Don’t follow the money if you want better earnings

Become a contrarian and see your investment grow faster

Mark Hulbert
25 April 2010

Mutual fund investors usually get the direction of the stock market wrong. Just before the market declines, they generally move money out of bond funds and into stock funds, and just before it rises, they shift their money in the other direction.

These are the findings of a new study that provides yet more evidence that most mutual fund investors would fare better if they did not try to time the market. And because so many fund investors try to do so anyway, the study suggests that these fund flows provide a new sentiment indicator for gauging excessive pessimism or optimism.

The new study, which is titled Measuring Investor Sentiment with Mutual Fund Flows, features in the Journal of Financial Economics, an academic publication. Its authors are Avi Wohl, a finance professor at Tel Aviv University; Azi Ben-Rephael, a PhD student there; and Shmuel Kandel, now deceased, who had been a finance professor there. They focused on exchanges between equity and fixed-income funds in the same mutual fund family.

In line with previous research on money flows into and out of mutual funds, they found that as the stock market rises, investors tend to transfer money from bond funds to stock funds, and vice versa.

They also found something that had escaped notice among researchers: that the stock market reverses itself in the weeks and months after these exchanges. For several months before the beginning of the bull market in March last year, for example, fund investors on average transferred money out of stock funds and into bond funds. It is a common pattern.

Still, the research also shows how we might become better market timers. The key is to do the opposite of what the average mutual fund investor is doing – in other words, to become a contrarian.

To illustrate the benefit of a contrarian interpretation of fund data, the authors built a hypothetical portfolio that, from the start of 1984 through 2008, switched between the S&P 500 and 90-day Treasury bills. If net exchanges in the three most recent press releases issued by a fund were out of equity funds, the portfolio would be fully invested in the index for the next month. Otherwise, it would hold T-bills.

Over those 25 years, the researchers said, the portfolio produced an annualised return of 12 per cent – or 1.6 percentage points a year ahead of buying and holding. The researchers did not take transaction costs into account in calculating these returns – though, except for taxes, those costs should be minimal.

But here is what makes this portfolio’s performance even more impressive: it was in riskless T-bills nearly half the time, and was therefore a lot more conservative than one that bought and held, which means its risk-adjusted return was even further ahead of the market’s.

In an interview, Ben-Rephael emphasised that he and his co-authors built the hypothetical portfolio for illustration purposes only, and they were not necessarily recommending it as the best way to exploit their research. For example, he said, its allocation to stocks was the same regardless of whether net exchanges out of stock funds were tiny or huge.

Though they did not explore the possibility, he said, it could very well be that the portfolio would have earned even greater profit through a more nuanced strategy – one that varied stock exposure according to the magnitude of fund exchanges.

The researchers did explore the relationship between their sentiment indicator and a number of better-known indicators that contrarians often use. Those include consumer sentiment and the average discount to net asset value among closed-end stock funds.

The researchers found that only their indicator had a significant correlation with the stock market’s subsequent return.

The bottom line for most mutual fund investors is this: shift money into or out of your stock funds at your own peril. If you still want to try, however, take the opposite path of the average fund investor.

The New York Times


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