Morningstar Magazine - June/July 2018 - 32

Dispatches

by early 2017, where it has stayed. The fund
gained more than 9% annualized in the five years
ended in March but still trailed 97% of
its peers and the Russell 1000 Growth Index.

TRENDS

Mind the Gap: Active Versus Passive Edition
Morningstar introduced Morningstar Investor
Returns in 2006 to approximate investors'
actual experience with funds as a result of their
own actions. This behavior gap looks at the
difference between the returns funds generate
(time-weighted returns) and the returns
average investors experience (cash-flow-weighted
returns). The gap is usually negative, though
we've found that less-risky and less-costly funds
tend to have narrower return gaps.
The April issue of Morningstar ETFInvestor
examines how investors in passively managed
funds have behaved relative to investors in
actively managed funds over the 10-year period
through March 31. Overall, investors did
themselves more harm than good when timing
their purchases and redemptions. However,
in most broad Morningstar Categories, passive
funds had substantially narrower average
return gaps than did actively managed funds.
(International-equity funds were an exception
to the overall trend.)

play here likely pertain to investors' expectations
and investment channels. Investors in passively
managed funds generally have a standard
set of expectations: They are content to sit tight
and earn the market's return. In addition, the
fact that index funds are prevalent in many
employers' 401(k) menus and represent a growing
share of target-date funds' assets contributed
to a population of well-behaved indexfund investors making systematic investment
contributions. In fact, past Morningstar
research has shown that target-date funds
have positive behavior gaps.
It is important not to attribute these gaps
entirely to investor behavior, good or bad. The
investor returns calculation is an approximation
and has its tics. It is particularly sensitive
to the timing, magnitude, and overall volatility
of cash flows. Larger funds with more
even flows-which tend to be more broadly
diversified-tend to have narrower gaps.

The difference between total returns and investor returns is more pronounced for actively managed
funds in most categories.
Passive

10-Year Gap Return
2%
0.19

-0.80

-1.08

-1.18

-1.90
-3.24

-0.83

-0.25
-1.70

-1.52

-1.84
-2.48

-2.99

-2

-4
-5.72
U.S. Diversiﬁed U.S. Sector
Stock
Stock

Int'l Equity

-6
Taxable Bond

Source: Morningstar. Annualized total return as of 03/31/2018.

Morningstar June/July 2018

Balanced

Alternative

All Funds

Loans, TIPS, Inflation,
and the Fed

Yields among the kind of leveraged bank loans
usually found in mutual funds are tightly
linked to short-term rates, and interest-rate futures
recently signaled that the market is expecting
the Federal Reserve to raise its key federal-funds
rate to between at least 2% and 2.5% by the
end of 2018, with modest probability baked in that
they could get as high as 2.75% or more.

Behavior Gaps by Broad Category Group

Active

Dan Culloton is director, equity strategies, manager
research, with Morningstar Research Services.

The Treasury Inflation-Protected Securities and
bank-loan sectors are notable for their sensitivity
to interest rates and the economy, but that's
about as much alike as they're ever likely to be.

Ben Johnson, CFA, is director, passive strategies, global
manager research with Morningstar Research
Services. He is a member of the editorial board of
Morningstar magazine.

What explains the differences in behavior
between the two? The most important factors at

Increased manager ownership does not guarantee
that the fortunes of these out-of-favor funds
will turn. There are many other data points and
attributes to consider. But it at least indicates
that the managers are willing to share their
investors' discomfort and remain confident in the
strategy they're asking shareholders to support.

In general, that's good news for investors in
bank-loan funds, given that leveraged loan rates
are typically set at a specified level above
three-month Libor (which usually trends closely
with the federal-funds rate) and reset periodically.
So, for example, if Libor goes up, a bank
loan's payout will normally go up along with it.
And unlike conventional fixed-rate bonds,
whose prices are generally driven down when
market yields go up, bank-loan prices usually don't
respond much because investors expect their
rates to catch up quickly as their loan rates reset.
You can see that in the experience of Eaton Vance
Floating-Rate EVBLX and Fidelity Floating Rate
High Income FFRHX between February 2004

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018