Aurora Borealis
1 November 2017 CFA Institute Journal Review

Individual Investor Activity and Performance (Digest Summary)

  1. Peter Eickelberg, CFA
Swedish pension investors who trade actively achieve higher returns without higher risk than investors who make fewer changes. More-active investors also seem to choose superior funds and display some timing ability. Evidence of coordinated trades across participants suggests financial adviser input. But excessive trading can harm other fund investors.

What’s Inside?

The authors weigh which investor types in Sweden’s Premium Pension System (PPS) fare better on a risk-adjusted basis over a 10-year period. Highly active investors who trade frequently across funds and asset classes earn significantly higher returns than the more numerous passive investors who make infrequent adjustments to their holdings. Outperformance seems due mainly to fund and asset class timing, with return advantages generally being front-loaded. Many trades also appear to be coordinated, suggesting financial adviser direction, although advised clients’ returns do not exceed those of passive investors when fees are taken into account. The authors caution that frequent trading creates costs that all investors must bear.

How Is This Research Useful to Practitioners?

Given that much academic and marketing literature over the last several decades has shown the follies of active trading, a study showing outperformance by active investors could be illuminating. The authors’ findings indicate advantages from superior fund selection, asset class timing, short-term fund performance persistence, and adviser involvement. Thus, both active and passive management proponents should review the authors’ methodology and findings to update or confirm their own views.
The authors decompose gains and find that some of the additional returns come from purchasing recent strong performers, suggesting performance persistence for the asset purchased. Outsized returns also appear to come early in the trade, underscoring the importance of fund timing. The authors differentiate between advised trades, which occur at the same time across many accounts, and trades made independently. They find that nonadvised investors trade more than advised investors and tend to trade in and out of the same assets most of the time. Higher-income investors and men trade the most frequently. (The authors are quick to point out that this study sample is quite small and thus might not be representative of gender differences.)
Of particular importance is the lack of trading costs. If investors had to pay transaction fees and taxes, active management might lose its advantage. In this study, paying advisory fees wiped out any return advantages relative to passive investing, and thus costs probably represent the most important consideration. This finding is consistent with prior researchers’ findings on passive versus active investing.

How Did the Authors Conduct This Research?

Collecting daily transaction data on more than 6 million investors in the PPS, the authors select a random sample of more than 70,000 individuals with a nearly 10-year history (September 2000–May 2010) to analyze. Taking the initial positions and then all daily changes over the period, they reconstruct investor net returns on the basis of the more than 1,200 funds available to control for survivorship bias. (Note that the authors cannot rely solely on published retail fund returns because of administrative costs and fee rebates.) The fixed-income fund options consist mainly of Swedish bonds, but equity funds contain exposure to many world markets, including North America and emerging markets.
Using each investor’s initial fund choices as well as all daily fund changes, the authors compute the returns, distinguishing between likely “robo-advised” investors and those acting independently. They count fund changes to classify investors by activity level. The authors include lags and equal-weighting rules to control for the possible price impact of fund changes and size differences among investors. For risk metrics, they rely chiefly on Fama–French–Carhart factors, with some adjustments for the Swedish focus.
The authors use one 10-year period that includes both the tech crash of 2000–2001 and the Great Recession of 2008–2009. Their results do not clearly indicate whether certain subperiods offered the greatest amount of outperformance, which is important because of the possible large active trading gains available during historically volatile times. Perhaps using rolling returns over a longer period would add explanatory power to the authors’ findings.

Abstractor’s Viewpoint

The authors’ findings highlight the importance of considering trading costs when computing final returns. Frictionless trading does not exist in the real world, and the authors rightly point out that active trading by one group may impose an unfair burden on other investors. The PPS administrators could consider limiting trade frequency or even penalizing traders who abuse the system.
The authors backpedal on their finding that men outperform women, on average. This finding runs counter to other published research and industry political agendas and should be investigated further. Perhaps an environment that rewards aggressive risk taking favors traditionally male tendencies, whereas “normal” markets do not.

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