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Why Fund Returns Are Lower Than You Might Think

Our most recent study of investor returns reveals a persistent gap between reported total returns and what investors actually earn.

Why would investors earn less than the funds they invest in? It all comes down to timing.

Our annual "Mind the Gap" study of dollar-weighted returns (also known as investor returns) finds investors earned about 7.7% per year on the average dollar they invested in mutual funds and exchange-traded funds over the 10 years ended Dec. 31, 2020. This was about 1.7 percentage points less than the total returns their fund investments generated over that span. This shortfall, or "gap," stems from inopportunely timed purchases and sales of fund shares, which cost investors nearly one sixth the return they would have earned if they had simply bought and held.

The persistent gap between the returns investors actually experience and reported total returns makes cash flow timing one of the most significant factors--along with investment costs and tax efficiency--that can influence an investor's end results.

What Is the Gap Between Investor Returns and Total Returns?

Investor returns (also known as dollar-weighted returns or internal rates of return) often differ from reported total returns because of the timing of cash inflows and outflows.

To use a simple example, let's say an investor puts $1,000 into a fund at the beginning of each year. That fund earns a 10% return the first year, a 10% return the second year, and then suffers a 10% loss in the third year, for a 2.9% annual return over the full three-year period. But the investor's dollar-weighted return is negative 0.4%, because there was less money in the fund during the first two years of positive returns and more money exposed to the loss during the third year. In this case, there was a 3.3-percentage-point per year gap between the investor's return (negative 0.4%) and the fund's (2.9%).

In our study, we estimate the gap between investors' dollar-weighted returns and funds' total returns in the aggregate. This allows us to assess how large the gap is and how it's changed over time.

One important methodology note: We changed the way we calculate the total returns used as benchmarks for the gap numbers in this year's study. In past studies, we used an equally weighted average, but this year we used an asset-weighted methodology to calculate the average. We believe using asset-weighted averages for both investor returns and total returns allows for a more apples-to-apples comparison and more accurate gap numbers overall. This change had the effect of increasing the average total return figures used as a benchmark for the gap calculations, leading to a wider return gap overall. (See more about the methodology change in the full study.)

The Results: Investor Returns Lag

As mentioned above, we find that investors suffered a 1.7-percentage-point annual return gap over the 10 years ended Dec. 31, 2020, owing to mistimed purchases and sales.

This annual return gap was in line with the gaps we measured over the four previous rolling 10-year periods (ended Dec. 31, 2016, 2017, 2018, and 2019), which ranged from 1.6 to 1.8 percentage points per year. (We recalculated these results to incorporate the new methodology.)

Under the surface, though, there's a more nuanced story. More specialized areas with the most volatile cash flows--namely, alternative funds and sector equity funds--fared much worse than average and pulled down the aggregate results. The more mainstream areas that are home to the majority of investor assets--such as U.S. equity funds and taxable-bond funds--fared much better, with return gaps of about 1 percentage point per year.

The two largest fund types by net assets, U.S. equity funds and taxable-bond funds, had smaller return gaps than the fund universe as a whole. U.S. stock fund investors saw a 1.2-percentage-point annual gap, while taxable-bond-fund investors experienced a 1.1-percentage-point gap per year.

A few other areas worth noting:

  • Allocation funds continued to excel, suggesting that their built-in asset-class diversification makes them easier for investors to buy and hold over time. Investors in these funds, which combine stocks, bonds, and other asset classes, saw the smallest gap, as their dollar-weighted returns lagged the funds' total returns by only 69 basis points per year over the 10 years ended Dec. 31, 2020. This continued a trend: Allocation funds had much narrower gaps than the other major asset classes in all five of the rolling 10-year periods we analyzed.
  • Alternative funds have proved difficult for investors to use successfully: The average dollar invested in these funds lost about 0.3% annually over the 10 years ended Dec. 31, 2020, which was more than 4 percentage points lower per year than the funds' total returns and a remarkable 12 percentage points per year less than the dollar-weighted returns that investors in U.S. stock funds earned over that span.
  • Sector-equity funds also saw negative gaps for investors, as their dollar-weighted returns lagged the funds' reported total returns by about 4 percentage points per year over the 10 years ended Dec. 31, 2020. Specialized funds were doubly disappointing. Not only did their total returns lag those of diversified U.S. equity funds by a wide margin to begin with, but investors failed to capture the full benefit of those lower returns. As a result, dollar-weighted returns for sector-equity funds were basically identical to investor returns for allocation funds (7.4%), which are easier to live with thanks to their built-in diversification and lower volatility.

We also found that the more volatile a fund, the more trouble investors tended to have capturing its full return. For instance:

  • The most volatile quintile of U.S. stock funds had an annual return gap of 1.7 percentage points over the 10 years ended Dec. 31, 2020, while the least volatile quintile had a far smaller gap of 0.9 percentage points per year.
  • The most volatile quintile of taxable-bond funds saw a 2.3-percentage-point return gap per year, and the least volatile quintile suffered a gap of only 0.6 percentage points.

Comparing the Results: How Does Systematic Investing Impact Investor Returns?

We also added a series of returns to see how the results would look in a hypothetical scenario in which an investor contributed equal monthly investments (dollar-cost averaging) to funds in each broad category group. We did so in order to gauge what investor returns would have looked like assuming consistent monthly cash flows.

Dollar-cost averaging doesn't usually lead to better results compared with a buy-and-hold approach. In fact, because market returns are often positive, dollar-cost averaging often leads to lower investor returns.

This simply reflects the underlying math of total returns: If returns are generally positive, investors are typically better off making a lump-sum investment and holding it for the entire period. Investors who buy and hold can take full advantage of performance trends when total returns are positive, but investors who contribute smaller amounts over time often have fewer dollars invested during periods with strong returns.

But dollar-cost averaging can help investors avoid some of the ill effects of poorly timed cash flows by enforcing a more disciplined approach. In fact, following a systematic investment approach would have improved investors' returns in six of the seven major category groups. With international-equity and sector-equity funds, for example, investor returns based on dollar-cost averaging came out more than 2 percentage points per year ahead of investors' actual returns.

Dollar-cost averaging pulled even further ahead for the alternative category group. Investors in these funds tend to make frequent purchases and sales, but all that trading activity hasn't led to better results. Following a more disciplined approach would have improved returns by more than 5 percentage points per year.

What to Do to Improve Investor Returns

Overall, this year's results show there's a persistent gap between the returns investors actually experience and reported total returns. This gap makes cash flow timing one of the most significant factors--along with investment costs and tax efficiency--that can influence an investor's end results.

The persistent gap between investors' actual results and reported total returns may seem disheartening, but investors can take away a few key lessons about how to improve their results. The study's results suggest:

  1. Keep things simple and stick with plain-vanilla, broadly diversified funds.
  2. Automate routine tasks such as setting asset-allocation targets and periodically rebalancing.
  3. Avoid narrowly focused funds, as well as those with higher volatility.
  4. Embrace techniques that put investment decisions on autopilot, such as dollar-cost averaging.

These findings shine more light on the merits of keeping things simple, favoring broadly diversified funds, and following a disciplined investment approach. In particular, funds that offer built-in asset class diversification--such as balanced funds and target-date offerings--have helped investors keep more of their returns.

Finally, we found that investors' trading activity is often counterproductive. Investors can improve their results by setting an investment plan and sticking with it for the long term.

Whether they invest a lump sum up front or follow a dollar-cost averaging system, investors who follow a consistent investment approach and avoid chasing performance will likely reap rewards over time.

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About the Author

Amy C Arnott

Portfolio Strategist
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Amy C. Arnott, CFA, is a portfolio strategist for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. She is responsible for developing and articulating best practices to help investors and advisors build smarter portfolios.

Before rejoining Morningstar in 2019, Arnott was an Associate Wealth Advisor at Buckingham Strategic Wealth, where she was responsible for portfolio analysis, asset allocation, rebalancing, and trade recommendations. Arnott originally joined Morningstar as a mutual fund analyst in 1991 and held a variety of leadership roles in investment research, corporate finance, and strategy from 1991 to 2017.

Arnott holds a bachelor’s degree with honors in English and French from the University of Wisconsin – Madison. She also holds the Chartered Financial Analyst® designation.

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