Total Return vs. Investor Return

Question: What should I pay more attention to, a fund's total return or its investor return?

Answer: Focusing on anything other than total return may sound ridiculous to some investors who obsess over how Fund A outperformed Fund B by 5 basis points (0.05%) last year. And yet, a performance metric such as Morningstar Investor Returns can provide useful insights about the fund's "real-world" performance, insights that can prevent some investors from making costly mistakes.

Defining Investor Return
Let's start by clarifying what we mean by investor return and how it differs from total return. Most fund performance data you'll find in a fund's prospectus, promotional materials, and on financial websites is based on the fund's total return performance. This represents how the fund performed over a given time frame, and any investor holding the fund for that entire time frame experiences those results. The thing is, many investors don't hold on to funds for long periods--and certainly not for the longest periods of a decade or more. Investor return is designed to reflect the average investor's actual experiences in owning the fund.

Many investors are their own worst enemies when it comes to trying to time their investing decisions. They jump into funds that have been on a hot streak just in time to experience the fizzle or they bail on funds that have experienced punishing downturns and miss out when they rebound. Investor return captures this real-world investor experience for each fund.

To do this, Morningstar uses fund-flow information--the amount of assets flowing into and out of a fund each month--to calculate the return experienced by the typical investor in that fund over that time period. If a fund on a two-year hot streak sees lots of inflows that third year, just as its performance fades, its investor return will reflect this performance shortfall. So, even if the fund's three-year total return performance is strong, its three-year investor return will be lower, reflecting the fact that many investors missed out on the good times.

The Investor Gap: A Case Study
Some people refer to the gap between a fund's total return and its investor return as the investor gap. (Morningstar's John Rekenthaler wrote about the gap in this article from earlier this year.) To illustrate how dramatic this gap can be, let's look at two examples at opposite ends of the investor-gap spectrum.

As an example of a fund that has whipsawed its shareholders,  Fairholme (FAIRX) is hard to beat. The large-value fund uses a highly concentrated portfolio dominated by financial stocks, and its performance has been remarkably inconsistent of late. Over the past five calendar years (including 2014), the fund's performance has landed it in the 1st, 100th, 1st, 14th, and 99th percentiles. Holding on to a fund that performs that way isn't easy, and the fund's investor gap bears this out. Over the five-year trailing period ended Oct. 31, the fund had returned 10.5% annually on average, but many investors were unable to hang on during all those performance gyrations. As a result, the fund's investor return--what the average Fairholme investor experienced over that time--was an annual return averaging just 7.2%, a shortfall of more than 3 percentage points per year.

In contrast, let's look at a fund with far less volatile performance relative to its category.  Vanguard 500 Index (VFINX) is a widely used fund that tracks the S&P 500 Index. Because index funds are designed to capture market-level returns (minus fees), they are less prone to excessive volatility than more speculative funds like Fairholme. Over the past five calendar years, the fund has landed in the 31st, 19th, 38th, 44th, and 17th percentiles in the large-blend category. More importantly, the fund's five-year-annualized return (again, as of Oct. 31) was 16.5%, while its investors on average experienced returns of 16.0%. As you can see, the average investor in the Vanguard index fund apparently had a much easier time hanging on to it than the average Fairholme investor did hanging on to that fund.

Using the Metric
This doesn't necessarily mean that investors should only own funds with a low investor gap and steer clear of those with a large investor gap. Rather, investor return can serve as an important supplementary piece of information--alongside such metrics as the Morningstar Risk rating and standard deviation--to provide a sense of whether investors have found the fund to be easy or not-so-easy to hang on to over long periods. You can find investor return numbers for any fund by clicking on the Performance tab on the fund page and then clicking on the Investor Returns link near the top. You'll see a comparison of the fund's total and investor returns over various time periods as well as how the fund's investor return ranks within its category over each time period.

While investor return has its uses, it would be a stretch to say it's more important than total return. First of all, investor return represents the experience of the fund's average investor. But how many of us are that average investor? If you have tremendous patience and a long-term outlook, a fund with a wide investor-return gap may not faze you in the least. But if you are the type of investor who panics at the first sign of trouble, a fund with a wide investor gap may not be for you.

Also, it often pays to dig into potential causes of the investor gap for a fund. Jeff Ptak, president of Morningstar Investment Services, recently wrote about investor return for Morningstar magazine. In his article, Ptak points out that focusing too much on investor return for individual funds can be misleading if you don't also consider the underlying causes of the fund's performance and asset flows. For example, in some cases the fund's function may play a role in the size of its investor gap. A target-date fund that is primarily offered through employers' 401(k) plans may have a lower-than-average investor gap because investors tend to make contributions on a regular basis, with each paycheck, regardless of market conditions. For other funds that are more prone to investors adding or subtracting assets in lump sums--especially those with more volatile performance--the investor gap may well be larger.

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