Testing DALBAR’s Claims about Mutual Fund Investors

To read DALBAR's response to this article, go here.

DALBAR’s Quantitative Analysis of Investor Behavior report is commonly cited as “proof” that mutual fund investors have historically made poor market-timing decisions. While DALBAR does not publicly disclose its approach, in this article I use a transparent and industry-accepted methodology, based on publicly available data[1], to demonstrate that investors’ returns have not been nearly as bad as DALBAR claims.

Two recent Advisor Perspectives articles, the first by Michael Edesess and the more recent by Wade Pfau, explored whether the market-timing decisions made by mutual fund investors were rational and intelligent. The majority of the research suggests that the average mutual fund investor doesn’t do a very good job timing the market (i.e., is “dumb”). But there are significant differences in the estimates of how much these poor decisions have affected performance. For example, DALBAR suggests that equity mutual fund investors have underperformed the S&P 500 by over 600 basis points annually. In contrast, Russ Kinnel, my colleague at Morningstar Research Services[2], has noted a more muted impact in his annual Mind the Gap report, typically in the neighborhood of 100 basis points annually.

In this piece, I’ll conduct my own analysis using historical mutual fund data to better calibrate the intelligence of mutual fund investors’ market-timing decisions.

Winners and losers

Every active investor (i.e., one who doesn’t hold the market-capitalization weighted portfolio) will lose or make money, and there will be a corresponding, offsetting winner or loser. While there can be more winners than losers (and vice versa), the asset-weighted alpha must be zero before fees (i.e., a lot of investors can win if one large investor loses). This is an important point Edesess made regarding the potential impact of timing decisions, whereby any “alpha,” be it positive or negative, is a zero-sum game in the aggregate (before fees).

One of the most commonly cited examples of the zero-sum game nature of alpha is that actively managed portfolios can’t (or shouldn’t) collectively outperform passive (i.e., index-tracking) investments. This is because passive investments, at least those that are market-cap weighted, hold the market.[3] Active funds can change only the relative weights of individual holdings; the market universe is the same. Therefore, for every dollar invested actively, one must lose.

This same zero-sum paradigm applies to timing decisions, which we can think of as how weighting decisions change over time. One important wrinkle when thinking about this paradigm for a specific set of investments, such as mutual funds, is that mutual fund investors don’t represent the entire market. Most mutual funds are actively managed, and there are a variety of other vehicles an investor could use to gain exposure to the stock or bond markets, such as purchasing securities directly, buying a passive ETF or some type of collective vehicle, futures, forwards, etc. So the average alpha for mutual fund investors as a whole could be positive or negative.

When thinking about the potential alpha related to timing, empirical evidence suggests mutual fund investors have been losers, on average. We see this in Exhibit 1, which includes historical monthly data on net flows for mutual funds obtained from Morningstar Direct.

Exhibit 1: Monthly Flows for US Equity Mutual Funds