Issue Briefs

Update

Considering recent market volatility and worrying financial news media headlines, I have decided to republish this post about yield curve inversion, a hot topic these days. Originally posted September 2018, it describes whether there is a relationship between yield curve inversion and stock market returns.

Eugene Fama, Nobel Laureate and Distinguished Professor of Finance at the University of Chicago Booth School of Business, and Kenneth French, Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College, have recently submitted a new paper on the topic, “Inverted Yield Curves and Expected Stock Returns”, first draft dated July 28, 2019. Both Eugene Fama and Kenneth French are on the Board of Directors at Dimensional Fund Advisors.

They concluded that there is “no evidence that yield curve inversions can help investors avoid poor stock returns,” and continue, “The simplest interpretation of the negative active premiums we observe is that yield curves do not forecast the equity premium. This interpretation implies that investors who try to increase their expected return by shifting from stock to bills after inversions just sacrifice the reliably positive unconditional expected equity premium.” You can read the paper here.

What does this mean for you? Simply, it’s just more supporting evidence that market timing is a losing investment strategy. Instead, your asset allocation is the main determinant for your returns. If it’s risk-appropriate for your tolerance, then you will be emotionally prepared for market volatility. Remember, without market volatility, there would be no risk, and without risk, there is no expectation for reward. To help improve your odds of investment success, resist the temptation to react to short-term market swings, stay disciplined, and focus on the long term.

Originally posted September 2018

What is a yield curve, and why are stock investors interested in its shape?

A yield curve gives a snapshot of how yields vary across bonds of similar credit quality, but different maturities, at a specific point in time. For example, the US Treasury yield curve indicates the yields of US Treasury bonds across a range of maturities. Bond yields change as markets digest news and events around the world, which also causes yield curves to move and change shape over time.

Exhibit 1 includes snapshots of the US Treasury yield curve on the last trading day of September for the last three years. Rates across the entire curve have generally moved higher since 2016. However, short-term rates moved at a faster pace than long-term rates leading to a “flattening” of the slope of the yield curve.

Historically, yield curves have mostly been upwardly sloping (short-term rates lower than long-term rates), but there have also been several periods when the yield curve has either been flat or inverted. One question often posed by investors is whether inverted yield curves predict a future stock market decline. While the handful of instances of curve inversions in the US may concern investors, the small number of examples makes it difficult to determine a strong connection, and evidence from around the world suggests investors should not extrapolate from the US experience.

US Treasury yield curve data (monthly) obtained from US Department of the Treasury website. Past performance is no guarantee of future results.

THE US MARKET

Exhibit 2 illustrates growth of a hypothetical $1,000 investment in the S&P 500 Index since June 1976 plotted against the difference between 10-year and 2-year Treasury yields. This difference is referred to as the term spread^[1] and is a commonly used measure of yield curve steepness. Also marked on the chart are the onset of the four periods when the yield curve inverted for at least two consecutive months, and short-term rates began to exceed long-term rates.

US Treasury yield curve data (monthly) obtained from FRED, Federal Reserve Bank of St. Louis. S&P 500 Index © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

The inversion prior to the 2008 financial crisis is interesting to review. The US yield curve inverted in February 2006, after which the S&P 500 Index posted a positive 12-month return. The yield curve’s slope became positive again in June 2007, well prior to the market’s major downturn from October 2007 through February 2009. If an investor had interpreted the inversion as a sign of an imminent market decline, being out of stocks during the inverted period could have resulted in missing out on stock market gains. And if the same investor bought additional stock once the curve’s slope became positive, they would also have been exposed to the stock market weakness that followed.

INCREASING THE SAMPLE

The small number of US yield curve inversions over the last 40 years makes it challenging to draw strong conclusions about the effect on stock market performance. We can, however, look at other countries to gain a better sense of the relation between inversions and subsequent market returns. Exhibit 3 shows the hypothetical growth of 1,000 of the country’s local currency invested in the local stock market index the month before yield curve inversions began in five major developed nations, including the US, since 1985.

In 10 out of 14 cases of inversion, local investors would have had positive returns investing in their home markets after 36 months. This is not much less than the historical experience of these markets over the same time frame, regardless of the shape of the yield curve.^[2] These results show that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion.

Yield curve inversions based on 2-year and 10-year government bond yields for each country. Yields obtained from Reserve Bank of Australia, Bundesbank, Japanese Ministry of Finance, Bank of England, European Central Bank, and US Federal Reserve. Stock returns based on local currency MSCI indices. MSCI Australia Index (gross div., AUD), MSCI Germany Index (gross div., EUR), MSCI Japan Index (gross div., JPY), MSCI United Kingdom Index (gross div., GBP), MSCI USA Index (gross div., USD.) These countries were selected to represent the world’s major developed country currencies. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. MSCI data © MSCI 2018, all rights reserved. Past performance is no guarantee of future results.

Though the data set is limited, an analysis of yield curve inversions in five major developed countries shows that an inversion may not be a reliable indicator of stock market downturns. So, what can investors do if they are concerned about potential equity weakness? By developing and sticking to a long-term plan that is in line with their risk tolerance, investors may be better able to look past short-term noise and focus on investing in a systematic way that will help meet long-term goals.

APPENDIX: TERM SPREAD AND SELECTED INVERSION EVENTS

For the purposes of this paper, a new inversion is defined, based on month-end data, as two consecutive months of inversion. Using two consecutive months of inversion helps to avoid short-term events that may not be as impactful to markets. An inversion is deemed to have ended when there has been no more than one inversion within a 12-month period. (Again, we apply the one-month exception to avoid potential false positives.)

Source: Dimensional Fund Advisors LP.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

1. . Term spread is the yield difference between bonds with different maturities but similar credit quality. ↑

2. . The data showed a 71% chance (10 of 14) of a three-year positive return following a yield curve inversion. To compare, we measured returns three years following every month-end between January 1985 and December 2014 in each of the five markets based on the local currency MSCI indices. The average chance of a three-year positive return in those five markets was 77%. ↑

Over the course of a summer, it’s not unusual for the stock market to be a topic of conversation at barbeques or other social gatherings.

A neighbor or relative might ask about which investments are good at the moment. The lure of getting in at the right time or avoiding the next downturn may tempt even disciplined, long-term investors. The reality of successfully timing markets, however, isn’t as straightforward as it sounds.

OUTGUESSING THE MARKET IS DIFFICULT

Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with substantial challenges. First and foremost, markets are fiercely competitive and adept at processing information. During 2018, a daily average of $462.8 billion in equity trading took place around the world.^[1] The combined effect of all this buying and selling is that available information, from economic data to investor preferences and so on, is quickly incorporated into market prices. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time an investor can react to it.

Dimensional recently studied the performance of actively managed mutual funds and found that even professional investors have difficulty beating the market: over the last 20 years, 77% of equity funds and 92% of fixed income funds failed to survive and outperform their benchmarks after costs.^[2]

Further complicating matters, for investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice. Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional:

“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.”

TIME AND THE MARKET

The S&P 500 Index has logged an incredible decade. Should this result impact investors’ allocations to equities? Exhibit 1 suggests that new market highs have not been a harbinger of negative returns to come. The S&P 500 went on to provide positive average annualized returns over one, three, and five years following new market highs.

Exhibit 1: Average Annualized Returns After New Market Highs
S&P 500, January 1926–December 2018

In US dollars. Past performance is no guarantee of future results. New market highs are defined as months ending with the market above all previous levels for the sample period. Annualized compound returns are computed for the relevant time periods subsequent to new market highs and averaged across all new market high observations. There were 1,115 observation months in the sample. January 1990–present: S&P 500 Total Returns Index. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. January 1926–December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. There is always a risk that an investor may lose money.

CONCLUSION

Outguessing markets is more difficult than many investors might think. While favorable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors. The positive news is that investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on the things they can control (like having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes) investors can better position themselves to make the most of what capital markets have to offer.

1. . In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Daily averages were computed by calculating the trading volume of each stock daily as the closing price multiplied by shares traded that day. All such trading volume is summed up and divided by 252 as an approximate number of annual trading days. ↑

2. . Mutual Fund Landscape 2019. ↑

Dimensional research shows that managers usually fall short when they try to outguess market prices. That’s good news for investors.

If markets do a good job of pricing securities, you should expect managers who focus on finding pricing “mistakes” to struggle. Dimensional’s Mutual Fund Landscape 2019 study confirms this principle, showing that most fund managers underperform their benchmarks.¹ The results suggest that investors are best served by relying on market prices.

A Test of Market Prices

The global financial markets process millions of trades worth hundreds of billions of dollars each day. These trades reflect the viewpoints of buyers and sellers who are investing their capital. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.

So, are investors better off relying on market prices or searching for mispriced securities?

Mutual fund industry performance offers one test of the market’s pricing power. If markets do not effectively incorporate information into securities prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. In this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.

Across thousands of funds covering a broad range of manager philosophies, objectives, and styles, a majority of the funds evaluated did not outperform benchmarks after costs. These findings suggest that investors can rely on market prices.

Survivorship and Outperformance

The size of the mutual fund landscape can obscure the fact that many funds disappear each year, often due to poor investment performance.

Investors may be surprised by how many mutual funds disappear over time. More than half of the equity and fixed income funds were no longer available after 20 years.

Including these non-surviving funds in the sample is an important part of assessing mutual fund performance because it offers a more complete view of the fund universe and possible outcomes at the time of fund selection. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.

Few Mutual Funds Have Survived and Outperformed
Performance periods ending December 31, 2018

The sample includes funds at the beginning of the 10-, 15-, and 20-year periods ending December 31, 2018. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their benchmark over the period.

Survival and outperformance rates were low. For the 20-year period through 2018, 23% of equity funds and 8% of fixed income funds survived and outperformed their benchmarks.

The Search for Persistence

Some investors select mutual funds based only on past returns. But sometimes good track records happen by chance, and short-term outperformance fails to repeat.

The exhibit shows that among funds ranked in the top quartile (25%) based on previous five-year returns, a minority also ranked in the top quartile of returns over the following five-year period. This lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market.

Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.

A Fund’s Past Performance Is Not Enough to Predict Future Results
Percentage of funds that were top-quartile performers in consecutive five-year periods

At the end of each year, funds are sorted within their category based on their five-year total return. The tables show the percentage of funds in the top quartile (25%) of five-year performance that ranked in the top quartile of performance over the following five years. Example in upper chart (2014–2018): For equity funds ranked in the top quartile of performance in their category in the previous period (2009–2013), only 25% also ranked in the top quartile in the subsequent period (2014–2018).

Most funds in the top quartile of past five-year returns did not repeat their top-quartile ranking over the following five years. Over the periods studied, top-quartile persistence of five-year performers averaged 21% for equity funds and 28% for fixed income funds.

Summary

The performance of US mutual funds illustrates the power of market prices. For the periods examined, the research shows that:

• Outperforming funds were in the minority
• Strong track records failed to persist

The results of this study suggest that investors are best served by relying on market prices. Investment methods based on a manager’s ability to outguess market prices have resulted in underperformance for the vast majority of mutual funds.

We believe the research highlights an important investment principle: The capital markets do a good job of pricing securities, which intensifies a fund’s challenge to beat its benchmark and other market participants.

Despite the evidence, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential.

Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, looking at past performance is only one way to evaluate a manager.

In the end, investors should consider other aspects of a mutual fund—such as underlying market philosophy and robustness in portfolio design—which are important to delivering a good investment experience and, ultimately, helping investors achieve their goals.

¹ In the study results, “benchmark” refers to the primary prospectus benchmark used to evaluate the performance of each respective mutual fund in the sample where available. See Data Appendix for additional information.

Data Appendix

US-domiciled open-end mutual fund data is from Morningstar.

Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, World Large Stock, and World Small/Mid Stock.

Fixed income fund sample includes the Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Government, Intermediate-Term Bond, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Short Government, Short-Term Bond, Ultrashort Bond, and World Bond.

Additional information regarding Morningstar’s historical categories is available from Dimensional upon request.

Index funds and funds of funds are excluded from the sample. Net assets for funds with multiple share classes or feeder funds are a sum of the individual share class total net assets. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations. Fund share classes are aggregated at the strategy level using Morningstar FundID.

Each fund is evaluated relative to its respective primary prospectus benchmark as of the end of the evaluation period. Surviving funds are those with return observations for every month of the sample period. Winner funds are those that survived and whose cumulative net return over the period exceeded that of their respective primary prospectus benchmark. Loser funds are funds that did not survive the period or whose cumulative net return did not exceed that of their respective primary prospectus benchmark. Where the full series of primary prospectus benchmark returns is unavailable, funds are instead evaluated relative to the Morningstar category index assigned to the fund’s category at the start of the evaluation period.

Index data provided by Bloomberg Barclays, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg Barclays data provided by Bloomberg. MSCI data © MSCI 2019, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2019 FTSE Fixed Income LLC. All rights reserved. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Diversification neither assures a profit nor guarantees against a loss in a declining market. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.