These are good days for investors. The last bear market was nearly a decade ago. Socking money away in mutual funds and then watching it grow has worked quite nicely.
We see the proof not only in strong market returns but also in solid investor returns. Investor returns measure return on investments for the typical investor by factoring in cash flows and fund size. When the markets move up steadily, investors are part of a positive feedback mechanism that encourages continued investment.
When markets lurch up and down, investors tend to do worse than the markets and mutual funds because they make timing mistakes. Investors large and small tend to sell after downturns only to buy back in after a rally. But times have been good lately, and we can see that in a look at aggregate investor-return data through the first quarter of 2018.
A second factor in the shrinking gap is industry assets under management. They have grown dramatically because of equity appreciation, overshadowing fund flows over the period.
We looked at investor returns over the trailing three-, five-, and 10-year periods by asset class and by Morningstar Category. Our data set included U.S. open-end mutual funds that hold individual securities and excluded funds of funds. We did not include exchange-traded funds because short-term trades and shorting make it difficult to calculate returns on investment.
The data shows when investors tend to use funds well and when they do not. There are some limitations to the granular data, however, so we find that broad trends are most telling when it comes to investor success.
To see all the data in our white paper, click here.
Inside the Data
To calculate fund investor returns, we adjust a fund’s official returns using monthly cash flows in and out of the fund. Thus, we calculate a rate of return generated by a fund’s investors. As with an internal rate of return calculation, investor return is the constant monthly rate of return that makes the beginning assets equal to the ending assets, with all monthly cash flows accounted for.
We aggregate this data across a larger peer group by asset-weighting investor returns among the group’s constituents, thus emphasizing the results of the peer group’s largest funds and better representing the typical investor’s experience. We then compare the peer group’s results with those of the average fund to see whether investors timed their investments well.
You can find Morningstar Investor Returns for a fund on its Morningstar.com page by selecting the Performance tab and then the investor returns tab. As you look, it is worth thinking about the investor return on its own as well as the gap with total returns. The investor return is essentially the aggregate investor’s bottom line. A significant gap, particularly in this recent bull market, means the typical investor has not captured the fund’s total return, but that is not necessarily cause for alarm. As long as the investor return is good, you know most of the fund’s assets did OK. If you see a big gap, it is worth considering why that gap happened and whether this is consistent with your own experience in the fund. For example, did you get out of volatile funds after a bad year only to miss the rebound? If so, then you will need to have more-realistic expectations or buy less-volatile funds to avoid repeating your mistake.
All single-fund investor returns come with the caveat that there is a fair amount of randomness in them that is beyond the fund manager’s control. Two funds doing the same thing might have different investor returns just because they are in different sales channels or had different launch dates. Some factors are more within the fund company’s control than others, such as how a fund is positioned in ads and other marketing, the soundness of the strategy, and the volatility of a fund. All of these things play key roles in how well investors use a fund.
A Narrowing Gap
Balanced funds, a group that includes allocation funds, target-date funds, and traditional balanced funds, saw a positive gap of 0.30 percentage points, with the average investor enjoying a 5.93% annualized return. That is an improvement over our last measurement. It reflects the continued strength of target-date funds, both in terms of investor behavior and strong gains among well-diversified funds. Target-date funds are easy for investors to use because performance swings are muted, and most investors buy in through 401(k) retirement plans with automated savings processes, which creates a disciplined track of continued savings.
The gap for municipal-bond funds shrank slightly to a 1.26-percentage-point annualized shortfall based on asset-weighted investor returns of 2.23%. It is encouraging that the gap shrank, but it still seems like a pretty high figure for a fairly tame low-return asset class. Outflows in this asset class correspond with headline scares over the past decade, driving investors away from munis at the wrong time--specifically, the Puerto Rico debt debacle and the wildly inaccurate prediction of doom by Meredith Whitney. This suggests fund companies and planners alike need to reassure investors when there are negative events in muni-land.
In other asset classes, the gap worsened. The gap among international-equity funds grew to 105 basis points, with total returns of 2.95% annualized. Investors’ timing in regional funds (dedicated to Europe and Asia) and foreign large-growth has been poor.
The gap in taxable-bond funds grew to 87 basis points annualized with an asset-weighted investor return of 3.01% annualized. It is not too surprising that investor timing has been off in more-speculative categories like emerging-markets bond and bank-loan funds, but even core intermediate-bond funds show a gap of 87 basis points.
Alternatives show the worst investor returns but the best investor returns gap. The investor return is a dismal 9 basis points for 10 years, but the gap is a positive 140 basis points. Those two results are actually related rather than contradictory: When a fund has poor returns for an extended period of time, then just about any time is a good time to sell. It is worth noting, though, that bear-market funds are in our alts group, and they drag down returns while boosting the positive gap.
The alts funds’ results also are affected by survivorship bias. Our figures only include funds that were in existence at the end of the period. Given the asset weighting, that likely has a very small effect in more-established asset classes, but it likely has an outsize impact in alts, which was quite small 10 years ago.
A Small Gap in the Aggregate
In the aggregate, the average investor trailed the average fund by 26 basis points annualized over the past 10 years. The asset-weighted investor return for the period was 5.53% annualized versus 5.79% for the average fund.
This aggregate figure excludes funds of funds, but our asset-class figures include funds of funds to capture investors’ experiences in areas where that structure is common, like balanced funds. As target-date funds are collectively the largest and fastest-growing subset of balanced funds and usually are funds of funds, we thought it was important to include that structure.
The five-year investor return gap figures are significantly better than the 10-year numbers, with one notable exception.
Alternatives funds saw their gap flip into negative territory with a 46-basis-point gap on asset-weighted investor returns of 1.21% annualized. As mentioned, the 10-year figures were likely boosted by survivorship bias, but the number of alts funds with investor-return figures triples when we go to the five-year record. As a result, the survivorship bias is likely smaller and reflects the fact that investors have had a hard time picking winning funds. Also, they tend to give up on alts funds more quickly than those in other asset classes.
Looking at the gaps for alternatives categories, we can see that dismal investor returns were not limited to bear-market funds. Multialternative funds produced a poor investor return of 0.00% over 10 years. Market-neutral funds made only 0.32% for investors, while long-short had a more tolerable 3.07% annualized figure. All three had a gap of greater than 100 basis points per year. So, the funds produced poor returns, and investors did a pretty poor job of timing them, too.
The picture gets considerably brighter, though, when we move to diversified U.S. equities where the asset-weighted investor return is a robust 11.73% and the gap is a positive 0.67 percentage points. Investors have benefited in a market that has been relatively stable and consistently rising. Thus, it is the best of both worlds for U.S. equity fund investors.
The gap for balanced funds also was smaller for the five-year period, though it was still a positive 2 basis points. For international equity, muni bonds, and taxable bonds, the gap also shrank relative to the 10-year period but remained negative.
Applying These Lessons to Your Investing Process
Over the years, we’ve seen some strong themes emerge among funds with strong investor returns. Low costs and relatively low-risk funds tend to work much better for investors because they have solid returns thanks to low costs and they avoid extreme performance thanks to low risk.
Understanding your fund will also go a long way to ensuring you make the most of it. Although investors focus on trailing returns, those figures can mask some of the highs and lows of a fund. Simply going back over calendar-year returns to see if you can handle a repeat of the worst years (usually that’s 2008) is a good way to get a real-world idea of the losses a fund can incur.
Finally, knowing a fund’s strategy and when to expect it to fare well or poorly will help you know when to sell and when to hold on. The better you know your funds, the better you’ll do.