Why do ETF investors fail?

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Abusing ETFs - Why do ETF investors fail?

Poor ETF selection and market timing are the main ways that individuals sabotage their own investment performance according to the authors of the research paper, Abusing ETFs. They discovered that investors lost 1.69 % in net portfolio returns per year in comparison to a MSCI World buy-and-hold strategy. By analysing investor data provided by a large German brokerage, the researchers further found that most of that loss (1.28 % per annum) resulted from choosing ETFs that underperformed a diversified MSCI World ETF. The remaining 0.41 % of the overall loss was caused by poor market timing, with investors succumbing to the dreaded “buy high, sell low” syndrome.

The cost of getting it wrong

A loss of 1.69 % per year may not sound so bad but it’s huge. Leakage on that scale would cost any investor dear over the long-term, as the following example shows: Imagine you contribute €500 to your portfolio per month for 30 years. Your portfolio grows 4.31% annually and you net €361,426 by the end of the period. But, in an alternative universe, you contribute the same amount to a MSCI World ETF buy-and-hold strategy that advances 6 % annually. After 30 years your account balance is 35 % bigger - weighing in at €487,256. That’s a massive gap in outcomes that would make all the difference to a happy retirement.

Following the evidence

The Abusing ETFs paper (by Bhattacharya, Loos, Meyer, and Hackethal) confirms the findings of other researchers and practitioners who’ve long pointed investors towards low-cost, diversified portfolios that track the total market: “We conclude that the average investor could have benefited from using ETFs by following the guidelines of classical finance theory.” That theory posits that large global stock markets are highly efficient. That means current prices reflect all known information and adapt rapidly to breaking news. Thus investors without access to privileged information are unlikely to consistently improve on the market return because the wisdom of the crowd should win over the long term. Indeed, by choosing a portfolio that doesn’t replicate the market, investors are liable to underperform global benchmarks. For that reason, rational investors opt for a broad market-tracking vehicle (e.g. an MSCI World ETF) because it's the cheapest and most convenient method of buying into the world’s stocks at fair value - as judged by the sum of all investors. This is why Warren Buffett, one of the all-time investing greats, says: "A low-cost index fund is the most sensible equity investment for the great majority of investors.” But what’s little recognised is that when you deviate from the consensus view, you’re actually betting that you know something the market does not. For example, everyone understands that AI is likely to be a transformative technology. Yet by putting more money into AI stocks than the market believes is warranted, you’re speculating that artificial intelligence is even more commercially valuable than the rest of the world realises. Now you may be right. In that case, your AI ETF will beat the MSCI World in the years ahead. But if it does not, then you were either wrong or too early. And as we’ve shown above, the risk of being wrong is high. It’s because most people misjudge the market that the Abusing ETFs authors discovered their sample of investors lost 1.28 % per year, on average, versus simply buying a MSCI World ETF.

The impact of skill

An obvious riposte is that perhaps the average return conceals large losses inflicted upon clueless individuals who don’t know what they’re doing. Meanwhile, highly skilled investors can easily outperform the average by making smart decisions. The researchers investigated this theory by checking if particular users were responsible for a disproportionate share of negative outcomes. First, they sorted investors by type:

• Overconfident - as measured by portfolio turnover i.e. the overconfident rapidly changed the composition of their portfolios relative to the less confident.
• Financially sophisticated - higher portfolio diversification and values indicated a higher degree of investment literacy.

The investor types were then graded by various measures:

• ETF selection skill
• Market timing ability
• Risk-adjusted returns
• Overall performance

While there were differences in performance between the various sub-groups, the authors found that: “...no groups will lose by investing in the right MSCI ETF.”

ETFs work when paired with a passive investing strategy

The authors also found that investing in ETFs did not by itself improve the behaviour of active individuals who also traded other assets: “Investors therefore appear to make the same mistakes when they trade ETFs that they have made in trading non-ETFs.” Those mistakes being the characteristic downsides of active investing:

• Trading too much
• Trading at the wrong time
• Not sufficiently diversifying their portfolio so it resembles the total market

By deviating from a passive investing gameplan, the investors studied cost themselves 1.69 % in returns per year on average. The authors identify this underperformance as an opportunity loss that’s easily remedied: “There is also an opportunity loss that results mostly from not choosing ETFs that are low-cost and well-diversified. Therefore, for the individual investors in our sample, buying and holding well-diversified, low-cost ETFs would have been a wise strategy. This strategy, of course, also saves transaction costs.” Finally, they advise solutions that help investors stick to healthy investing habits: “From a policy perspective, therefore, programs promoting savings in well-diversified, low-cost ETFs that simultaneously limit the potential to actively trade in them might be beneficial to individual investors.” But you do not have to wait for policy action to avoid the biggest mistakes investors make. There are positive moves you can make today to adopt the best practices recommended by the paper’s authors. Foremost among them is creating a savings plan that automates your investments and drip-feeds your cash into your chosen ETFs. In one fell swoop you can solve the problems of trading too much and at the wrong time. Then by balancing a global stock market ETF (such as a MSCI World product) with a government bond ETF you’ve got diversification covered too.