Investors Behaving Badly

Don't expect to get pulled over or sent to detention for this offense, but, make no mistake, investors are constantly putting their financial well-beings at risk. The culprit of this little-understood crime can be traced back to performance chasing, or investing in an asset class (or fund) that has recently done well (also see Avoiding Psychological Traps). At Morningstar, our research suggests that it is not uncommon for investors to buy and sell funds at inopportune times, which results in inferior returns for investors compared with a fund’s published total returns. To better gauge the real experience of average investors, Morningstar introduced Morningstar Investor Returns in 2006. The data point has been serving as a useful tool in fund analysis ever since.

Calculating Investor Returns
In contrast to total return, which simply measures the change of a fund’s net asset value over a given period of time, the Morningstar Investor Return takes into account a fund’s total net assets in the calculation. For example, suppose a fund’s one-year total return is 10% but the majority of the gains (for example, 8%) come from the first three months when the fund only has a small asset base. After more assets flow in, the fund has only mediocre performance for the remainder of the year. In this case, the fund’s investor return will be much lower than 10% for the year, which suggests that the average investor poorly timed his investment.

A fund’s investor returns can also be higher than its total return (although this is very rare). Higher investor return is a sign that investors manage to buy low and sell high during the measured period. Overall, investor return is representative of a typical investor’s experience. Narrow gaps between investor returns and total returns show that the majority of shareholders buy and hold and are able to capture most of the fund’s returns. Wide gaps often suggest that investors poorly time their entry and exit of the fund, chase performance, or fail to stay with the fund for a reasonable period of time.

Investor Returns for Alternative Funds
Morningstar often cites investor return figures as evidence that investors tend to time their purchases and sales of traditional stock and bond funds poorly. Do investors handle alternative mutual funds better? Our research shows that alternative mutual funds have much larger investor return gaps compared with long-only stock and bond funds. In other words, a typical alternative mutual fund investor has a worse investment experience than a traditional stock- or bond-fund investor.

Over the past five years (as of May 31), investor returns for alternative funds have lagged total returns by an annualized 2.25%. The average annualized total return of alternative mutual funds over the past five years is 0.21%, but unfortunately, investors on average actually lost 2.04% (annualized) in their alternative investments because of their poor timing. Over the past 10 years, the gap is slightly smaller, but it still stands at 2.12%. In other words, history shows that a typical investor makes 2.12% less (annually) than the fund’s total return in the alternative space.

These figures are abysmal given that investors exhibit better track records at allocating to traditional funds. The five-year gap between investor returns and total returns is 1.27% and 1.26% for the large-cap blend category and short-term bond category, respectively. Over 10 years, the numbers decrease to 0.39% and 1.02%, respectively.

Using Diamond Hill Long-Short DIAMX as an example, it's apparent that investors are poor fund-timers. The fund is one of the oldest long-short equity offerings and also has a longstanding history of investors behaving badly. Over the past 10 years (as of May 31), the fund has delivered an annualized 4.8% return, slightly outperforming the S&P 500’s 4.1% return over the same time period. However, its 10-year investor return is negative 2.4% (annualized). That is to say, instead of making the happy 4.8% per year, an average investor in this fund has surprisingly been losing 2.4% every year.

The reason is that the fund put on an astonishing show between 2003 and 2006, returning 19.5% annually, when the fund had only $302 million by the end of 2005. Massive assets flew in between 2006 and 2008 (fund’s total assets increased more than sixfold by the end of 2008 to $2 billion), but the fund’s performance has been middling since 2007. The majority of the investors did not capture the fund’s glory days between 2003 and 2006. As a result, there is a whopping 7.19% gap between investor returns and total returns for this long-short equity fund over the past 10 years.