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5 Lessons From the Investor Gap

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.

John Rekenthaler, 06/16/2014

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.

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.

2. The Problem Owes More to Asset Allocation Than to Fund Selection
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.

3. The Gap Generally Is Larger for Riskier and/or More Specialized Funds
Stable, predictable fare such as target-date funds, high-quality bond funds, and blue-chip stock funds tend to be bought and held. Sector funds, emerging-markets funds, and gold funds, on the other hand, are frequently traded. Sometimes that’s because they were bought speculatively. Other times, the investor truly intended a long-term purchase but sold early after being spooked by a heavy loss.

4. The Gap Grows With Uncertainty
Nothing sparks redemptions like unexplained poor performance. It’s one thing to watch a fund’s net asset value slide when the reason is understood, as with an index fund that follows its benchmark downward during a bear market. It’s another thing altogether to suffer through a mystery slide. Investors bail rapidly from funds with opaque portfolios.

5. The Size of the Gap Varies by Fund Family
Fund companies cannot eliminate the investor gap, but they can do things to minimize its effect:

is vice president of research for Morningstar.

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