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January 11, 2017

Top 3 research papers for investors

Facts tell, stories sell. This is, sadly, especially true in the investing world. Most meetings with financial advisors are quite short and the easiest way to get a client to invest in a new fund is to tell a good story. However, If you prefer an evidence-based approach to investing, you might find the following three studies more interesting. We enjoyed reading them and they were our favorites research papers of 2016.

1. ETF are bad for your health

What they found: Investors who used low-cost index funds (ETF) underperformed on average by 1-2% p.a.

What this means for you: Doesn’t this run contrary to everything we have said? Even Warren Buffett recommends index funds as the core building block for your investments. But ETF are not the holy grail. Behavior is more important than products! The study showed that the disappointing performance of ETF investors is based on over-trading and their choice of poorly diversified niche ETF. Ironically, the low cost and high liquidity of ETF seem to encourage trading and aggravate the individual temptation to engage in this behavior. ETF stands for ‘Exchange Traded Fund’ but investors too often treat them as ‘Excessively Traded Funds’. A well laid-out financial plan is therefore key for investors. Advisors can help to take out the emotional aspects of investing.

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2022442

2. Small is better

What they found: A study of 16,000 active equity funds spread across 35 countries over a 25 year span showed that small funds outperform large funds. Fund size is negatively correlated to net returns and to alpha (ie. excess return over the benchmark)

What this means for you: Advisors like to recommend big funds because, well, “nobody ever got fired for buying IBM”. Large funds offer a certain brand recognition and most investors feel intrinsically safer with a well-known product where thousands of other investors are involved too. But this comes with a significant performance penalty! Investors should also take a closer look at smaller funds, where some real gems can be found. However, the truth is that most individual investors (and advisors!) lack the analytical capabilities to search through the thousands of less-well known mutual funds. If you don’t have the skill-set, you should stick to broadly diversified index funds.

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801930

3. Winner‘s curse

What they found: Fund managers that win the coveted Morningstar “Manager of the Year” award show poor subsequent performance because performance-chasing investors flood the winners’ funds, effectively hamstringing them.

What this means for you: Be careful with slick marketing pitches. A “Manager of the Year” award might seem attractive, but the results of the study suggest that the ex-post value consequences of superstar status for investors are negative. The same is true for other typical sales pitches like „3 year performance“ – often it only tells us that the underlying assets are now expensive and why would you want to invest there?

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2732363

 

… we initially only wanted to present 3 studies. However, we could not resist highlighting another research paper. It is actually quite funny, but it also tells us a lot about the reality of the people doing all the investing… Enjoy!

4. Fund managers who drive sports cars don’t deliver alpha

What they found: Fund managers who own powerful sports cars take on more investment risk. Conversely, managers who own practical but unexciting cars take on less investment risk. Put another way, the average fund with a hot-rod driver at the helm is more than 16 percent more volatile than those with a manager who drives a more practical car. The incremental risk taking by performance car buyers does not translate to higher returns.

What this means for you: Fade the fund manager with the brand-new Maserati and put your faith in the one who just bought a Honda Odyssey.

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2882983

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