Are Investors Still Late to the Party?
The gap between investor returns and average fund returns persists across most asset classes--but there is a bright spot, says Morningstar's Russ Kinnel.
Are Investors Still Late to the Party?
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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar Investor Returns data provide a clear depiction of investor behavior. Joining me to discuss some current research on that topic is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, in your cover story in Morningstar FundInvestor, which is coming out in early March, you took a look at investor-return data, asset class by asset class. Before we get into what the data are telling you about investor behavior, let's just talk about this investor-return statistic and how we arrive at it.
Kinnel: It's a little complicated. Essentially, what we are doing is we are asset-weighting flows in individual funds, then rolling that up and comparing those returns with the average returns of all funds. What that [shows] us is the gap [between the] average investor versus the average fund. So, if there is a big gap, we know something is not working. We're not getting quite the right usage. Or if it's a small gap, maybe people are using the funds right. So, it's kind of complicated; but if you just think about it as average investor return versus average fund, it's really kind of simple in the end.
Benz: So, the main idea is to tell a tale about investors' timing: How well have they made their timing decisions, their purchase and sales decisions, within these various categories?
Kinnel: Exactly. A big gap means the timing hasn't been great. A small gap means it's been pretty good.
Benz: Let's start with domestic equity. When you look at the recent rally that we've had in domestic equity, have investors been able to capture that or did they get to the party late?
Kinnel: A little of each, really. So, investors coming out of the bear market in '08 kept redeeming for a number of years, in general, in U.S. equity, though not on a huge scale. So, what that means is they captured some of those gains--still had a pretty good overall return, but not all of them. Another element of that story is kind of subtle; it goes all the way back to the beginning of that 10-year period. Coming out of that bear market, people took about a year to come back to equities; but once they did, they did so in a big way, and that helped their returns going forward, whereas with this more recent bear market, people were much slower to dive in and, therefore, missed a little more of the returns.
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Benz: How about international equity? It's been kind of interesting. Even though we have seen really strong performance from domestic-equity markets and funds, we have seen investors continue to buy international equity all the way through this great runup in U.S. equities.
Kinnel: That's right. It's kind of funny that we have seen more money going into international equities than U.S., even though U.S. has done better. I think there is sort of an insecurity about the U.S. The '08 bear market was pretty traumatic for everyone, not just because of the bear market but because of the economy and all these worries about growing U.S. debt. People tended to focus on that rather than on returns. So, they invested more overseas--and overseas markets generally did pretty well, just not as well as the U.S. So, it wasn't a bad spot to be. You still did pretty nicely, just not as well.
Benz: One area that you think may be dragging down international-equity investor returns is emerging markets. Let's talk about the timing pattern that we have seen there.
Kinnel: A big theme coming out of that bear market in 2008-09 was that China and a lot of the emerging markets were going to be really crushing the U.S. To the contrary, emerging markets have actually been a pretty weak performer in the last few years, partly because of a China slowdown but also because of a slowdown in natural resources--with oil and copper and some other natural-resource prices plummeting. That hits a lot of emerging-markets economies, particularly those in Latin America.
Benz: One area that we've been monitoring, in part, because the investor returns had recently looked quite poor has been the fixed-income space. It looks as though many investors got into bonds late; even though they haven't had a terrible experience, their returns have not been great when you look at the timing of their purchases and sales.
Kinnel: That's right. The timing hasn't been that great. If you look at some of the big purchases, we have seen some big clumps into taxable and muni bonds, often when rates are at their lowest, and that then led to years like last year where, in a lot of places, returns were not as good as in equities. But muni bonds are maybe the starkest example. In munis, we have seen two big scares that led investors out at just the wrong time. First, there was Meredith Whitney's prediction of huge defaults, which was off by a massive amount.
Benz: It didn't materialize.
Kinnel: Right. She said about $100 billion, and there was $1 billion or so in defaults. Then, we had a second scare that was a little more reality-based: Puerto Rico and Detroit had some very serious problems, but they only touched the muni-fund world a little. Yet, investors moved out a lot. So, what that meant is you had two [scares in muni funds that led to outflows], and in both cases, investors then missed some good rallies. What's particularly disappointing there is that munis tend to have pretty boring returns, so they should have kind of stable inflows. The returns are not that big. Obviously, you are getting aftertax returns, and they're pretty meager to begin with. So, if you time it wrong, you really can be cutting into your returns.
Benz: A more positive story when you look at the data is in the allocation-fund space--the funds that split their assets among stocks and bonds. One area, in particular, that looks pretty encouraging is the target-date area. It looks like investors, when they've bought target-date funds, have tended to hold on.
Kinnel: Target-date funds are really the shining star of these mind-the-gap reports. We find that investors actually tend to get better returns than the official returns in the funds. The reason for that is that they're just continuing to invest. If you're in a target-date fund, you are almost certainly in there through a 401(k), so you're investing every paycheck. We found that people really consistently invested in them. So, it's really an encouraging example. [This is an area] where the fund industry and fund investors have really found a good solution; target-date funds--and 401(k)s, to a large part--are really working nicely.
Benz: So, what are the takeaways for investors? Is the idea that I should just buy a target-date fund and call it a day, because it will tend to encourage better investor behavior? What should investors think about when they are looking at these data?
Kinnel: I think, on one hand, you see a group of investors in target-date funds who are largely ignoring all the headlines and just plugging away investing. On the other hand, you have groups that are more skittish. They are rushing into China, and then they are selling their muni funds or whatever. They are doing much worse. So, there's clearly a message there: Instead of trying to predict macro movements, it's much better to just stick to your plan and keep plugging away.
A second lesson is that dull seems to work well for investors. Target-date funds are boring. They've got a really diversified mix of stocks and bonds, U.S. and foreign, and so the returns tend to be more muted and that seems to work. One approach could be to think about your overall portfolio and ignore the fact that one of your funds is up 30% and other is down 20%. Or if that doesn't work for you, maybe just buy either a target-date fund or a boring old balanced fund, which has a lot of the same characteristics of muting extremes.
Benz: Russ, thank you so much for being here to share this data. Fascinating stuff, as always.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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