At a seminar I attended recently, the conversation turned to DIY investing; specifically the "conventional wisdom" among many investment professionals that do-it-yourself investors have a tendency to under perform due to cognitive bias, poor timing or -- especially -- a propensity for active trading.
This conversation reminded me of a 2012 study by Vanguard, "ETFs: For the better or bettor?" that evaluated the potential for an increasingly popular asset, ETFs or exchange-traded funds, to transform long-term investors into short-term traders. The introduction of active ETFs, or funds that don't track an index, in 2008 further fueled speculation about investor behavior. The study raised some interesting questions about investor behavior... and the results may just surprise you.
Strategic Wealth Management and the ETF Temptation Effect
Because investors can essentially trade ETFs like stocks, many investment professionals believed that this asset's growing popularity would lead to an influx of active traders into the traditionally passive domain of mutual funds, otherwise known as the "ETF temptation effect." Would these individual investors throw caution to the wind and abandon any commitment to long-term investing, thus greatly increasing their chances of achieving nothing more than an underperforming portfolio?
After all, if ETFs tempt investors into active trading, they would incur transaction costs and fees that would hurt their returns. Plus, active traders tend to let emotions influence their decision making and timing the market just doesn't consistently work, as indicated by a broad body of research.
So what does Vanguard's study suggest?
After tracking 3.2 million transactions in almost half a million accounts over four years, research indicated that -- surprisingly -- most ETF investors tended to be long-term investors, just like traditional mutual fund investors. Findings include that:
- 62 percent of ETF account holders held their investments for more than one year and engaged in no more than two reversals
- 83 percent of mutual fund account holders held their investments for more than one year
This indicates that most investors weren't actually succumbing to the ETF temptation effect.
Is Investment Professionals' Conventional Wisdom Correct?
The study also found that 27 percent of ETF accounts were short-term, as compared to 12 percent of mutual funds. However, according to Vanguard, most of this trading behavior can actually be attributed to personal characteristics of individual investors, rather than the type of asset they invested in.
And therein lies the main point of the study: The investment vehicle does not necessarily impact investor behavior. Assets like ETFs don't change investor behavior, but they do attract investors who are predisposed to active trading. In other words, investors cause their own under performance.
Other data leads to the same conclusion.
- A 5-year Morningstar study found that investor returns lagged behind total returns by a margin of 1.26 to 2.25 percent
- Dalbar's Quantitative Analysis of Investor Behavior (QAIB) found that average equity investors under performed the S&P 500 by 4.32 percent over a 20-year period
- Equity investors under performed the Barclay's Aggregate Bond Index by 5.56 percent over the same time
While research indicates that ETF temptation may not be a pressing concern, it also highlights the fact that active trading simply isn't an effective investment management solution.