Another reason to stick to low-fee funds

Fund investors improved their market timing according to a recent study Morningstar.com. But they still underperformed their funds by an average of 0.54 percentage points annually from 2004 through 2014.

If you’re wondering how investors can underpeform the funds they own, let me walk you through the details. It all has to do with when investors–on average–put their money into, and take it out of, their funds.

Technically speaking, the study considered the difference between time-weighted returns and dollar-weighted returns. Fund companies report time-weighted returns with the assumption being that all of the money is put into the fund at the start and then held there until the end of the period in question. However, most investors put money into, and take it out of, their funds over time. As a result, they earn dollar-weighted returns, which are also sometimes referred to as asset-weighted returns.

To see how it works, it’s useful to think through an example using a volatile fund that gains 40% in the first year, falls 50% in the second year, and climbs 50% in the third year.

An investor who puts all of their money into the fund at the start and holds it there for three years would gain 5% in total. (i.e. $1.00 grows to $1.40 in the first year, drops to $0.70 in the second, and climbs to $1.05 by the end of the third year.) In this case, the investor’s dollar-weighted return is equal to the fund’s time-weighted return because no purchases, or withdrawals, were made during the period.

The second investor puts half of their money in at the start of the first year and then invests the second half at the end of the year. By the end of year three, they would have lost 10% overall. (i.e. $0.50 grows to $0.70 by the end of the first year and then $0.50 is added to the fund. The $1.20 falls to $0.60 by the end of the second year, which then grows to $0.90 by the end of year three.) The second investor didn’t fare as well as the first due to their poorly timed purchases.

It is possible to do better than the first investor. For instance, a third investor who puts all their money into the fund at the end of the second year would walk away with a 50% gain by the end of year three.

But the study didn’t look at individual investors. Instead it calculated average results across all funds and all fund investors in the United Sates. (They also reported results by fund category.) Naturally, some individual investors fared better than average and others fared worse.

The study determined that funds sold in the U.S. gained an average of 5.75% per year based on their time-weighted returns from 2004 through to the end of 2014. But investors in those funds gained an average of 5.21% per year based on their dollar-weighted returns over the same period. That is, investor returns trailed fund returns by 0.54 percentage points per year on average.

The gap between the two returns varies depending on the period in question. For instance, the 10 year period from 2003 through 2013 saw investors trail their funds by a whopping 2.49 percentage points annually. But, generally speaking, the return gap clocks in at roughly one, or two, percentage points annually.

It is also worth highlighting that investors who hold low-fee funds tend to benefit from both higher time-weighted returns and higher dollar-weighted returns. It’s a reason to stick to low-fee funds for the long term.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of Aug. 14. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase–barring some calamity.

Notes

Source: Bloomberg, Aug. 14, 2015

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

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