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Vanguard Investors Outperform Fidelity Investors

Russell Kinnel, director of mutual fund research at Morningstar, recently compared investor returns at Vanguard to investor returns at Fidelity. His study is interesting because it looks at investor returns (aka “dollar-weighted returns“) rather than investment returns (aka “time-weighted returns”).

A brief example of dollar-weighted returns

If Mutual Fund ABC earned a 25% return in Year 1, then lost 20% in Year 2, its effective annual return over the two years would have been 0% (because it would be back exactly where it started).

If, however, the fund had doubled in size at the end of Year 1–due to investors chasing performance and buying the fund after a great year–its dollar-weighted return would be significantly below 0%, because the performance in Year 2 would be weighted twice as heavily in the calculation. In short, dollar-weighted returns measure how the investors performed rather than how the investments performed.

What did Morningstar’s research show?

The study showed that Vanguard investors earned greater returns than Fidelity investors over the last 10 years. But that doesn’t really mean a great deal to me. It could simply be the result of Vanguard’s larger funds being in more successful asset classes than Fidelity’s.

What does interest me, however, are the two following facts:

  • As usual, mutual fund investors underperformed their own investments across the board.
  • Vanguard’s investors underperformed their investments by a smaller margin than Fidelity’s investors.

Why do we underperform?

We underperform because we try to time the market, and we (usually) fail. We chase performance–both in terms of hot asset classes and in terms of hot funds–and it destroys our returns.

Why do Vanguard investors perform better?

My hypothesis is that it has to do with the core philosophies of the two companies. As a company whose success has been based on index funds, Vanguard’s core tenets are minimizing costs, diversifying, and buying and holding.

In contrast, Fidelity, at its core, is about active investment. Many of their own fund managers turn over their portfolios more than once per year. It wouldn’t be terribly surprising to learn that their investors do something similar.

Kinnel has a similar opinion:

“It’s possible that the performance gap also has something to do with each firm’s message to investors. Vanguard preaches long-term investing and goes so far as to warn investors away from hot-performing funds…Fidelity also preaches long-term investing, but it sometimes nudges people to invest based on short-term results.”

What can we learn here?

Surely, some people will look at this study and see it as evidence of an opportunity to outperform the market. They’ll draw the conclusion that we must learn to “be fearful when others are greedy and greedy when others are fearful,” as Warren Buffett would say.

To me, the lesson is slightly different. I see it as another piece of evidence that our predictive abilities are decidedly lacking. After all, nearly every single one of those people who underperformed sincerely believed that he was going to outperform.

“I am above average!” is the battle cry of underperformance.

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Comments

  1. Rob, I did not say that all investors fail at timing the market. I simply said that mutual fund investors usually fail when attempting to do so. There is an abundance of information regarding mutual fund cash flows that backs up this claim.

  2. Aaron Margeson says:

    I admit I “timed the market”. When I had some extra cash to either invest or put in an emergency fund once I paid my debts off back in July, Even though I hadn’t built a proper rainy day fund yet, I fully funded my Vanguard Roth IRA target retirement age fund, knowing that:

    A. I would have extra cash later to put towards savings for an emergency.
    B. This lump sum wasn’t all the extra cash I had.
    C. The market had nowhere to go but up significantly in the long run, and would likely rally in the short run significantly.
    D. I could pull some money out of a Roth IRA penalty free if I absolutely had to.

    Conventional wisdom would have been to build the emergency fund first, but I decided to be more risky and do that.

    Turned out to be a solid choice. I’ve socked away more money in my emergency fund since then, although it’s still not completely built to where I want it to be, but I’ve also made an almost 20% return on my IRA money already in four months.

    Normally, I don’t believe in “market timing”, but decisions like mine where it’s long run focused and pretty obvious you’re going to likely do well, how can you not? I’m an Oblivious Investor, but not THAT oblivious… 🙂

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