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Kinnel: Investor-Returns Gap Continues to Shrink

Russel Kinnel
Karen Wallace

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. The timing of investors' buys and sells can have a big impact on their investment performance. Joining me to discuss some current research on this topic is Russ Kinnel. He is the director of manager research for Morningstar, and he is also the editor of Morningstar FundInvestor.

Russ, thanks for being here.

Russ Kinnel: Glad to be here.

Wallace: You recently updated your Mind the Gap study. This is an annual study that comes out. What exactly are you looking at?

Kinnel: We are looking at investor returns versus total returns, which is essentially, asset-weighted or dollar-weighted returns versus time-weighted returns. As you said at the top, essentially, it's telling you about investor timing. Is it good timing? If it's good timing, the gap will be smaller or even positive. If it's bad timing, it will be negative, meaning they left some money on the table because they didn't make the most of their funds.

Wallace: You make a point in the piece to not put too much stock in an individual fund's investor returns, but when you look at it across a larger, a broader category asset class, it tells a fuller picture.

Kinnel: Yeah. We really like to look to see what's the typical investor doing, how are things working for them. But on an individual fund basis, there can be a fair amount of noise. Sometimes it tells you an interesting story, but you don't want to read too much into it.

Wallace: Russ, what are some of the big headlines, the big takeaways from this study?

Kinnel: We are seeing the gap has really been shrinking over the last few years and that trend has continued to where we have a small gap overall. I think that's really because we've had a nice steady bull run. The gap tends to expand the most when you have dramatic pivot years. Years like '08, '09 where people are essentially selling all the way down and then they miss out on the rally. That's really bad for them. But the last decade almost entirely the market's more or less has been going up and that's worked really well for investors. Whenever you have a relatively stable move in one direction, that works well for investor timing. That's what we are seeing in the numbers.

Wallace: So, it's easier to hold on to a fund when it's steadily rising?

Kinnel: That's right. Investors do worse when returns trigger either fear or greed. But if it's sort of steadily rising, you have a positive reinforcement mechanism.

Wallace: That makes sense. We saw the gap in domestic equity funds overall decline. What are some of the things that you found there?

Kinnel: As you say, the gap has shrunk to where it's a fairly small gap and that's really encouraging. I think it's largely the story about equities just rallying and people making a good use of their funds really.

Wallace: And balanced funds are an example of where investors have very good timing. They actually had a positive gap.

Kinnel: Right. So, we see balanced funds--every year we do this, we see really good results in balanced and specifically, where it's really good is the target-date funds. The reason, I think is that partly target-date funds are very stable, boring funds. They don't move a lot. They are super diversified. But on top of that, people hold them in a 401(k)--401(k)s are vehicles where you are investing every paycheck. So, really, you'd have to have people are held to the steady discipline of investing regularly. That's where you get the best results, because in downturns people are continuing to invest and obviously, you get more shares when in a downturn. We really see that works well. 

We've done the study globally. We see in other markets like Australia and South Korea where you have something similar to a 401(k), again you see really good results there. There's definitely something to that steady commitment of assets from investors.

Wallace: One surprise that you saw was municipal funds which had--the gap is shrinking but it's still fairly significant.

Kinnel: That's right. The gap is over 100 basis points, which is really odd, because if you look at muni bond returns, they are pretty steady, pretty boring. You don't see double-digit returns when they lose money. It's usually a very small amount. It's really unusual that such a boring space would have such a dramatic gap. But I think we've had a couple of events that have kind of thrown investors.

Obviously, muni investors are very risk-averse. Even a whiff of risk scares them. In this case, the last 10 years, we've had two events that scared people. One was the Puerto Rico crisis, and people withdrew a lot of money even though most of the big funds out there had very little Puerto Rico exposure. The muni market sold off. People got out. But really, they were missing out on the fact that the rest of the muni market was really strong. The previous event was when Meredith Whitney went on "60 Minutes" and predicted huge bankruptcies which never came to pass. Again, people got out at the wrong time. It's a little unusual, but it just speaks to how skittish the typical muni investor is.

Wallace: Those headlines were enough to spook people.

Kinnel: And not a good time to sell.

Wallace: Finally, I wanted to touch o the alts category, which had sort of an interesting profile that it had the worst investor return, but the best investor return gap. How did that work?

Kinnel: Essentially, we talked about how the gap is really telling you how people did at timing. Alts have done so poorly that really if you sold anywhere over the last 10 years, it's probably a good move. And so, essentially, that's what it's showing, is that the typical alts investor got almost a 0% return, but the typical alts fund lost about 1% a year. We are seeing that the people did pretty good with their timing. But of course, those returns are not going to make people happy. The alts world clearly has to do better.

Now, there is a caveat and that is that the 10-year figures go back to a point in time when there were not a lot of alts funds. You have to take it with a bit of a grain of salt. But even if you look at more recent results, you see that alts returns have not been very good, and I think clearly the alts world is going to have to do better if they want to keep investors in.

Wallace: When we roll all of this data up and look at it holistically, what kinds of lessons can investors take away from this?

Kinnel: There are a few lessons. Some are about the kind of funds and some are about the kind of investors. I think when we look at it by data we see that low-cost funds lead to better investor returns and better investor returns gaps, even by significantly more than the fees themselves. I think it's really smart investors finding good funds. We also find that low-volatility funds work better for people. The really high volatility funds don't work so well. Low cost, low volatility funds work for people.

And then the other part, I think, is just know yourself and know your fund. Know how much risk you can take, but also just go and look through funds' annual returns to see are these numbers I can stomach. You go back to '08 and other times of crisis and look at fund's individual calendar year reruns, you might be surprised because if you just look at the trailing returns, you might see an equity fund that's returned 9% a year and it looks great. But then you go and see, oh, but it actually lost 40% in '08. I have to be able to tolerate that to get to the good stuff.

Wallace: Right. Well, this is really interesting research. Thanks so much for being here to share it.

Kinnel: You're welcome.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.