sponsored by the Zero Alpha Group, investors in load funds fare especially poorly.
We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds. Investors in all three principal load-carrying retail share classes (A, B, and C) significantly underperform a buy-and-hold strategy. Among all load funds, Class B investors suffer from the poorest cash flow timing, underperforming a buy-and-hold strategy by 2.28 percentage points annually,
The study was co-authored by Mercer Bullard, a securities law professor at the University of Mississippi School of Law; Geoff Friesen, assistant professor of finance at the University of Nebraska-Lincoln; and Travis Sapp, assistant professor of finance at Iowa State.

Perhaps the most intriguing finding, highlighted by The Wall Street Journal, is that Index-Fund Tortoises Are Long-Term Winners. "Investors in no-load (that is, no-commission) index funds actually beat the returns of the funds they hold by 0.42 percentage point annually."

How can investors in a fund that matches the market return wind up with a return four-tenths of a percent higher? Must be that they not only buy and hold but also tend to invest new money regularly.

If you put $500 per month or $3,000 per annum into an index fund, year after year, you are dollar-cost averaging. That is, you cannot avoid buying more shares when the market is down, fewer when the market is up.

Just don't listen to those hot tips on sector rotation from brokers or registered investment advisers.

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