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Mind the Gap: Why Investors Lag Funds

Even muni bond funds have proved challenging for investors.

What happens when investors meet mutual funds? Sometimes it's a great thing, as investors find good funds and enjoy solid returns for a long time. At other times, even funds with great returns get used poorly because people don't get in until after they've put up huge returns and then the funds fall flat, as often happens with any asset that has spiked in value.

Big surges and big declines spur greed and envy, then fear and anger. The more emotional an investor, the worse his decisions will be. The past two bear markets are perfect examples. Some people bought stock funds heavily prior to the bear markets only to see their investments plunge. Then they bailed close to the bottom only to miss big rebounds. Not everyone did that, of course--many were patient--but flow data tell us too many went in the wrong direction.

Fund companies, financial planners, and brokers exist to get investors to their goals, and a key part of that equation is narrowing the gap between a fund's actual returns and investors' experience. It's not easy. Of course, it isn't just individual investors. As John Rekenthaler points out, institutional investors do a lot of the same thing. If private equity or hedge funds have a couple of good years, they decide to allocate more to them.

For open-end funds, we calculate investor returns to get a handle on how investors are doing in the funds they buy. Investor returns weight returns based on inflows and outflows. When you compare investor returns to official returns, you can see how well investors timed their investments. That gap tells you about their timing, while the actual investor returns tell you how people fared. The investor return is closer to a bottom line for investors.

The part I'm most interested in is a comparison of the average fund with the average investor. First, let's run a straight average of fund returns, then asset-weight the investor returns to arrive at the results of the average investor. Let's take a look at the past three-, five-, and 10-year periods.

Starting with the big picture, how much did the average investor lag the average fund over the past 10 years ended 2012? A total of 0.95% annualized. The average fund returned 7.05%, but the average investor netted 6.1%. That's a good chunk of the return.

If we break down the gaps further by asset class, we see some interesting details. The biggest gap was in international stocks, where the typical fund returned 10.0% annualized over the past 10 years versus 6.8% for the average investor. Why the gap? Emerging markets are volatile, and some investors are prone to buying after rallies and selling after downturns. It probably also reflects the fact that investors are mostly in diversified foreign funds, where emerging markets take up a small portion of assets. These funds lag emerging markets' 10-year return because developed markets lagged over that time.

More intriguing was the asset class that had the second-biggest gap: municipal bonds. Munis are probably the least-volatile asset class in the fund world (short of money market funds), yet the average fund's 4.1% return shrunk to 2.7% for the typical investor. Looking at the returns of the muni long category, you see very little reason for fear or greed. In the past 10 years, there was one year in the red (2008) and two years of double-digit gains (2009 and 2011) but generally modest single-digit gains. Even the one year of loss was 9.5%--not a big blow. Unlike equities, investors were not scared off by the 2008 losses and they boosted inflows to muni bond funds from $10 billion in 2008 to nearly $73 billion in 2009.

That was great timing. But then came a warning of disaster as everyone became worried about governments defaulting in late 2010 and early 2011. That's when some investors bailed to the tune of $11 billion in 2011, leading people to miss out on the robust 10.6% return in 2011 and possible 8.9% gain in 2012. Since 2008, flows seem to have followed headlines more than performance, and this is a case where it really hurt investors (not that chasing performance is the way to go, either). While I'm sure some advisors couldn't talk their clients out of bailing out of equities in 2008, they should've been able to at least explain that the fears about munis were overblown.

Meanwhile, taxable-bond funds had a smaller gap and bigger returns as investors have had a steady love affair with taxable bonds for most of the past 10 years. There we saw a 5.6% return for the average fund and a 4.8% return for the average investor.

Balanced funds produced solid results. There, a 6.4% gain for the typical balanced fund became a 5.5% gain for the average investor. Balanced funds tend to score well on this measure because they smooth out the highs and lows. They also have the benefit of including target-date funds where 401(k) flows are very steady.

Sector funds had the highest investor returns at 9.1% versus 9.4%. Sector funds were redeemed just like U.S. equity funds in 2008, but investors came back strong in the ensuing years and were able to participate in much of the gains. The bulk of those flows came in commodities. We saw $11 billion in inflows in 2009, $15 billion in 2010, and $10 billion in 2011. Not perfect timing, but not bad. By contrast, tech and health care have had steady redemptions but not enough to counterbalance that in commodities.

Investor Returns for Individual Funds
I find aggregate investor return numbers more interesting than individual fund investor returns because for a single fund all sorts of circumstances, such as when the fund was launched, come into play. Still, it can be telling when you see a big gap in returns on a really unpredictable fund.

You can find investor returns by clicking on the Performance tab for a fund data page and then, below that, selecting investor returns.

Among those funds with the highest 10-year investor returns are  Allianz NFJ Small-Cap Value and  Vanguard Energy (VGENX).

Funds in their category's top percentile for 10 years include  PIMCO Investment Grade Corp Bond (PIGIX),  Merger (MERFX), and  TCW Total Return Bond (TGLMX).

Editor's Note: We have corrected references to balanced-fund results in the article.


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Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.