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Why Investors Lag the Returns of Their Funds

Volatility proves challenging for many shareholders.

Russell Kinnel, 04/16/2013

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.

Seeing the Bigger Picture
First, the big picture: The average fund investor lagged the average fund over the past 10 years by 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 investors failed to capture and evidence that investors overall made poor choices in the past decade.

Next, let’s break down the gaps by asset class. Some interesting details start to emerge. The biggest gap by far was in international stocks. The typical international fund returned 9.95% annualized over the past 10 years versus 6.84% for the average investor. Why the huge 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 trailed emerging markets’ 10-year return because developed markets lagged over that time.

More intriguing was the asset class that had the second-biggest gap: municipal-bond funds. Munis are probably the least volatile asset class in the fund world (short of money market funds), yet the average fund’s 4.06% 10-year return shrunk to 2.71% for the typical investor. Looking at the returns of the muni-long category, we see very little reason for fear or greed. In the past 10 years, there was one year in the red (2008), two years of double-digit gains (2009 and 2011), and generally modest single-digit gains in the remaining years. Even the one year of loss was negative 9.5%—not a big blow. Unlike equities, investors were not scared off by the losses in 2008. Asset inflows into muni-bond funds rose from $10 billion in 2008 to nearly $73 billion in 2009. In other words, investors had great timing.

But then came a warning of massive defaults in late 2010 and early 2011, when everyone became worried about governments defaulting. That’s when some investors bailed to the tune of $11 billion in 2011. However, the defaults never came, and municipal bonds gained a robust 10.6% return in 2011 and 8.9% in 2012. Since 2008, flows into municipal-bond funds have followed headlines more than performance, and this is a case where it really hurt investors (not that chasing performance is the way to go, either). While it’s certain that some advisors couldn’t persuade their clients to refrain from bailing out of equities in 2008, they ought to have been able to explain that the muni fears were overblown in 2010.

Meanwhile, taxable-bond funds had a smaller gap and bigger 10-year returns than munis did, as investors have had a steady love affair with taxable bonds for most of the past decade. Here, the average fund returned 5.63% and the average investor earned 4.76%.

As investors were buying bond funds, they were selling U.S. equities. The average 10-year annualized return for U.S. stock funds was 7.89% versus 6.88% for the average investor return. Investors bailed on equities and bought bonds for much of the time after 2008, but of course, equities had better returns.

Balanced funds produced solid results. There, a 6.37% gain for the typical balanced fund became a 5.53% gain for the average investor. Balanced funds tend to score well on this measure because they smooth out the highs and lows. They also have the benefit of including target-date funds where 401(k) flows are very steady.

Finally, we come to the stars of the show. Sector funds had the highest 10-year investor returns at 9.07% versus 9.44% for the average sector fund. Sector funds were redeemed just like U.S. equity funds in 2008, but investors came back strong in the ensuing years and were able to participate in much of the gains. The bulk of those flows came in commodities: $11 billion of inflows went into commodity funds in 2009, $15 billion in 2010, and $10 billion in 2011. Not perfect timing, but not bad, either. By contrast, technology and health-care funds have had steady redemptions but not enough to counterbalance that in commodities.

Thus, you see good timing in a fairly volatile area. The data has a way of being untidy, but I still think we’re on firm ground when we say that volatility is more challenging for investors. If you look at individual fund or category details, you can always find exceptions to the rule. While their asset-class timing is usually poor, investors are bound to make some decent timing moves.

Narrow the Gap
Aggregate investor return numbers can be more interesting than individual fund investor returns. For a single fund, all sorts of circumstances come into play, such as when the fund was launched. Looking at the bigger picture, the reasons why investors have lagged funds’ stated returns become more evident. Advisors and investors can see how others erred. Armed with this knowledge, they can take steps to guard against making investment decisions based on emotions and instead stick to their plans.


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