The Return Gap

Many investors understand, agree with, and even subscribe to the value philosophy, but surprisingly few reap all of the benefits.  According to a recent paper by Jason Hsu at Research Affiliates, there is often a gap between the performance of top mutual funds and the actual experience of a typical investor in these funds.  Why is this?

To begin with, though value investors have been able to earn a premium over the long-term, this premium is not dispensed evenly across all time periods.  Rather, investment styles are often cyclical, and value (like any other strategy) has experienced in-favor and out-of-favor seasons. 

Below is a chart showing the 5-year return for the Russell 1000 Value minus the return for the Russell 1000 Growth on a rolling basis.  Periods of outperformance for value (area above zero) eventually give way to outperformance for growth (area below zero), and vice versa. 


Data is from Morningstar Direct.

The problem is that most market participants exhibit pro-cyclical behavior.  The longer and deeper the phase, the more people will be inclined to jump to the “winning” strategy, and usually right before the tide begins to turn.  Carl Richards succinctly captures this tendency: “Buy high.  Sell low.  Repeat until broke.” 

Jason Hsu thus explains the relative underperformance of many value investors: 

“The trend-chasing habit has been detrimental to the average fund investor even if he or she invests in outperforming strategies executed by skillful managers. In our assessment, a trend-chasing allocation process, combined with cyclical (mean-reverting) style or strategy performance, has contributed most appreciably to the observed return gap.”

So what is the takeaway from this?  Don’t abandon a fund or strategy just because it is lagging.  Time periods spent in the “valleys” portrayed in the above chart are never fun, but they must be endured if one is to avoid the dreaded return gap.

Aaron Pettersen, CFA, CFP®