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Performance Gaps

Investors have a worse returns experience in alternatives funds than they do in traditional funds.

Terry Tian, 12/18/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The return an investor gets from a mutual fund does not only depend on the fund’s published total return, but also on the timing of the investor’s buy and sell decisions. To better gauge the real experience of average investors, Morningstar introduced Morningstar Investor Return in 2006. Our studies have shown that Investor Returns generally fall short of total returns in most traditional mutual funds, some more than others. Typically, investors’ experience in gimmicky or niche strategies, such as technology and natural resources, lag the Investor Returns in more-core holdings. With the rapid growth of alternative mutual funds in recent years, we are now examining investor behavior and returns in these nontraditional investments to see if they are any better or worse than in traditional investments.

What Is Investor Return?
The traditional total return calculation measures the change in a fund’s net asset value over a given timeframe. This methodology assumes that investors hold the fund throughout the entire period without any additions or redemptions. In reality, however, this is hardly the case, as mutual funds allow daily subscriptions or redemptions.

Investor Return tackles this issue by taking into account a fund’s total net assets at each month-end. Returns achieved during months with larger asset bases will be overweighted relative to those months with large redemptions.

Suppose a fund with beginning net assets of $50 million returned 10%, 1%, and negative 5% in three consecutive months, respectively. Also, suppose the fund received $10 million, $100 million, and $20 million of inflows over those three months, respectively. The fund’s Investor Return will be the constant monthly rate of return that makes the beginning assets equal to the ending assets with all monthly flows accounted for. The result will be a 2.9% loss over the three-month period, a far cry from the 5.6% total return.

Our Findings for Alternative Funds
We examined funds in six of the seven alternative mutual fund categories. The small asset bases and the leveraged nature of bear-market funds make Investor Returns highly sensitive to asset flows. The gaps between their total returns and Investor Returns are off-the-chart outliers when compared with other alternative categories.

We then calculated Investor Returns on funds over one-, three-, five-, and 10-year periods (as of Sept. 30), based on monthly returns for the oldest share classes of each fund in each category. We equally weighted the returns of each fund in a category to reach category averages. A positive return gap in a fund indicates that Investor Return is worse than total return; a negative gap suggests that investors made more than the fund’s total return over a particular period of time.

Worse Investor Returns
We selected large blend and intermediate-term bonds to represent traditional stock and bond categories, respectively. We found that alternative fund investors behaved roughly the same as traditional bond fund investors over the one- and three-year periods. Over a longer timeframe, however, alternative investors fell behind. Over the past 10 years, the gap between total return and Investor Return for alternative funds increased to 2.43 percentage points annualized, while the gaps for the large-blend and intermediate-term bond categories were 0.14 and 1.23 percentage points, respectively (Exhibit 1).

Terry Tian is an alternative investments analyst at Morningstar.
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