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5 Lessons From the Investor Gap

Ten years later.

John Rekenthaler, 04/23/2014

Paper Tigers
A decade ago, Morningstar popularized the existence of the "investor gap": the difference between how funds perform on paper and how they perform for their owners.

If a $10 million fund gains 15% per annum for four years, is rewarded at the start of its fifth year with $50 million in sales, and then declines 15% over the next 12 months, its official five-year total returns will be 8.2% annualized. That number will be printed in the prospectus and on morningstar.com. In aggregate, though, that fund will have lost more dollars for its shareholders than it made. The return on the average dollar in the fund, aka Morningstar Investor Return, will be negative.

That, of course, is a dramatic example, simplified for illustration purposes. In real life, few funds with healthy, positive total returns outright lose money for their shareholders. More likely, a fund with an 8.2% annualized gain has an investor return that falls modestly short of that mark--for example, landing at 7.2%. Morningstar calls the difference between the former and the latter--the space between the official total return and the investor return--the investor gap. In this example, the gap is negative 1%.

The investor gap isn't a very useful indicator for single funds because it's unstable. In the initial example, the investor gap quickly shifted from zero (the fund's first four years, when money was neither flowing in nor out) to deeply negative (after year five). Had the fund enjoyed a fifth straight bull year by gaining 20%, though, the investor gap would have been positive. Thus, for a reason that is out of shareholders' control--the fund's performance in year five--the investor gap can fluctuate widely.

The gap is, however, fairly instructive for larger groups of funds, where the instability is dampened. Below are the gap's lessons:

1. In Aggregate, Investors Mistime Their Trades
For either investment categories or fund families, the investor gap is almost always negative for longer time periods. A negative figure means that, on the whole, investors are getting their trades wrong. They are buying when they should be selling, or selling when they should be buying. Of course, there are many exceptions, but the general pattern consistently holds true.

2. The Problem Owes More to Asset Allocation Than to Fund Selection
If investors were poor at selecting funds of a given investment category, then the category's largest funds, where most investors have placed their bets, would lag smaller funds. However, the opposite holds true. In most years and in most categories, the asset-weighted average, which is dominated by the giant funds, outperforms the conventional equal-weighted average. Big funds fare well.

Unfortunately, investors are betrayed by their restless allocation decisions. Allocation trades take two forms. One is the active version, when an investor sells off a losing fund and reinvests into a winner. Generally, this is a closet asset-allocation decision, as the new and old funds occupy different investment categories. The other is the passive version, when investors put cash to work--all too often in a hot investment sector that subsequently cools.

is vice president of research for Morningstar.

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