There's More to Fund Investing Than Mutual Funds

As investors, it's natural to focus on the performance of our investments. Being overly fixated on performance can lead to too much trading in our portfolios, but we like see how our decisions are measuring up nonetheless. Most investors take stock of how their investment decisions have been playing out at year-end and at tax time and then decide whether or not to make modifications.

There are, believe it or not, many ways to measure a fund's performance. You can just look at the straight-up total return over various time periods. That is, after all, what your investment has returned, assuming you've been invested and have reinvested distributions during those time periods. However, this straightforward method of looking at performance ignores volatility: How much heartburn did you have to suffer as your fund's returns lagged and then (hopefully) soared to deliver you the final total return?

Volatility-adjusted measurements of return abound. You really can have your pick. We have the Morningstar Risk-Adjusted Returns (MRaRs), which essentially adjust total returns for volatility and double ding funds for downside volatility (losing money). Research has shown that typical investors are more likely to bail out of  funds on downward swings, thus increasing the chances that they may miss out on volatile funds' rebounds--hence the feature in the MRaR.

One interesting thing about MRaRs: They're not just available for open-end mutual funds, but also for closed-end funds and exchange-traded funds. As the head of CEF research at Morningstar, I've found it beneficial--to say the least--to compare category-average MRaRs across investment vehicles (mutual funds, ETFs, and CEFs). I think you'll find it beneficial, too. So let's look at one-, three-, and five-year average net-asset-value total returns as of Dec. 31 for Morningstar categories where mutual funds, CEFs, and ETFs are represented.

Performance Comparisons
For the one-year period, that is to say 2012, there were 48 categories where all three investment vehicles had category averages. CEFs had the highest NAV total returns in nearly 63% (30 of 48) of the categories and the highest MRaRs in about 60% (29 of 48). This largely was due to CEFs' use of leverage, which magnifies volatility and returns. In 2012, leveraged CEFs' returns more than made up for their increased volatility, resulting in higher MRaRs--we'll see this throughout our review.

Meanwhile, ETFs and mutual fund categories battled it out for second place, with mutual funds winning slightly more category averages.

Take the long-term bond category. If you owned the average mutual fund in that category for all of 2012 and reinvested your distributions, you're probably feeling pretty good about your 12.97% total return. Not bad for a bond fund, and you even beat the average ETF long-term bond fund with its 10.91% total return. You may be thinking, "Ha! And the news media hypes those ETFs." But look at the average long-term bond CEF: 21.64%. Move over to the MRaR and you'll see that, even taking the higher volatility into account, the return was still more than eight points higher in one year. That's the power of leverage and of closed-end funds.

Granted, that's just one 12-month period. It's also just a category average, and category averages aren't investable. And leverage brings its own set of risks, but it gets you thinking, especially if you see such investment-vehicle performance month in and month out over various time periods.

So, let's look at the three-year period. Remember, the three years ending Dec. 31, 2012, include 2010, 2011, and 2012--there is no market crash of 2008 or 2009 in these figures. A great time, at least in theory, for leverage to help with returns. There were 45 categories during this period that had averages for mutual funds, CEFs, and ETFs.

 

Again, the CEFs rocked the house, taking nearly 58% (26 of 45) of the categories on a NAV total return basis and nearly 65% of the categories (29 of 45) on an MRaR basis. But now we see the emergence of ETFs, which took far more categories than mutual funds. In fact, during the past three years since Jan. 1, 2010, mutual fund category averages only placed first in four categories on a total return basis and five times on an MRaR basis. Bear in mind, with 45 categories, if all three investment vehicles were created equally they'd each capture 15 category averages. So, it's fair to say that over this time period, mutual funds haven't pulled their weight compared with the other investment vehicles.

You might argue that those one-year and three-year periods were bull-market times, perfect for leverage. It's unfair to compare leveraged funds like CEFs with unleveraged funds like ETFs and mutual funds over a period when everything is largely going up. Point taken, especially considering the amplified losses that leverage can deliver in down markets.

So, let's take a look at the five years beginning Jan. 1, 2008. This period encompasses the financial crisis and market meltdown as well as the ensuing recovery. There were 43 categories during this period that had averages for mutual funds, CEFs, and ETFs. Again, the CEF category average total return was the highest in nearly 49% of categories (21 of 43) and in 56% of categories (24 of 43) on an MRaR basis. Although ETFs scored highest in 14 of 43 categories on a NAV basis, that total falls to nine on an MRaR basis. In fact, in a five-year period like in the one-year period, mutual funds and ETFs battled it out for second place in the MRaR average performance, with mutual funds winning 10 categories and ETFs winning nine. 

Traits of CEFs
So, why do I bring this up? Well, most investors don't know much about CEFs. What they do know is that CEFs are quite different from mutual funds. CEFs use leverage. They don't trade at NAV. They can return capital. For nearly three years we've been providing education on CEFs to investors who are interested in expanding their areas of expertise.

Leverage, as the MRaR performance shows, can cut both ways. For long-term investors especially, the benefits of owning leveraged CEFs has been proved time and again in the data. The caveat is that many of those investors would have had to withstand stomach-churning volatility and potential losses during the financial crisis--and resist the temptation to sell those funds at their low points--in order to benefit from their eventual rebound and capture those longer-term gains. Many investors are not equipped to weather such swings, due to risk tolerance or liquidity needs, for example. Our research shows that many investors tend to bail out of volatile funds at inopportune times, thus locking in their losses and missing out on any rebounds. For open-end mutual funds, that tendency has resulted in significant gaps between funds' total returns and the returns investors are actually pocketing. Given that tendency and the amplified losses that leverage can deliver at times, CEFs might not be appropriate for all investors.

As for not trading at NAV, over the long term, both the NAV and share-price returns for CEFs are very similar. As for return of capital, the overwhelming majority of CEFs do not use return of capital to pad their distribution rates and, besides, return of capital shows up in total return figures; return of capital's bark has been far worse than its bite, except for a small number of funds that we have lambasted previously.

Conclusion
Again, you can't invest in category averages and you can't invest for past risk-adjusted returns. However, even though this article looks at only three periods ending Dec. 31, 2012, it suggests that fund investors could be missing a large opportunity presented by CEFs and ETFs. The averages suggest something is afoot.

When I've written about this issue in the past, one recurring piece of feedback has been that people don't eat risk-adjusted returns. That's true. But it's also true that people do fret about their funds. And if you're not paying attention to the risk-reward trade-off in your investments, sooner or later something untoward will happen to your portfolio. Risk-adjusted returns are just one measurement of risk, but it can be argued that, they are the most accurate since they reflect the market's view of risk.

So, if you're looking for a better risk-reward trade-off from your mutual fund investments, consider taking a broader view of fund investing. The numbers suggest that better returns may await you.

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