Why Investors Earn Less Than the Funds They Invest In

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Morningstar recently updated its annual “Mind the Gap” study, which examines the difference between the reported total returns of funds and the returns that investors actually receive. Joining me today to share some highlights from the study is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Thanks for being here today, Amy.

Amy Arnott: Thanks. Great to be here.

Dziubinski: Let’s begin by talking a little bit about what investor returns are and how they differ from the total returns that most of us are used to seeing?

Arnott: An investor return is basically a dollar-weighted return, or you might also see it referred to as an internal rate of return. And it reflects the timing of cash flows into and out of a fund. So, the regular total returns that fund companies report and that you see in Morningstar and other sources, those are called time-weighted returns. And it assumes that you bought in at the beginning of the period and held for the entire time. But obviously, if maybe you bought in the middle of the period, or you sold partway through, your actual results are going to be different than the reported total return.

Dziubinski: When we look at this study over time, we found that there is a persistent gap between those reported total returns and what we’ve called investor returns, or the returns that investors have actually earned in a particular fund, and the gap usually isn’t in favor of the investor, right?

Arnott: Right. What we found is for the most recent 10-year period that we looked at for the study that we recently published, the gap was about 1.7 percentage points per year overall for the average investor. So, that really can be a significant amount that adds up over time.

Dziubinski: What causes that gap to exist?

Arnott: It’s really the timing of cash inflows and outflows. As I mentioned, if you didn’t invest in the fund for the whole period, you’re not going to get the benefit of returns if they were positive. Some of these differences are outside of an investor’s control. A lot of people can’t invest a lump sum up front but instead are maybe investing a portion of each paycheck through their 401(k) for retirement, which is fine. But unfortunately, we also see a pattern where investors have a tendency sometimes to buy in after there’s been a big runup and then sell after things are out of favor, and that is definitely a negative factor for investor returns.

Dziubinski: In the latest study, have there been particular Morningstar fund categories where we’ve seen wider gaps between the investor returns and the total returns?

Amy Arnott: Right. The more mainstream categories that tend to be the home to the largest amount of assets like diversified equity funds and taxable-bond funds, allocation funds, those areas tend to do relatively well. But on the other hand, sector funds and alternative funds, some specialized categories like single-country funds tend to have much wider gaps.

Dziubinski: It sounds like, in general, investors are less likely to poorly time investments in pretty well-diversified investments like an asset-allocation fund. Is that right?

Arnott: Exactly. Especially, if you’re looking at fund categories where they have a built-in asset mix that’s diversified between stocks and bonds, investors are tending not to try to time the market with those funds, but they’re usually buying and holding them for the long term, which is helpful.

Dziubinski: What should be the main takeaway for investors, Amy, from this study?

Arnott: I think one interesting thing is that this investor return gap is sort of a hidden cost. It’s something that you may not realize, but it can really have a significant impact on your returns over time. If you look at something like a typical fund expense ratio, that might be around 1.0% or more, a tax-cost ratio could be 1.5% or more, and then the investor return could be another 1.7%. So, if you take all those miscellaneous costs and combine them, it’s really a significant drag on your returns. But the positive thing is that you can improve your results by taking a more disciplined approach and holding for the long term.

Dziubinski: Well, Amy, thank you so much for these insights today. It’s really in particular fascinating to think about how this gap in investor to total return is really a cost, like so many other costs in investing, but this one we can do something about.

Arnott: Exactly.

Dziubinski: I’m Susan Dziubinski. Thanks for tuning in.

https://www.morningstar.com/articles/1063474/why-investors-earn-less-than-the-funds-they-invest-in