What factors lead to better investment timing?
A version of this article was published in the May 2016 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.
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 at its peak?
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's 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.
I discuss the study with Morningstar's Christine Benz in this video.
How Are Investor Returns Useful?
Generally, it is 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, 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. It's a good idea to find out why the fund was used poorly or well. It helps 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.