Why investors get less than their funds' total return.
It's time for our annual look at how well investors are making use of mutual funds. I do this by looking at the average investor's returns versus the average fund's returns.
We look at monthly fund flows and monthly returns, then we weight those by asset size to come up with an estimate of returns for the average investor. We then compare those figures with the average fund return on a category and asset-class basis. The gap between those returns tells us how well investors timed their investments. The average investor return is really the bottom line, though. Ideally, you want no gap in returns and a high average investor return.
Recently I've seen the suggestion that the gap is a cost unique to mutual funds. But the gap is applicable to investor behavior in all realms. Whether trading stocks, exchange-traded funds, mutual funds, or something else, investors collectively tend to buy and sell at the wrong times. In fact, a study of equity investors found a gap in returns quite similar to the ones we see on the fund side. Mutual fund flow data just makes it easier to examine mutual funds than most other securities types.
Surprise! The Investor-Returns Gap Shrinks
The figures through 2014 are intriguing. Not only did the gap shrink, but the typical investor's return also rose. Overall, the average investor enjoyed a 10-year return of 5.21% compared with a 5.75% return for the average fund, giving us a 54-basis-points returns gap. That compares with a 4.8% return for the typical investor versus a 7.3% return for the average fund through the end of 2013. So, the gap shrank and the average investor return rose. Not bad.
The biggest change came in the balanced-allocation group, where the gap shrank to 2 basis points from 212 basis points. U.S. equities also saw the gap shrink to 98 basis points from 166 basis points. Taxable bonds’ gap shrank to 69 basis points from 222 basis points.
You can see some of the changes in the shorter-term figures. Most asset groups had a positive gap for the trailing three years and an only slightly negative gap for the trailing five years. For example, U.S. equity investors enjoyed a 19.31% annualized return compared with a 18.73% average fund return for the past three years, producing a positive gap of 58 basis points. For the past five years, they enjoyed a 13.89% gap versus a 14.23% average return, producing a modest negative-34-basis-points gap. Why the improvement? Virtually everything except commodities has risen dramatically the past three and five years. This meant that investors could hardly go wrong. Investors were less likely to sell a fund because of poor performance, and, if they did, they likely jumped into a new fund that generally performed well.
The long run of the equity bull market is much easier on investor returns than wrenching pivot years when big gains turn to big losses or vice versa, prompting many investors to sell low or buy high. Thus, bear markets and the dramatic snapbacks that often follow are the worst environment for fund investors. Conversely, a long-running move in one direction produces a positive reinforcement cycle. The 10-year figures now have the pivot years from the 2000–02 bear market out of the system, and the three- and five-year figures are further from the more recent bear market.