The Biggest Fund Cost You Can Control

Buy and hold is dead. That's the topic filling the room at conferences, garnering hits on websites, and making pundits popular. The past decade's desultory equity returns and extreme volatility have convinced many investors that at least some action is better than no action.

Yet investors have never quite stood still with their mutual funds holdings. While we've found that investors generally select better-than-average funds, they tend to buy these funds on the heels of strong performance and sell them when times are tough. We see this pattern on many levels starting with flows into and out of broad asset classes all the way down to individual funds. We're able to dig into the outcomes of this behavioral tendency with the help of Morningstar Investor Returns. Whereas trailing total returns reflect the gains or losses of shareholders who bought on the first day of the measurement period and held tight through the end, investor returns are dollar-weighted. Because they account for money flows into and out of a fund, investor returns provide a clearer picture of what a typical shareholder experienced.

To gauge investor gains or losses due to timing, we pulled every mutual fund in Morningstar's database with at least 10 years of history and compared their trailing 10-year total returns through December 2011 with their investor returns in the same period. The difference between those figures represents an estimate of the impact of investor timing over that period. It's worth noting that the 10-year period started in early 2002 when this century's first bear market was coming to a close, so flow activity was more pronounced with assets still fleeing and markets on the verge of turning up. Because that magnifies the 10-year gap, we also considered the past five years.

Let's start with the big picture. Across Morningstar's mutual fund database, investor returns lagged total returns by a margin of 1.45 percentage points per year over the past 10 years. The five-year gap was less pronounced but still significant at 1.21 percentage points. These are asset-weighted figures, so larger funds account for much more of that gap than tiny ones do (though the straight averages were very similar). To help put that figure in perspective, consider that the asset-weighted average expense ratio of the funds we surveyed is approximately 0.8%.  Shareholders, in other words, have lost more to poor timing than they are paying in expenses, which are often considered the biggest cost that investors can control. 

Digging deeper, the data showed that the 10-year gap existed for every broad asset class; it was largest for alternatives and smallest for domestic-equity offerings. The alternatives asset class was quite small 10 years ago, so the sample size is somewhat limited. Funds focused on gold and other precious metals dominated the space and therefore account for the bulk of the performance gap. Even though alternative funds had the biggest gap, they also had the largest 10-year return on both a trailing and investor return basis. Investors arrived late to the party, but they didn't miss out on all the fun. A much wider array of alternative strategies have launched and attracted assets in the past three to five years. As that's happened, the gap has narrowed, but returns have also moderated.

The return gap among domestic-equity funds relative to other asset classes is surprisingly small. While investors, on average, may have been steadier within this group, many have had as much trouble buying and selling these funds as have those in other asset classes.  CGM Focus is a case in point and an extreme one at that. The fund's 10-year trailing return was an annualized gain of 6.99% through the end of 2011. Its 10-year investor return was a 6.34% annualized loss.

What buoyed the domestic-equity average was the flip side. A significant number of funds had a gap close to zero, and many locked in investor returns higher than their total returns.  Fidelity Low-Priced Stock (FLPSX) was a standout, for example. This was likely driven by the fact that the fund closed in 2004 and therefore slowed the inflow of new money that would've arrived as the fund and asset class came under more pressure in the latter half of the decade.

The taxable-bond and international gaps were largely driven by funds focused on emerging markets. Many fund investors have flooded emerging-markets stocks and bonds over the past five years, and the ride has been rockier during the past five campaigns than the past 10. Therefore, more of the money in these funds experienced the volatility rather than the good times that preceded it. Interestingly, though, investors have continued to add money to funds in these asset classes even following a rough 2008 and 2011.

Investor returns aren't a perfect measure. They can be thrown off by large institutional flows that mask the broader experience, and there can be noise in shorter-term observations or with individual fund numbers. Moreover, the measurement period under the microscope can impact the magnitude of the gap. Even so, investor returns are telling overall, and the patterns are clear and persistent. Investors tend to buy what's been hot and sell what's not to their detriment. Over the years, we've tried to help investors buck these tendencies with studies such as Buy the Unloved, by Morningstar's director of fund research Russel Kinnel, and through our written analysis of individual funds. We hope Morningstar's new Analyst Ratings can help, too, by drawing more focus to a fund's fundamental picture and providing broader context to its recent past.