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How Target-Date Funds Have Helped Investor Returns

Key findings from our annual "Mind the Gap" study on investor returns

Russel Kinnel, Morningstar Research Services LLC


Investor returns can be most useful when viewed as part of the big picture—very much more forest than trees. Seeing investor returns from this point of view shows how much of fund returns investors are actually capturing. Or to be more cynical, it shows how much investors hurt themselves with bad timing.

And really, how investors use funds is something that falls on the collective investment industry: fund managers, fund marketers, financial planners, brokers, fund researchers, and even the financial press. The better we do our jobs, the higher the investor return relative to overall market returns.

I’ve updated Morningstar's annual "Mind the Gap" study with data through the first quarter of this year. I’m pleased to report that the gap between official total returns and those actually experienced by investors across all mutual funds has shrunk to 26 basis points over the 10 years that ended March 31, 2018. For U.S. equity funds, the average investor (as measured by asset-weighted investor returns) gained 8.32% compared with 8.93% for the average equity fund.

Here are other highlights from the study:

  • The gap improved for U.S. equity, balanced, and municipal-bond funds while worsening for international-equity and taxable bonds.
  • Balanced funds continue to have a positive gap, meaning investors enjoyed better returns than the average fund’s returns.
  • Municipal-bond funds had the largest gap—something we have observed in past studies.

How does Morningstar calculate investor returns?

To calculate fund investor returns, we adjust a fund’s official returns using monthly cash flows in and out of the fund. Thus, we calculate a rate of return generated by a fund’s investors. As with an internal rate of return calculation, investor return is the constant monthly rate of return that makes the beginning assets equal to the ending assets, with all monthly cash flows accounted for.

We aggregate this data across a larger peer group by asset-weighting investor returns among the group’s constituents—emphasizing the results of the peer group’s largest funds and better representing the typical investor’s experience. We then compare the peer group’s results with those of the average fund to see whether investors timed their investments well. We also use asset-weighted total returns to help provide a different perspective on the shortfall.

We limited the study to open-end mutual funds because there isn't sufficient data on exchange-traded fund flows.

Why has the gap shrunk?

It appears that secular and cyclical trends are at work here. I would expect that the gap will rebound closer to the levels seen in previous years when those cyclical trends reverse.

We’ve found that investors seem to do better when the market is a positive feedback mechanism. When trends persist, investors tend to hop on board at various points and often do quite well. When markets pivot in dramatic fashion, we see many investors make a hash of things, as in 2008-09. Since then, the long-running bull market has been ideal for many investors and that’s reflected in the study’s strong results.

However, we know the bull market will end at some point and the narrow gap will likely widen.

On the secular side, the growth of target-date funds has led to often positive gaps in our allocation group. Investing steadily through a 401(k) can be a great way for investors to commit to saving without the drama. Target-date funds can serve many investors well. That's because they're generally very diversified and tend to have lower costs, so investors aren’t inspired to chase performance. We’ve observed similar behavior outside the U.S. where investment vehicles require a long-term commitment.

So, maybe even after a bear market, the gap will settle at levels below those observed in the past thanks to target-date funds in 401(k)s.

A second way to measure investor return

What if instead of averaging fund returns, we used an asset-weighted measure? True, you’d be allowing investor behavior to have an impact on the benchmark, but we believe there’s some merit to this approach. When you do it this way, the gap expands dramatically to 137 basis points per year for all funds over the 10 years ending March 31, 2018.

What’s linked to investor returns?

I touched on why target-date funds work well for many investors, but the reasons are borne out by past studies that we’ve done on individual fund characteristics and investor returns.

For example, lower costs tend to lead to better investor returns and smaller gaps. In fact, there’s much greater improvement in both than would be suggested by the mere difference in costs. It could be that lower-cost funds and the investors who use them are the meeting point of good investment design and good investors. Another factor could be that higher cost funds tend to take on greater risk to recoup their costs.

That leads to a second factor: volatility. We’ve found that the gap widens as standard deviation rises. Presumably investors have a tougher time when funds have big swings because the swings inspire fear and greed.

We believe this provides some indication of where responsibly designed investments should be headed.

Please see below for important disclosure.

Read more details on investor returns in the full version of Morningstar’s 2018 "Mind the Gap" study.

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Important Disclosure

Throughout this article, “Morningstar” may refer to Morningstar, Inc. or Morningstar Manager Research. Morningstar’s manager research analysts are employed by various wholly owned subsidiaries of Morningstar, Inc. including but not limited to Morningstar Research Services LLC (USA), Morningstar UK Ltd, and Morningstar Australasia Pty Ltd.

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. Investment research is produced and issued by subsidiaries of Morningstar, Inc. including, but not limited to, Morningstar Research Services LLC, registered with and governed by the U.S. Securities and Exchange Commission.​

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