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Stock Strategist

Six Reasons to Not Take Returns at Face Value, Part 2

Stock or fund returns may not tell the whole story.

Click here to go to Page 1 of this article.

4. I own a stock that dropped 5% today. Am I 5% poorer?
Not necessarily. Over short time periods like a day or a week, there's evidence of return reversals. A stock that drops 5% tends, on the average, to get some of that return back.

There are two likely reasons. First, there's the bid-ask bounce. Even if there's no news for a stock, the price quote can bounce around between the bid and the ask price. Or consider a stock that falls on a given day. Chances are that the last trade of the day occurred at or near the bid price; a seller came to the market with a sell order and sold the stock at the best available price a buyer was willing to pay, which is the bid. The following day, however, there's an equal chance of the first trade occurring at either the bid or the ask price. If the first trade is at the asking price, the price of the stock will go up, when in fact we're simply seeing transactions move between the bid and the ask.

Second, there are liquidity-driven price moves. Maybe the price dropped because a trader with no new information--a so-called noise trader--sold off a big position. If other traders come to believe the seller really had no fundamental reason to sell, the stock price will quickly gravitate back to its presale price.

The academic literature on return reversals is rich. One of the more recent papers is "Liquidity and Autocorrelations in Individual Stock Returns" by Adramov, Chordia, and Goyal.

5. My mutual fund had a great day--up 5%. Am I 5% richer?
Not necessarily. The 5% reflects the one-day change in the fund's reported net asset value. There are at least three reasons reported NAVs may not correspond to the fund's true net asset value. The first is nonsynchronous trading, which we explained in Part One of this article. The second is that the fund company mis-estimated the value of a holding for which a market price wasn't readily available. The third is the focus of a recent academic paper, "Live Prices and Stale Quantities: T+1 Accounting and Mutual Fund Mispricing" by Tufano, Quinn, and Taliaferro. By a quirk of fund-company accounting, the prices used to calculate NAV at the end of each trading day are current, but the quantities are a day old.

For example, if a fund owns 10,000 shares of  Microsoft (MSFT) on Tuesday and buys an additional 1,000 shares on Wednesday, the NAV at the end of the day Wednesday is calculated using 10,000 shares of Microsoft, not the 11,000 actually in the portfolio. If Microsoft's stock moved sharply late on Wednesday after the trade, the fund's NAV will be inaccurate. Fortunately, this is one of the return oddities that's small enough for most investors to ignore.

6. My fund was up 5% in the last week of the quarter, while the market was flat.
The fund may have been juicing returns near quarter-end. In a 2002 paper called "Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds" by Carhart, Kaniel, Musto, and Reed, the authors claim to "present strong evidence that some mutual fund managers mark up their holdings at quarter end through aggressive trading of stocks they already hold."

It works like this. Say I'm a fund manager who owns 500,000 shares of an illiquid stock that's been flat. As the quarter-end approaches, I place aggressive buy orders for an additional 50,000 shares, moving the stock up 20% in the last week of the quarter. Suddenly my return on the stock goes to 20%. If the stock were 2% of my portfolio, I've just boosted my fund's quarterly return by 40 basis points. And because my trading had nothing to do with the fundamentals of the company, the share price is likely to drift back down after the quarter closes. By that time, though, I've managed to post a slightly better quarterly return, which might get me a few more dollars in inflows in the upcoming months.

Conclusion
Of these six return oddities, the first two are the ones most of us should focus on. The other four teach us much about how markets work, but the impact on our pocketbooks is minimal.

How much does the first oddity--trades moving prices--cost us? Even if my own trades aren't big enough to move prices, the funds I outsource my investing to might face this problem. The bigger such funds become, or the more rapid their managers trade, the bigger the bite such transaction costs take out of my wealth. Various studies suggest that such transaction costs can be in the ballpark of 100 basis points per year for some investing styles.

As for dollar-weighted returns, my colleague Russel Kinnel ran a study in Morningstar FundInvestor in July 2005. He found that bad timing in large-growth funds cost investors 3.4 percentage points in annualized return over the past 10 years. And that was wonderful compared with investors in technology funds, who posted dollar-weighted returns that were 14 percentage points behind the official time-weighted returns.