Morningstar Magazine - August/September 2018 - 51

Mind the Gap 2018
Investors made good use of mutual
funds in an up market.

INVESTMENT RESEARCH: MIND THE GAP

Russel Kinnel

These are good days for investors. The last bear
market was nearly a decade ago. Socking
money away in mutual funds and then watching
it grow has worked quite nicely.
We see the proof not only in strong market returns
but also in solid Morningstar Investor
Returns. Investor returns, or dollar-weighted returns,
measure return on investments for the typical
investor by factoring in cash flows and fund
size. When the markets move up steadily, investors
are part of a positive feedback mechanism that
encourages continued investment.
When markets lurch, investors do worse because
they make timing mistakes. Investors large and
small tend to sell after downturns only to buy back
in after rallies. But times have been good
lately, as we can see in our latest look at aggregate
investor return data through the first quarter.
A second factor in the shrinking gap is industry
assets under management. They have grown
dramatically because of equity appreciation, overshadowing fund flows over the period.
We looked at investor returns over the trailing
three-, five-, and 10-year periods by asset
class and by Morningstar Category. Our data set
included U.S.-domiciled open-end mutual
funds, but not exchange-traded funds
because short-term trades and shorting make it
difficult to calculate returns on investment.
The data shows when investors tend to use funds
well and when they do not. There are some

limitations to the granular data, however, so
we find that broad trends are most telling.
In this article, we home in on the 10-year results
broken down by asset class.
Inside the Data
To calculate fund investor returns, we adjust a
fund's official returns using monthly cash flows in
and out of the fund. Thus, we calculate a rate
of return generated by a fund's investors. As with
an internal rate of return calculation, investor
return is the constant monthly rate of return that
makes the beginning assets equal to the ending
assets, with all monthly cash flows accounted for.

We aggregate this data across a larger peer group
by asset-weighting investor returns among the
group's constituents, thus emphasizing the results
of the peer group's largest funds and better
representing the typical investor's experience. We
then compare the peer group's results with
those of the average fund to see whether investors
timed their investments well.
You can find Morningstar Investor Returns for a fund
on its Morningstar.com page or in Morningstar
Direct. The investor return is essentially the
aggregate investor's bottom line. All single-fund
investor returns come with the caveat that
there is a fair amount of randomness in them that
is beyond the fund manager's control. Two funds
doing the same thing might have different
investor returns just because they are in different
sales channels or had different launch dates.
Some factors are more within the fund company's
control than others, such as how a fund is
positioned in ads and other marketing, the soundness of the strategy, and the volatility of a
fund. All of these things play key roles in how
well investors use a fund.

Narrowing Gaps
As seen in the exhibit, the typical investor (as
represented by asset-weighted investor
returns) in diversified domestic-equity funds
earned a robust 8.32% annualized return for the
10 years ended March 31. That compares
with 8.93% for the average fund, making for a
shortfall of 0.61 percentage points. That is
a modest improvement over our previous report.
It is worth noting that the gap might be different
if we included ETFs in the study. Although
it is hard to know whether short-term traders
in ETFs generated strong returns, long-term
investors have been steadily building positions
in low-cost large-cap equity funds.

Balanced funds, a group that includes allocation
funds, target-date funds, and traditional balanced
funds, saw a positive gap of 0.30 percentage
points, with the average investor enjoying a 5.93%
annualized return. That is also an improvement
over our last measurement. It reflects the
continued strength of target-date funds, both in
terms of investor behavior and strong gains
among well-diversified funds. Target-date funds
are easy for investors to use because performance swings are muted, and most investors buy
in through 401(k) retirement plans with
automated savings processes, which creates a
disciplined track of continued savings.
The gap for municipal-bond funds shrank slightly
to a 1.26-percentage-point annualized
shortfall based on asset-weighted investor returns
of 2.23%. It is encouraging that the gap
shrank, but it still seems pretty high for a fairly
tame low-return asset class. Outflows
corresponded with headline scares over the past
decade, driving investors away from munis
at the wrong time-specifically, the Puerto Rico
debt debacle and the wildly inaccurate
prediction of doom by influential market researcher
Meredith Whitney.
In other asset classes, the gap worsened. The gap
among international-equity funds grew
to 104 basis points, with investor returns of 2.95%
annualized. Investors' timing in regional funds
dedicated to Europe and Asia, and in more
diversified foreign large-growth funds, has been
particularly poor.

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