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Fund Spy

Mind the Gap 2011

Some fund investors have lousy timing, but you don't have to.

Fund investors have been buying and selling at the wrong times lately.

The latest figures on investor returns confirm it, but it's no surprise. Large flows from equity funds to bond funds in the past couple of years have meant that investors who did make changes were generally going the wrong way. Sure, huge sums remained in equity funds and participated fully in the rally that began two years ago. However, the money that did move was mostly selling low and buying high. For pretty much all of 2009 and 2010, bond funds had net inflows and stock funds had net outflows.

To see what impact these moves had on investors' wallets, we turn to Morningstar Investor Returns. Investor returns are calculated by adjusting a fund's returns to reflect inflows and outflows. We then asset-weight those individual funds' investor returns to arrive at a figure that tells us how the average investor fared in an asset class. We can then compare those numbers with the average fund and see which fared better. Morningstar director of personal finance Christine Benz put it this way: "A fund's investor return takes into account the fact that not all of a fund's investors bought it at the beginning of a period and held it until the end. To use a simple example of investor returns in action, assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year's first quarter. If investors added substantial sums of money to the fund after its first-quarter runup, the fund's investor returns for that year would be lower than the fund's 10% total return."

You can find a fund's investor returns by going to its performance page and then selecting the "Investor Returns" tab. We have calculated the data for the trailing one-, three-, five-, and 10-year returns ended Dec. 31, 2010. It's clear the market's swings in recent years have been hard on some fund investors. Compared with our study ended 2009, the gaps between total returns and investor returns are growing in those trailing periods except for the 10-year period. Why? The 10-year figure loses the year 2000, which was one of the worst years for investor returns. Back then, people were buying growth stocks and selling everything else just in time for a bad decade for growth stocks.

Let's take a look at the latest batch of data.

In 2010, the average domestic fund earned a return of 18.7% compared with 16.7% for the average fund investor, making for a gap of 200 basis points. For the trailing three years, that gap was 128 basis points. For the past five years, it was 98 basis points, and for the past 10, it was 47 basis points.

For taxable bonds, the return gaps were 138 basis points for one year, 52 basis points for three years, 57 basis points for five years, and 106 basis points for 10 years. That 10-year figure is pretty large considering it meant that returns fell to 4.47% annualized from 5.53%. Municipal bonds have consistently had an even bigger gap ranging from 113 basis points last year to 173 annualized for the trailing 10 years.

Balanced funds were the main bright spot. The gap for the past year was just 14 basis points, and it was only 8 for the past three years. Best of all, the gap went the other way for the trailing 10 years as the average balanced-fund investor outperformed the average balanced fund by 30 basis points.

What It Means
It's striking that holding bonds and stocks together in one mutual fund led to smaller gaps for investors than having the same holdings in separate funds. In theory it shouldn't matter at all, but in practice it does. Balanced funds tend to be rather dull performers that don't inspire fear or greed.

Yet, it's intriguing that investors used them more wisely than bond funds, which are less volatile than balanced funds. One likely reason is that some investors were making market calls when they bought bond funds and unfortunately were doing it at the wrong time. I doubt that many try to do that with balanced funds. The positive gap was evident in target-date funds and in moderate- and conservative-allocation funds. While target-date funds may have benefited from the steady stream of 401(k) investments, that factor probably doesn't explain the success of moderate- and conservative-allocation funds.

Whatever the reason, investors are better at buying and holding balanced funds than other types. You can approximate the 401(k) effect by setting up your own program of automatic investment so that you'll be dollar-cost averaging. What's clear is you need a plan and you need to stick to it. Chasing last year's winners and selling the losers is a sure way to fall behind.


Drilling Down to the Fund Level
To see where investors have managed to get the most out of their funds, I looked for Morningstar 500 funds with top-quartile 10-year investor returns and investor returns that were close to or better than the fund's total returns.

Two themes jumped out. First, lots of balanced funds did well, as we'd expect given the overall data I shared. Second, many of the funds on the list had closed to new investors at one point in the past 10 years.  Wasatch Core Growth (WGROX),  Royce Special Equity (RYSEX),  Vanguard Capital Opportunity (VHCOX),  Fidelity Contrafund (FCNTX), and  Artio International Equity (BJBIX) were among such funds.

While closing helps the manager stay true to his or her investment style, there's a second benefit for investor returns. Closing keeps new investors from coming in at the worst moment. Funds usually close after a stretch of red-hot returns and are thus due for a dry spell. Closing to new investors prevents investors from buying high and they are thus less likely to sell low.

The Investor Is As Important As the Fund
While fund companies and advisors bear much of the responsibility for ensuring a good investor experience, it is clear that the same fund can be used well or poorly by different investors. The differences in investor returns for S&P 500 Index funds show how the very same portfolio can lead to wildly different results. The S&P 500 funds in our database produced returns that spanned a mere 30 basis points annualized from best to worst over 10 years. Yet the top investor returns for an S&P 500 fund were for Nationwide S&P 500 Index Institutional (GRMIX) with 6.64%--more than 400 basis points greater than the fund's total returns. On the downside, Victory Stock Index  saw investor returns of negative 7.87% annualized compared with total returns of 2.23%.

Vanguard 500 even saw a 200-basis-point difference in investor returns between its Admiral shares (VFIAX) and its  Investor shares (VFINX), in Admiral shareholders' favor. This is particularly intriguing because Vanguard's Admiral shares were designed for accounts of more than $100,000 and those shareholders who stayed around for a long time. So, you have a rare occasion where shareholders were actually grouped based on their patience, and it turned out that the more patient group enjoyed significantly better returns. Across the board, it appears that Admiral shareholders enjoyed better results than their Investor-shares counterparts.

What Can You Do to Improve Your Returns?
I've already touched on the importance of having a plan and not chasing returns. But you can also look at your fund trades from recent years to see what kinds of funds were more successful for you. Were you able to handle supervolatile funds, or did you buy when funds were hot or sell when they crashed? If things didn't go well, then you might want to get that same exposure through an allocation fund. You may find that to be a more palatable option, as it can tone down the highs and lows through diversification.

The main thing is to find a way to keep buying near the lows so that you get all that a fund has to offer.

Mind the Gap1 Yr  3 Yr  GroupAv Tot RetAstWgt Inv RetGapAv Tot RetAstWgt Inv RetGapDomestic Equity18.6416.651.99-1.48-2.761.28Intl Equity13.6813.130.55-5.08-5.880.8Balance1211.860.14-0.03-0.110.08Taxable Bond8.166.781.385.294.770.52Municipal Bond1.730.61.132.551.021.53Alternative3.6116.31-12.7-4.034.17-8.2All Funds13.2812.211.07-0.28-1.120.84Data as of      Dec. 31, 2010.      

This is a shortened version of an article that originally appeared in Morningstar FundInvestor.

Russel Kinnel has a position in the following securities mentioned above: VHCOX, RYSEX. Find out about Morningstar’s editorial policies.