Investment irrationality undermining returns

Investors have physiological biases that lead their investment strategies astray, Vanguard Quantitative Equity Group principal Nelson Wicas believes.

“Investors tend to think they are acting in a rational way, when in fact they are often acting in opposition to their strategies,” he said at an Association of Superannuation Funds of Australia lunch in Melbourne.

“One bias people have is that they are over-confident and believe their investment management is better than average.”

Wicas said this could be illustrated by people who constantly trade their portfolio because they believe they can deliver a better return compared to those who are passive investors.

Vanguard interviewed a number of US 401K plan investors on whether they were an active trader, active rebalancer or passive investor.

“People who actively trade the portfolio do not achieve any risk-adjusted excess returns,” he said.

“The people who are active rebalanced investors achieve an excess of 0.24 per cent out-performance, and the passive investor 0.84 per cent.

“An aside, we found men trade their portfolios more than women.”

But Wicas is not against investors using actively managed funds, as long as they understand the excess returns may not match their expectations.

“We sampled a small number of global equity managers and looked at how they outperformed the MSCI index,” he said.

“In a small sample, we found 80 per cent of managers outperformed, but when we increased the sample we found the percentage of outperforming managers halved.”

Another physiological bias is the expectations people form based on previous experiences. But this can be very misleading.

Wicas said Vanguard looked at monthly excess returns for US large cap funds and compared this to the MERs investors pay.

If the investor paid a MER of 0.67 per cent, the excess return against the index would be -0.06 per cent, while at the other end of the scale, the excess return would be 0.28 when paying a MER of 2.13 per cent.

“You get what you pay for, and the average excess return for large cap funds appear to be negative,” he said.

However, applying the same criteria to US small cap managers, the higher the MER the greater the excess return against the index.

A MER of 2.22 per cent delivers an excess return of 0.06 per cent.

“There is an argument for going active in small caps, with median fund excess returns after costs being positive,” he said.

“But the investor needs to look carefully at the data, as a spike in 10-year returns for small cap funds is just a bubble, and we seem to get one every 30 years.”

Wicas said active funds and indexed funds can work together in a portfolio, but many people have a bias against indexing.

“We believe there is a powerful case for indexing, but investors should diversify as well, and that means we can work with an active manager in a portfolio,” he said.