Morningstar Advisor - Spring 2007 - 18

Gray Matters Your Mileage May Vary Morningstar Investor Return shows that shareholders often earn less than a fund’s total return. by Christine Benz and David Kathman The new Morningstar Investor Return figure not only sheds light on mutual fund investors’ timing, but it also tells a story about the effect volatility has on shareholders and reveals something about a fund family’s stewardship. Investor return, also known as asset-weighted return, factors in the timing of investors’ purchases and sales. It takes into account the fact that not all of a fund’s investors bought it at the beginning of a period and held it until the end. Therefore, investor return depicts the return earned by the fund’s typical investor. To use a simple example of investor return in action, assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year’s first quarter. If investors added substantial sums of money to the fund after its first-quarter run-up, the fund’s investor return for that year would be lower than the fund’s 10% total return. Based on Morningstar Investor Return, we now have solid evidence to support the anecdotes about investors’ poor timing. Although most fund categories’ total returns and investor returns were fairly close to one another over the past three- and five-year periods, the gap between the two widened substantially over the trailing 10-year period. That’s likely because the 10-year period encompassed the late 1990s bull run as well as the bear market, and both extremes tended to stimulate poor decision-making. In fact, in every diversified stock-fund category and all but a handful of sector categories, 10-year investor returns lagged the total returns of the funds. The divergence was, in several cases, quite striking. For example, technology-sector funds have, on average, generated 10-year total returns of 6.7%—not great, but not absolutely terrible, either. But investors have, in aggregate, had a terrible experience in these funds, losing an average of 4.14% on an annualized basis over the past 10 years. It was a similar story for growth funds, which generally posted 10-year investor returns that fell far short of their total returns. Ditto for communications and health-care funds. The graph to the right reveals the divergence for one fund, ING International SmallCap C NARCX. The fund has an impressive 10-year total annual return of 16.13%, but its 10-year annual investor return is only 0.18%. The fund’s net cash flow tells the story of the discrepancy. Investors piled into the fund during its run-up and then fled as the fund’s returns plummeted. Investors were still leaving as it rebounded and weren’t around to recoup their losses. The disastrous investor returns of high-octane growth and technology funds led us to pursue another angle: Within categories, is there a link between volatility and investor returns? In an effort to determine whether high-volatility funds tend to stimulate poor investor decision-making, we grouped all of the funds in each of our categories into quartiles based on their standard deviations. From there, we examined whether the lowrisk quartile posted better investor returns over the past 10 years than the high-risk quartile. The answer was a resounding yes. In every diversified domestic-equity category, the investor returns of the low-volatility group trounced those of the high-volatility group. It’s worth noting that in many cases the low volatility group had better total returns (that is, not accounting for asset inflows and outflows) than the high-volatility group, so naturally the investor returns of the former are also bet- 18 Morningstar Advisor Spring 2007
Morningstar Advisor - Spring 2007

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