Every portfolio manager gets redemption requests from clients. Pivot Point Advisors manages mostly stock portfolios, so we get them more often during economic turbulence. Bond managers tend to get them more often during economic expansions when stocks do well and bonds generally don’t. This reflects investors desire to improve their return by changing their asset allocation in response to the economic cycle.
Whether this works is a hotly debated subject. However, Exchange Traded Funds (ETFs) give us a daily snapshot of what the investing public is doing with their money. We can use this data to examine how well an average investor times the market.
For this analysis we will focus on SPY, an ETF that tracks the S&P 500. This ETF is nearly three times as large as the closest competitor. It should be a good proxy for how an average person invests in the S&P 500.
The five turbulent years form 2006 to 2010 presented many opportunities for market timers. Avoiding just one of the several deep market declines would provide a significant boost to returns.
We will compare two investors to see how well market timing has worked:
- The buy-and-hold investor buys $1 of SPY and never changes his allocation.
- The market timer also starts with $1, but adjusts his investment each month to reflect in and out flows from SPY. For example, if investors redeem 5% from SPY during the first month, the market timer would invest 95% of his assets for the second month and leave 5% in cash. If SPY gained 7% of new assets instead, the investor would invest 107%, borrowing the necessary funds. (Simulation details are available upon request.) The market timer’s returns will be similar to those of an average SPY investor, because his investment decisions reflect the net in and out-flows from SPY.
We assume that people who liquidate their SPY holdings keep the proceeds in cash (at 0%), and that people who buy SPY either use idle cash or borrow the money (at 0%). In this analysis cash is the only alternative to SPY even though a real investor may shift his money out of SPY into another investment. Our goal is to measure how well an average investor times his SPY purchases and sales, not how well he times his entry and exit from that other investment. Limiting the investment choices to cash and SPY accomplishes that.
|Investment Returns and Net Fund Flows|
The chart shows the cumulative return for the buy-and-hold investor in blue and the market timer in red. The market timer loses 16.7% over the five years while the buy-and-hold investor escapes with a 1.4% loss.
The green line shows the in and out-flows from SPY each month (scale on the right). Through the middle of 2007 SPY has no material in or out-flows. Then inflows start picking up and keep rising until early 2009 even as the market was declining. Scaling up the investment during the downturn magnified the losses for the market timer.
This is pretty common behavior. Near the end of long up-trends, many people get greedy and add to their investments. Any market decline is viewed as an opportunity to buy the dips.
Sometime in early 2009, the investing public gave up and reduced their SPY position. The six months leading up to the large withdrawals from SPY saw the S&P 500 decline over 40% and the investing public did not see any reason why this would stop. Fear dominated the market, and institutional investors, who were following Buffett’s advice, started snapping up bargains. Because the market timer was investing less during the upswing, he was unable to recoup his losses from the downturn and fell farther behind the buy and hold investor.
The reason for Warren Buffett’s success is that he looks past the short-term market swings that drive the investment decisions for most people. He actually does buy when stocks are on sale and sells when greed has driven up the prices. Our analysis of SPY trading shows that most members of the investing public do the opposite, causing them to underperform a buy-and-hold investor by 15% over the last five years.