Investor returns are often lower than fund returns

By Morningstar Analysts |  11-05-17 | 

Morningstar calculates investor returns for open-end mutual funds to capture how the average investor fared in a fund over a period of time. Investor return incorporates the impact of cash inflows and outflows from purchases and sales and the growth in fund assets.

Investors know they should hold diversified portfolios, but many chase past performance and end up buying funds too late or selling too soon. As a result they suffer from poor timing and poor planning.

Investor return measures the experience of the average investor in a fund. It is not one specific investor’s experience, but rather a measure of the return earned collectively by all the investors in the fund. The gap between investor return and total return indicates how well investors timed their fund purchases and sales.

When investor return is less than total return, it means that more investors participated in the downside returns and less in the upside returns. This sometimes happens when investors chase returns and assets flow into a fund at its peak of performance. This effect can be exacerbated when investors aim to break even and refuse to sell a losing fund.

Russ Kinnel, director of manager research for Morningstar, presented the latest ‘Mind the Gap’ results at the Morningstar Investment Conference in Chicago. Here he answers queries put forth by Morningstar’s Personal Finance Editor Christine Benz. You can watch the original video here.

Why does Morningstar look at investor returns?

Investor returns essentially weights performance based on flows, because not everyone got in at the beginning of, say, a 10-year period and then sold at the end. They are buying and selling all along the way, and so that can lead to a difference between how investors actually get their returns versus the fund's official returns.

Essentially, the difference between investor returns and the official returns are telling you how good the investors' timing was. Sometimes it's positive and they do better. But in general, they do a little worse than the actual returns because human nature, being what it is, we tend to buy after a fund has had a good run and sell after it's had a poor run.

While they are depicted on a per fund basis, why do you believe that the data is a little more interesting and reliable when you roll up funds within an asset class?

There's a lot of randomness and noise in individual fund investor return. Sometimes it tells you a story. But you have to remember when the fund was launched can have a big impact, when the fund became popular. Some of that is under the fund company's control, but some of it isn't. So, you could find funds that have identical strategies but are different funds for one reason or another or the same index in a different fund format. You can see different investor returns again because of those reasons.

So, you want to kind of understand that difference. Generally, I like to look at the forests for the trees, and that's where it really tells you the story of investor behaviour. I wouldn't read too much into an individual fund's investor returns.

Let's take a look at the data starting with domestic equity - the 10-year return gap between investor returns. Is that weighted by the types of funds, asset-weighted?

That's right. We asset-weight the investor returns to get at essentially what the average investor does. Since the investor returns on a fund level are asset-weighted, you want to then asset-weight it again. Otherwise, you are kind of, apples-and-oranges territory. So, we're kind of saying, how did the average investor do versus the average fund.

Within domestic equity, investor returns versus the total returns of all of the funds, you see a 79-basis-point return gap. It looks like investors have essentially given up 79 bps or 0.79% of returns due to somewhat ill-advised timing decisions.

That's right. And that's actually a little below the historic norm, but not too far off. So, the good part for investor returns is that when you have a fairly steady market like we've had in recent years, that tends to work a lot better. What really throws people off is the really dramatic highs and lows.

For instance, in the 2008-09 time period, you see those investor return gaps really stretch out and get worse, because people may have sold near the bottom out of panic and then missed out on the rally. So, a little more steady market, like we've had in recent years, seems to work better for investors. We say that both on a macro basis and on an individual fund basis.

Let's look at fixed income; 73 basis points is the gap between investor returns and total returns. Does not seem much. But when you think of the returns on fixed-income investments, that's a big chunk of investors' gains that they've given up through some of these poor timing decisions.

That's right. When I look at this batch of numbers, the number that stood out was that fixed-income gap. Because fixed income is less volatile, more predictable, and returns are lower. So, a bigger gap--or almost equal size gap to equity is disappointing because people should be able to handle it better. But I think it shows that timing can be bad there, too.

And as you pointed out, with fairly low returns, that gap is even more costly just as it is paying higher fees in a fixed-income fund eats up even more of your returns.

Do you think that part of this return gap owes to the fact that following the bear market you still had some investors who did not want any equity risk so put more money into fixed income.

That's right. I think that was part of the error --in 2009 a lot of people reacted by buying bonds and selling stocks, obviously wrong in both directions. But also, you see occasionally there are some blips.

We see that if you break down the muni area separately, you see that that timing is not very good there and often it's because the only headline news in munis are negatives. We had Puerto Rico had some serious issues. We had Meredith Whitney incorrectly predicting something near Armageddon for munis, and people sold off causing sort of reinforcing losses. But in fact, it was a great time to buy. Those defaults never materialized. Unfortunately, I think some of the headlines around munis really give people a head fake that if anything, you'd be better off buying when you see those negative headlines.

Lessons to be learnt

  • Be disciplined.
  • Don't jump around.
  • Stick to your strategic asset allocation plan.
  • Look at your whole portfolio rather than saying "this fund did poorly, I'm going to sell it".
  • Find funds that work for you and keeps you from buying and selling at the wrong times and kind of keeps you on a steady path.
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