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Mind the Gap: Why Investors Lag Funds

Even muni bond funds have proved challenging for investors, writes Morningstar's Russ Kinnel.  

Russel Kinnel, 02/04/2013

What happens when investors meet mutual funds? Sometimes it's a great thing, as investors find good funds and enjoy solid returns for a long time. At other times, even funds with great returns get used poorly because people don't get in until after they've put up huge returns and then the funds fall flat, as often happens with any asset that has spiked in value.

Big surges and big declines spur greed and envy, then fear and anger. The more emotional an investor, the worse his decisions will be. The past two bear markets are perfect examples. Some people bought stock funds heavily prior to the bear markets only to see their investments plunge. Then they bailed close to the bottom only to miss big rebounds. Not everyone did that, of course--many were patient--but flow data tell us too many went in the wrong direction.

Fund companies, financial planners, and brokers exist to get investors to their goals, and a key part of that equation is narrowing the gap between a fund's actual returns and investors' experience. It's not easy. Of course, it isn't just individual investors. As John Rekenthaler points out, institutional investors do a lot of the same thing. If private equity or hedge funds have a couple of good years, they decide to allocate more to them.

For open-end funds, we calculate investor returns to get a handle on how investors are doing in the funds they buy. Investor returns weight returns based on inflows and outflows. When you compare investor returns to official returns, you can see how well investors timed their investments. That gap tells you about their timing, while the actual investor returns tell you how people fared. The investor return is closer to a bottom line for investors.

The part I'm most interested in is a comparison of the average fund with the average investor. First, let's run a straight average of fund returns, then asset-weight the investor returns to arrive at the results of the average investor. Let's take a look at the past three-, five-, and 10-year periods.

Starting with the big picture, how much did the average investor lag the average fund over the past 10 years ended 2012? A total of 0.95% annualized. The average fund returned 7.05%, but the average investor netted 6.1%. That's a good chunk of the return.

If we break down the gaps further by asset class, we see some interesting details. The biggest gap was in international stocks, where the typical fund returned 10.0% annualized over the past 10 years versus 6.8% for the average investor. Why the gap? Emerging markets are volatile, and some investors are prone to buying after rallies and selling after downturns. It probably also reflects the fact that investors are mostly in diversified foreign funds, where emerging markets take up a small portion of assets. These funds lag emerging markets' 10-year return because developed markets lagged over that time.

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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