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The Impact of Investors' Bad Behaviors

Investor returns shed light on the implications of chasing performance or selling at the wrong time.

Russel Kinnel, 06/07/2016

It probably won’t be too costly for you this year to correct an investing mistake you made last year. But if you made a mistake 10 years ago that you didn’t quickly fix, you’ll be paying for it for a very long time.

That’s one clear lesson gleaned from Morningstar Investor Returns data. We’ve updated our figures through 2015, and they vividly illustrate how decisions made a decade ago have an impact that compounds powerfully over time.

What Are Investor Returns?
Investor returns are dollar-weighted returns, as opposed to time-weighted returns, which are the standard way of displaying an investment’s total returns. We calculate investor returns for a single fund by adjusting returns to reflect monthly flows and their compounding effect over time. Generally, investor returns fall short of a fund’s stated time-weighted returns because, in the aggregate, people tend to buy after a fund has gained value and sell after it has lost value. Thus, they miss out on a key part of the return stream.

That fact plays out for all types of investors— not just fund investors. Studies show stock investors and pension fund managers do the same thing. Who really was there to buy Apple AAPL at its low or sell Fannie Mae FNMA at its high? To aggregate fund investor return data, we roll up the figures by asset-weighting them so that big funds count for much more than little ones. Then, we compare the asset-weighted number to the average fund total return. Essentially, we are comparing the average fund to the average investor experience. The gap between the two figures tells us how well investors timed their investments in the aggregate. Exchange-traded funds were not included because it is difficult to estimate flows into them.

How Are They Useful?
Generally, I find it more useful to look at the forest than the trees when it comes to investor returns. Taken as a whole, they tell us something interesting about aggregate investor behavior. But individually, it can get pretty noisy. While investor returns often tell an interesting story of how a fund is used, you have to be careful about reading too much into an individual fund’s investor returns. Take two similar funds launched at different times and you may find very different investor returns. So, when you see a fund’s investor returns, it’s a good idea to find out why the fund was used poorly or well. I find it helpful to look at that return gap and then look at calendar-year performance for the fund. Usually, the answer can be found in the first two or three years of the time period. Maybe a fund had a great year that led investors to rush in too late, or, conversely, a fund closed to new investors was able to hold on to longtime shareholders through a difficult year, thus enabling them to reap the benefits beyond that year.

Backing out to the forest view, we can test various factors to see which ones have a link to better investor returns and which ones don’t. These may be the most obvious lessons for what we should look for in a fund and what behavior can be self-destructive.

What the Data Say
For the 10 years ending in December, the investor returns gap shrank from the average over recent years ( EXHIBIT 1 ). For U.S. equity funds, the gap was 74 basis points, but international funds had a much wider gap of 124 basis points. Municipal-bond funds continue to be the most confounding group, with a big 132-basis-point gap, while taxable-bond funds had a more moderate 82-basis-point gap. As usual, allocation investors fared the best, with a gap of just 17 basis points.

More telling than the latest batch of data is the average annualized gap for 10-year periods ended 2012 to 2015: negative 1.13%. That smooths out some of the issues with end-date bias to illustrate just how much we cost ourselves through bad timing moves.

Flows were strong across the board at the beginning of the 10-year period. Flows were particularly strong into foreign and domestic equity because equities had rallied off the lows of the bear market that ended in 2002. Some of that money later left in 2008 and 2009 as skittish investors sold near the bottom, but that initial wave of good flows and a return to equities after 2009 seemed to have ensured pretty good results.

Allocation funds enjoyed steady inflows throughout, so, while some dumped their equity funds at the wrong time, many maintained and added to equity exposure through allocation funds. In addition, target-date funds are part of the allocation group, and they consistently show investor returns that are superior to time-weighted returns. For one, target-date funds have sufficiently moderate returns to avoid scaring shareholders away while not attracting hot money. In addition, target-date funds are mostly held in 401(k) accounts where investors buy with every paycheck. Although they could still panic and sell at the wrong time, most investors ride out the downturns. You don’t have to be in a target-date fund, though, to invest like those who do. Systematic investing and rebalancing is a great way to stick to your plan through thick and thin.

Before I started running these figures, I would not have guessed that boring old municipal-bond funds could be so misused, but it has been going on for a while. The problem here is that you have some very risk-averse investors and a sector with scary headlines. You won’t see many headlines about how nearly all muni issuers are making their payments on time or how once-troubled states like California have improved their balance sheets dramatically. Rather, you hear about Puerto Rico’s crushing debt and Meredith Whitney’s ill-informed doomsday call. Those news events spurred muni investors to sell, and that led to a drop in muni-bond prices and a spike in yields. Thus, they created a buying opportunity just as investors were fleeing. This speaks to the downside of trying to time the market and the benefit of staying focused on the long term. Oddly, sector funds did quite well as investors had good timing in some real estate, utilities, and communications funds.

What Factors Are Linked to Investor Returns?
Expenses are strongly linked to investor returns. Cheapest-quintile funds have significantly higher investor returns and smaller gaps, while both figures progressively get worse as you move up in fee quintiles. In fact, the differences are much greater than the fee differences themselves.

There are two reasons. First, low costs lead to better returns and, therefore, investors are in a positive feedback loop that makes them more likely to stay with their fund. Second, investors in low-cost funds tend to be better-informed investors who will use their funds correctly more often. The other factor is volatility, whether measured by Morningstar Risk or standard deviation. The story is quite simple: More volatility means more-extreme performance that triggers fear and greed. Boring funds are often a better bet for the typical investor.

Lessons From Fund Investor Returns
Let’s take two relatively conservative funds ( EXHIBIT 2 ). Royce Special Equity RYSEX has 6.6% annualized 10-year total returns through the first quarter of 2016. But its investor returns are an impressive 8.3%, meaning investors got the most out of the fund. Franklin Mutual Beacon TEBIX has 10-year returns of 4% annualized— not as good as Royce Special, but OK. However, its investors earned only 0.5% annualized returns over the 10-year period, thus leading to a huge gulf between the two shareholder bases.

The explanation can be found in 2008. That year, Franklin Mutual Beacon lost 40%, while Royce Special Equity lost only 20%. So, not only did Franklin Mutual Beacon lose more than the market but it also likely disappointed shareholders who expected it to have some defensive qualities. (Other Mutual Series funds held up better.) As a result, money poured out of Franklin Mutual Beacon in 2008–10 while Royce Special Equity got inflows, meaning shareholders were there for the big rally that started in March 2009. In addition, Royce Special Equity has closed to new investors from time to time, and this helps to keep investors from buying at the worst time while also keeping hot money out.

Franklin Mutual Beacon is a decent fund that just happened to be leaning the wrong way on financials and distressed investing in 2008. While the example does illustrate some of Royce Special Equity’s appeal, I doubt shareholders will actually beat stated returns the next decade. In fact, recent outflows mean the fund would have to go down from here in order for that to happen.

We can also draw some lessons from Fidelity Tax-Free Bond FTABX. The fund’s 10-year return of 5.05% annualized falls to 3.72% on an investor return basis, yet it still has investor returns in the top 4% of its Morningstar Category. The fund has a Morningstar Analyst Rating of Gold, and it is clear that investors have been well-served by the fund. Yet when they do get out, timing isn’t great. The fund had outflows in early 2011 because of weak returns and Whitney’s doomsday call, but that turned out to be a great year, with a nearly 11% return. The story is similar for Vanguard Intermediate-Term Tax-Exempt VWITX, where investor returns were strong but lagged total returns by 1.1%. Both funds are well-run and easy to understand, but skittish shareholders cost themselves some money.

Lessons
This illustrates the importance of sticking to your investment plan on a fund level and on an asset-allocation level. If we stick to our guns and avoid getting too excited by rallies or worried by bad news, we’ll make the most of our funds. Understanding your investments and their role in your plan can help you make the right decisions. Quarterly checkups on your portfolio will also help, as you won’t feel overwhelmed when markets go south. Informed and patient investors are the ones who will most easily reach their goals. 

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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