Why Bulls Should Fear The "Money On The Sidelines"
Much has been made of equity inflows this week (though we note a significant outflow from high-yield bond funds - just as risk-on in its nature) and once again the money-on-the-sidelines fallacy is hawked at every opportunity. Two critical aspects are important to get past this 'fact' as some positive driver. First, money does not 'enter' the market, it is swapped (e.g. Person A's cash is used to buy shares from Person B; after the transaction the roles are swapped with Person B holding cash on the sidelines and Person A holding shares); and secondly, as Morgan Stanley's Gerard Minack notes, despite all the disclaimers – retail flows assume that past performance is a good guide to future outcomes. Consequently money tends to flow to investments that have done well, rather than investments that will do well.
Via Gerard Minack, Morgan Stanley,
Investing is an unusual profession: perhaps the only one where amateurs have a good shot at beating the pros. However, evidence suggests that amateurs don’t: flow data indicate that retail often buys high and sells low.
Amateurs normally stand no chance against professionals. It’s not just that none of us could take a point off Roger Federer, or a hole off Tiger Woods. Investing is different.
It’s not unusual for the majority of professionally-managed funds to under-perform their benchmark.
The chart above shows the percentage of US large-cap equity funds that under-perform the S&P500 index. On average, over the last decade 60% of funds have returned less than the S&P500 (after fees) for a calendar year. Moreover, the share of funds that under-perform increases over longer time horizons: 86½% of funds under-performed the S&P500 on a rolling three year basis to end-2012.
US large-cap equity investors are not special in this regard.
The chart above shows the percentage of funds in a range of assets that have under-performed their benchmarks on a 1, 3 and 5 year rolling basis. This is Lake Wobegone upside-down.
The good news for the professionals is that many amateurs persist in trying to beat the market and, in aggregate, they seem to do a significantly worse job than the professionals.
In short, amateurs may be able to beat the investment professionals, but most do far worse. This keeps professional investors in business.