Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors' timing can have a big impact on their take-home returns. Joining me to discuss some current research on this topic is Russ Kinnel. He is director of manager research for Morningstar, and he is also editor of Morningstar FundInvestor.
Russ, thank you so much for being here.
Russ Kinnel: Happy to be here.
Benz: Russ, you are the keeper of the "Mind the Gap" study you call it, where you every year look at the intersection between investors' timing of their purchases of various funds and their sales of those funds and how those stack up when paired with what the funds themselves actually returned. So, let's talk about how, first of all, you arrive at this data. We call them investor returns. How does Morningstar come up with those numbers?
Kinnel: That's right. So, investor returns were essentially weighting performance based on flows, because of course not everyone got in at the beginning of, say, a 10-year period and then sold at the end. They are buying and selling all along the way, and so that can lead to a difference between how investors actually get their returns versus the fund's official returns. So, if you think about it, the difference between investor returns and the official returns are essentially telling you how good was the investors' timing. Sometimes it's positive, sometimes they do better. But in general, they do a little worse than the actual returns because human nature, being what it is, we tend to buy after a fund has had a good run and sell after it's had a poor run.
Benz: When investors are looking at these investor returns, I know we do depict them on a per fund basis. So, I can see them for each of my holdings. But you tend to think that the data are a little more interesting and reliable when you roll up funds within an asset class. Why is that?
Kinnel: Well, there's a lot of randomness and noise in individual fund investor return. Sometimes it tells you a story. But you have to remember when the fund was launched can have a big impact, when the fund became popular. Some of that is under the fund company's control, but some of it isn't. So, you could find funds that have identical strategies but maybe they are different funds for one reason or another or the same index in different fund format. You can see different investor returns again because of those reasons. So, you want to kind of understand that difference. Generally, I like to look at the forests for the trees, and that's where it really tells you the story of investor behavior. I wouldn't read too much into an individual fund's investor returns.
Benz: So, let's take a look at the data, which you unpacked in FundInvestor in the May issue. Starting with domestic equity where if you look at the 10-year return gap between investor returns. Is that weighted by the types of funds, asset-weighted?
Kinnel: That's right. We asset-weight the investor returns to get at essentially what does the average investor do. Since the investor returns on a fund level are asset-weighted, you want to then asset-weight it again. Otherwise, you are kind of, apples-and-oranges territory. So, we're kind of saying, how did the average investor do versus the average fund.
Benz: So, within domestic equity, investor returns versus the total returns of all of the funds under that domestic equity heading, you see a 79-basis-point return gap. So, investors have essentially given up 79 basis points or 0.79% of returns due to somewhat ill-advised timing decisions it looks like.
Kinnel: That's right. And that's actually a little below the historic norm, but not too far off. So, the good part for investor returns is that when you have a fairly steady market like we've had in recent years, that tends to work a lot better. What really throws people off is the really dramatic highs and lows. So, like in '08-'09 time period, you see those investor return gaps really stretch out and get worse, because people may have sold near the bottom out of panic and then missed out on the rally. So, when you have a little more steady market like we've had in recent years, that seems to work better for investors. We say that both on a macro basis and on an individual fund basis.
Benz: Russ, to what extent are flows into ETFs captured here or not?
Kinnel: This is purely open-end. Unfortunately, the ETF flows make investor return calculations fairly tricky to calculate because you have the short side as well.
Benz: Sure. And you have people thinking really short-term in some cases with their positions. So, I'm sure that the data are really kind of ephemeral and difficult to capture.
Benz: OK. So, this is open-end mutual funds. It would encompass index funds though? OK. Let's look at fixed income. What's surprising to me is, 73 basis points might not sound like a lot. That's the gap between investor returns and total returns. But when you think of the returns on fixed-income investments, that's a big chunk of investors' gains that they've given up through some of these poor timing decisions?
Kinnel: That's right. When I look at this batch of numbers, the number that stood out was that fixed-income gap because fixed income is less volatile. It's more predictable. Returns are lower. So, a bigger gap--or almost equal size gap to equity is disappointing because people should be able to handle it better. But I think it shows that timing can be bad there, too. And as you pointed out, with fairly low returns that gap is even more costly just as it is paying higher fees in a fixed-income fund eats up even more of your returns.
Benz: So, do you think that part of this return gap owes to the fact that following the bear market you still had some investors who were like, I don't want any equity risk. I'm going to put more money into fixed income. Do you think that's partially why we're seeing this drag?
Kinnel: That's right. I think that was part of the error was--in '09 a lot of people reacted by buying bonds and selling stocks, obviously wrong in both directions. But also, you see occasionally there are some blips. We see that if you break down the muni area separately, you see that that timing is not very good there and often it's because the only headline news in munis are negatives. We had Puerto Rico had some serious issues. We had Meredith Whitney incorrectly predicting something near Armageddon for munis, and people sold off causing sort of reinforcing losses. But in fact, it was a great time to buy. Those defaults never materialized. And so, unfortunately, I think some of the headlines around munis really give people a head fake that if anything, you'd be better off buying when you see those negative headlines.
Benz: Good point. Let's look at allocation funds, and I know this is a category or group of funds that you and the team have been monitoring in terms of investor returns. First, let's talk about what falls under that allocation heading.
Kinnel: So, any kind of allocation fund, your standard balance fund, like Vanguard Wellington, your 60-40 funds. But any mix of stocks and bonds is going to fall into there. But also target-date funds, which of course, are ever-growing segment of the fund world.
Benz: OK. So, you mentioned at the outset that sometimes we can see this return gap actually go positive, where it looks like investors' timing has actually helped them outperform what they would have done with just simply buying and holding the portfolio over the whole 10-year period. That's what's going on with allocation funds where we do see a slight positive return gap for investors. What's your best conjecture on what's going on there?
Kinnel: Well, it's really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You've got tremendous diversification. They don't cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to '08, '09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.
Benz: So, in these other categories where we see gaps, your point is, do that, mimic the behavior that's going on in allocation funds, be disciplined, don't be jumping around, that you'll earn yourself a better return if you can kind of stick with a strategic asset allocation plan?
Kinnel: That's right. Stick to your plan. Ideally, look at your whole portfolio rather than saying this, fund did poorly, I'm going to sell that. And if you can't do that, then look for funds that are equally as boring as target-date, so allocation funds, maybe, say, really diversified equity funds. Find something that works for you that keeps you from buying and selling at the wrong times and kind of keeps you on a steady path.
Benz: Thanks, Russ. Always fascinating research.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.