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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).

Within the alternative categories, long-short equity and nontraditional bond funds exhibited the worst Investor Returns in most of the timeframes measured. Market-neutral funds had relatively narrow and consistent gaps (Exhibit 2).

Our results show that alternative mutual funds have worse Investor Returns compared with traditional stock and bond funds most likely because alternative funds have much shorter histories marked by a very volatile market environment. Massive inflows to alternative funds occurred after the 2008 financial crisis, when the performance of many of these strategies lagged. Investors poured almost $90 billion into alternative mutual funds between 2009 and 2011, when total assets in these funds stood at only $34 billion at the end of 2008. Flows into traditional stock and bond funds have been smoother and less reactive to category performance over the long run.

Link With Volatility
Our studies seem to indicate that one important determinant factor of Investor Returns is a fund’s volatility.

We ranked all alternative funds based on their monthly standard deviation in descending order and divided them into four quartiles. Funds in the first quartile have the highest standard deviation, and funds in the fourth quartile have the lowest. Funds in the most volatile quartile almost always have the largest Investor Return gaps1(Exhibit 3).

The gaps are particularly prominent over the last five- and 10-year periods. For example, over a 10-year period, although the first quartile alternative funds achieved a total return of 6.33% annualized, the average investor in these funds only made a dismal 1.58% annualized, a 4.75 percentage point return gap.

There are a couple of reasons Investor Returns could be worse in more-volatile funds. First, assuming investors are rational and do not attempt to time their investment, they still must enter and exit the fund at some point in time. In a more-volatile fund, these entry and exit points are more likely to coincide with peaks and troughs than in a less-volatile fund, making Investor Return worse. Second, more-volatile funds are more likely to attract irrational behavior and timing, as the potential for profits is larger.

Asset-Weighted Investor Returns
We also tested whether investors behave differently in large versus small alternative funds. Larger funds are likely to have drawn more assets because of better performance and are also more likely to survive over the long run. But is it easier for investors to deal with larger investments than smaller offerings?

To address this problem, we asset-weighted all alternative funds2, which means that large funds, such as Gateway GATEX (with $6.7 billion in assets as of Sept. 30) and Merger MERFX ($4.8 billion in assets), will carry more weight in the calculation than small funds such as ICON Long/Short IOLCX ($25 million in assets). Exhibit 4 demonstrates that the gaps between total returns and Investor Returns are virtually the same for large and small funds over the five- and 10-year periods but different over one- and three-year periods.

The reason for asset-weighted gaps to be wider than equal-weighted gaps in the past one vand three-year periods is most likely because of the massive inflows into nontraditional bond funds (more than $48 billion from 2009 to 2011). Unfortunately, these giant funds had worse Investor Returns than other alternative funds in the past three years. Over a long timeframe, it becomes apparent that investors exhibit similar behavior regardless of fund sizes.

Mind Investor Return
It is helpful for advisors and investors to keep an eye on Investor Returns, which demonstrate how other investors historically have been handling the fund. A large gap between Investor Returns and total returns should serve as a red flag—if so many investors failed to buy and sell the fund at right times, chances are your clients could make a similar mistake.

Terry Tian is an alternative investments analyst at Morningstar.
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