Investors in low-fee index funds can still rack up big bills by behaving badly.
A version of this article appeared in the April 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
When it comes to investing, we are so often our own worst enemy. Countless studies have shown that we tend to chase performance: buying high, selling low, and failing to learn from our mistakes every time. This applies to individual stocks, funds, Beanie Babies, you name it.
We pay a steep price for our actions, one that can be many multiples of a commission or an annual fee. In the realm of funds, we can roughly quantify the cost of this bad behavior. For years, my colleague and Morningstar FundInvestor editor Russ Kinnel has documented this phenomenon and sized the toll it takes on investors' returns in his annual "Mind the Gap" study.
Sizing the Gap
We can approximate the penalty investors incur as a result of their own actions by looking at the difference between the returns funds generate (time-weighted returns) and the returns investors experience (cash flow weighted returns). Time-weighted returns are commonplace; they are a simple measure of the compound rate of growth in an investment. These are the returns featured in fund company fact sheets and Morningstar's "Growth of 10K" charts. Cash flow weighted returns are less familiar. They account for money flowing into and out of individual funds. Morningstar introduced Investor Returns in 2006 to better measure investors' actual (average) experience with funds.
By subtracting funds' time-weighted returns from their Morningstar Investor Returns, we can get a sense of how well investors tend to use a particular fund or a specific group of funds, on average. Negative values indicate that investors may be leaving money on the table, while positive ones might be indicative of good behavior. Through the years, Russ has found that the behavior gap across most broad Morningstar Categories (U.S. equity, sector equity, taxable bond, and so on) has been generally negative, though its magnitude has varied over time. Also, Russ has found that less risky and less costly funds tend to have narrower return gaps.
How Do Investors in Passive Funds Tend to Behave?
Here, I examine how, on average, investors in passively managed funds have behaved relative to investors in actively managed funds. To do so, we calculated average time-weighted returns and Morningstar Investor Returns for all active and passive mutual funds in Morningstar's U.S. funds database. The summary results appear in Exhibits 1 and 2.
Survey Says ...
On average, passive funds had a positive return gap during the trailing one-, three-, five-, and 10-year periods ended Dec. 31, 2016. Not only was this gap positive, but its size was substantial. Passive funds' 10-year return gap was 2.60%. The average return gap across all active funds during the decade ended 2016 was negative 0.67%. At first blush, it appears that investors in passive funds are heading to choir practice while active fund investors are smoking in the boys' room (hat tip to Brownsville Station).