How Can You Outperform Your Fund's Return?

Q: How can a fund's investor return be higher than the fund's return? I understand why the return borne by investors over a certain holding period would be lower than the fund's published return, after accounting for fees, trading costs, etc.--but not higher.

A: Looking at the difference between a fund's total returns with its Morningstar Investor Returns can show you how well the typical investor used that particular fund. The bigger the gap between total return and investor return, the worse the average investor has fared in the fund, and vice versa. But the "gap" between investor returns and total returns isn't due to the drag of fund costs—rather, it's the timing of investors' purchases or sales. That's why a fund's investor return can either exceed or lag its total return. (And in fact, both total returns and investor returns are calculated net of expenses.)

What Is Investor Return? To understand the difference between total returns and investor returns, it's helpful to understand the difference between time-weighted returns and internal rates of return. We'll use a simplified scenario illustrated in this word problem. (Wait, don't leave. This will be fun.)

Let's say two investors (because I'm very creative, we'll call them Investor A and Investor B) bought two shares of the same investment at the same time--a stock that was selling at $100 per share. At some point over their holding period, they each acquire one more share. Three years later, they both sell three shares for $110 per share. Sounds like a pretty similar story, right? Only their returns were very different. Here's a closer look at what happened:

How Is it Calculated? Morningstar calculates a fund's investor return based on fund flow data, and it's computed in a similar manner to an internal rate of return. If we were to combine all the cash flows from Investor A and Investor B in the example above and find these investors' average internal rate of return, it would be 1%. Similarly, but on a much larger scale, to calculate Morningstar Investor Return we first calculate the monthly cash inflows or outflows for each fund. Then investor return is the compound growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets. (To find a specific fund's investor return, go to the fund's quote page, click on the performance tab, then click "Investor Return".)

By contrast, total returns are time-weighted rates of return, meaning periods longer than one year are expressed in terms of compounded average annual returns (also known as geometric total returns). Total return figures are widely available: You can find them on fund companies' websites, in other media sources, and on Morningstar's performance tab.

Both total returns and investor returns account for the fund's expense ratio, which includes management, administrative, 12b-1 fees, and other costs that are taken out of assets. (They do not include sales loads, however.) Both types of return are calculated for various time periods that are standard in the industry--one year, three years, five years, and 10 years.

Here is the 10-page methodology document in case you are interested in reading more (though you'll be forgiven if you aren't).

What Investor Returns Can Tell You Looking at investor returns can tell you how well investors use a specific fund or type of investment, or how well they time their trades. Often investors mistime their trades because they chase performance. Looking at Investor B's return can give you a sense of the damage that performance-chasing can do: Even when an investment has a positive annualized return over a certain period, an investor can lose money in it by buying after a hot streak and then selling after performance has cooled.

Many times the funds and categories that experience the biggest gaps are more volatile categories--particularly narrowly focused funds that are more prone to investors adding or subtracting assets in lump sums. For example, Fidelity Select Biotechnology FBIOX has gained more than 21% per year over the trailing five-year period through April 30, but its typical investor earned 9.2 percentage points less per year over the same period. During the past three years, Fidelity Select Biotech's standard deviation was 25.30--more than double the S&P 500's 12.19.

By contrast, funds such as a target-date funds, S&P 500 or total-market index funds, or high-quality bond funds may have smaller investor return gaps, both because investors tend to dollar-cost average into them steadily over time through 401(k)s and other retirement accounts, and because performance tends to be more stable and predictable. For instance,

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Takeaways When you are considering investing in a fund, investor return is one metric to pay attention to (among many, many others, such as the fund's expenses, its Morningstar Analyst Rating, its Morningstar Risk score, and volatility measures like standard deviation of returns, to name just a few). That's not to say investors should only own funds with a small gap and steer clear of those with a large gap. Rather, If you see a fund with a big gap between its total return and its investor return, that can provide a sense of whether investors have found the fund to be easy or not-so-easy to hang on to over long periods.

At the end of the day, the investor return reflects the "average" investor's experience, and you may be far from average. If you know you are risk-tolerant enough to hold steady when your investment's return falls, like Investor A, 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, more like Investor B, a fund with a smaller gap may a better fit for you.

For more

Are Investors Still Their Own Worst Enemies?

5 Lessons From the Investor Gap