We just had a research paper accepted in SSRN’s elibrary. Click here for the abstract and the full 10 page paper.
Here’s a snippet and some of our key conclusions:
Return chasing is often cited as one of the primary behavioral foibles of investors, resulting in sub-par returns. Surprisingly, however, the literature does not provide a generally accepted and testable description of return chasing.
Indeed, there is much supportive evidence for the notion that return chasers are losing money in the finding that mutual fund investors have earned 1.5% to 3% a year lower returns than the returns of the funds they invested in. This is separate from the effect of fees on investor returns, which gets so much coverage in the financial press; rather it has to do with the timing of investor flows. The effect probably comes from a combination of poor market timing and poor dynamic selection of funds themselves, putting money into funds that are hot and redeeming from those that are not. That dollar-weighted investor returns have been lower than fund returns historically has not attracted as much attention perhaps because it’s a story wherein the perpetrator and the victim are the same party: the investor.
Our interest in the topic was piqued further after a thriving investment manager started his presentation to a roomful of potential investors saying:
“Before I tell you what I do, I’m going to ask and answer the most important question you should put to me: Who is losing the money that I’m going to make for you?
The answer: return chasers.”
Sounds plausible, but then how can trend following and momentum strategies have worked so well, while ‘return chasing’, which sounds like the same thing, be so misguided as to be the primary source of the superior returns of smart investors?
Return chasing is an idea in search of a definition, so the first thing we do is put forward a simple, plausible one that we can test: When the past 1 year return has been good, buy some stocks, and when it’s been bad, sell some.
Our research finds that return chasing so defined would have indeed put a big dent into investor returns and, furthermore, provides a powerful explanation for why value and momentum-oriented strategies have worked in the past. Looking at historical returns, a return chasing strategy would have underperformed a static 50/50 balanced equity/T-bill portfolio by over 1% per year, while a simple momentum strategy outperformed thestatic 50/50 portfolio by 2-3.5% per year. Quite a gap. In the paper, we also conduct a Monte Carlo simulation, with similar results.
We conclude that the thriving investment manager was on to something: despite its superficial similarity with the historically profitable strategy of trend following, return chasing may indeed be investing’s original sin. Worse, when the return chasing crowd becomes too big, they may be the primary cause of the too frequent bubbles and busts our system suffers.
Update: Click here to see a short interview Victor gave on Bloomberg relating to the above research.