Volatility proves challenging for many shareholders.
What happens when investors meet mutual funds? Sometimes, it’s a great thing. Investors find good funds and enjoy solid returns for a long time. Other times, investors have a poor experience, even in a fund with great returns. People don’t get in until after the fund has put up huge returns. Then, as often happens with any asset that has spiked in value, the fund falls flat, and impatient investors flee.
Big surges and then big declines spur greed and envy, then fear and anger. The more emotional investors get, the worse their decisions will be. The past two bear markets are perfect examples of these behaviors. As stock markets soared, investors bought stock funds heavily, only to see their investments plunge in the ensuing bear markets. Then, they bailed out of the funds close to the bottom, only to miss the big rebounds. Not everyone did that, of course; many investors were patient. But flow data tells us too many investors went in the wrong direction.
Timing Is Off
The real-world returns investors experience in the funds often don’t resemble the funds’ published returns (which are based on arbitrary time frames, such as calendar years). The difference between the two returns is often called the behavior gap, and fund investors are usually on the lagging end of the gap because of their poor timing of when they buy and sell their funds.
Fund companies, financial planners, and brokers exist to help investors meet their goals. A key part of that equation is narrowing the returns gap. It’s not an easy task. Greed and fear are emotions hard-wired in our brains. And, of course, it isn’t just individual investors making these mistakes. Institutional investors are guilty of the same behaviors. Just follow the boom-and-bust cycles of private equity and venture capital, or performance chasing of hedge-fund buyers. As Morningstar researcher John Rekenthaler puts it, “The big money looks a whole lot like the small money.”
To give advisors and investors a view of how shareholders in a fund are actually faring, and to prepare them for the kind of experience they might have in the fund, we created Morningstar Investor Returns, which weight returns based on asset inflows and outflows. In essence, investor returns are closer to a bottom line for investors than the fund’s stated returns. By comparing a fund’s investor returns to its official returns, we can see how well investors timed their investments. The wider the gap, the more they mistimed their investments.
Looking at an individual fund’s investor returns can be insightful. Morningstar research has found that highly volatile funds have worse investor returns than those of low-volatility funds. This makes sense: Investors see a fund with large short-term gains and rush in, only to lose their nerve and bail out when the fund tanks. We’ve found investors in alternatives funds exhibit the same behavior.
But if we pull back and compare the investor returns of broad categories to average returns, we can get a better view of how investors behaved. The table above shows the past three-, five-, and 10-year periods through Dec. 31, 2012.