Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 428

Why do investors earn less than the funds they invest in?

Why would investors earn less than the funds they invest in? It all comes down to timing.

Our '2021 Mind the Gap' study of dollar-weighted returns finds investors earned about 7.7% per year on the average dollar they invested in equity funds over the 10 years ended 31 December 2020. This was about 1.7% less than the total returns their fund investments generated over that time span.

This shortfall, or ‘gap’, stems from inopportunely-timed investment in and redemptions from funds, which cost investors nearly one-sixth the return they would have earned if they had simply bought and held.

The persistent gap makes cash flow timing one of the most significant factors – along with investment costs and tax efficiency – that can influence an investor's end results.

What is the gap between investor returns and total returns?

To use a simple example, let's say an investor puts $1,000 into a fund at the beginning of each year. That fund earns a 10% return the first year, a 10% return the second year, and then suffers a 10% loss in the third year, for a 2.9% annual return over the full three-year period. But the investor's dollar-weighted return in this simple example is negative 0.4%, because there was less money in the fund during the first two years of positive returns and more money exposed to the loss during the third year. In this case, there was a 3.3% per annum gap between the investor's return (negative 0.4%) and the fund's (2.9%).

In our study, we estimate the gap between investors' dollar-weighted returns and funds' total returns in the aggregate. This allows us to assess how large the gap is and how it's changed over time.

The results by different fund types

More specialised areas with the most volatile cash flows - namely, alternative funds and sector equity funds - fared much worse than average and pulled down the aggregate results. The more mainstream areas that are home to the majority of investor assets such as broad equity and bond funds fared much better, with return gaps of about 1% per year.

In this US study, equity fund investors experienced a 1.2% annual gap while bond fund investors suffered a 1.1% gap per year.

A few other areas worth noting:

  • Asset allocation funds had the smallest gap, suggesting that their built-in asset-class diversification makes them easier for investors to buy and hold over time. Investors in these funds, which combine stocks, bonds, and other asset classes, experienced a dollar-weighted return lag of only 0.69% per year over the 10 years. 
  • Alternative funds have proved difficult for investors to use successfully. The average dollar invested in these funds lost about 0.3% annually over the 10 years, which was a remarkable 12% per year less than the returns in US equity funds.
  • Sector-specific equity funds also saw negative gaps for investors, by about 4% per year. These specialised funds were doubly disappointing, with returns lagging diversified equity funds and investors failing to capture the full benefit of those lower returns. 

How does dollar-cost averaging impact investor returns?

We also added a series of returns to see how the results would look in a hypothetical scenario in which an investor contributed equal monthly investments (dollar-cost averaging) to funds in each broad category group. 

Dollar-cost averaging doesn't usually lead to better results compared with a buy-and-hold approach. In fact, because market returns are often positive, dollar-cost averaging often leads to lower investor returns.

This simply reflects the underlying maths of total returns: If returns are generally positive, investors are typically better off making a lump-sum investment and holding it for the entire period. Investors who contribute smaller amounts over time often have fewer dollars invested during periods with strong returns.

The results show dollar-cost averaging can help investors avoid some of the ill effects of poorly-timed cash flows by enforcing a more disciplined approach. In fact, following such a systematic investment approach would have improved investors' returns in six of the seven major category groups. With international-equity and sector-equity funds, for example, investor returns based on dollar-cost averaging came out more than 2% per year ahead of investors' actual returns.

What to do to improve investor returns

The persistent gap between investors' actual results and reported total returns may seems disheartening, but investors can take away a few key lessons about how to improve their results. The study's results suggest:

  1. Keep things simple and stick with plain-vanilla, broadly diversified funds.
  2. Automate routine tasks such as setting asset-allocation targets and periodically rebalancing.
  3. Avoid narrowly-focused funds for long-term investing, as well as those with higher volatility.
  4. Embrace techniques that put investment decisions on autopilot, such as dollar-cost averaging.

These findings shine more light on the merits of keeping things simple. In particular, funds that offer built-in asset class diversification, such as balanced funds, help investors keep more of their returns.

Finally, we found that investors' trading activity is often counterproductive. Investors can improve their results by setting an investment plan and sticking with it for the long term. Investors who follow a consistent investment approach and avoid chasing performance will likely reap rewards over time.

 

Amy C. Arnott, CFA, is a Portfolio Strategist for Morningstar.

For more details on the results and methodology, see the 2021 Mind the Gap Report. We changed the way we calculate the total returns used as benchmarks for the gap numbers in this year's study. In past studies, we used an equally-weighted average but this year we used an asset-weighted methodology to calculate the average. This change had the effect of increasing the average total return figures used as a benchmark for the gap calculations, leading to a wider return gap overall. This article is general information and does not consider the circumstances of any investor. It has been edited somewhat from the original US version for an Australian audience.

Register for a free trial of Morningstar Premium on the link below, including the portfolio management service, Sharesight.


Try Morningstar Premium for free


 

3 Comments
AlanB
October 26, 2021

Why do fund managers earn more than the funds we invest in?

john
October 08, 2021

Yes and many funds advertise returns which are actually false, if one scrutinises their results deeply. One example is the IRR.

Jerome Lander
October 07, 2021

Investors earning less than the funds they invest in is a really important point for those interested in client results. Fund managers could do a lot more, as we do, to differentiate themselves and ensure that investors are less likely to be their own worst enemy in this regard. Unfortunately the industry generally over-emphasizes and rewards the very top performers in any one period - hoping that it will continue - rather than the best risk-adjusted returns. Fund managers respond to the market by building jackpot type products that have a chance of being lucky in good markets and performing the best for a short period of time (without an emphasis on long term risk-adjusted performance and compounding). Investors who think differently can do a lot better for themselves long term by backing the rare funds that are different from the mainstream. While the main point of this article is important, I think some of the general conclusions made about what to do about it are incorrect. For example investing in plain vanilla funds won't work if overall returns and markets are weak from here in coming years, which should not be a surprise at all given valuation levels and credible forecasts. Furthermore, plain vanilla equity funds are actually risk and the potential investor gap is hence very large if markets crash.

 

Leave a Comment:

     

RELATED ARTICLES

Five stocks that have worked well in our portfolios

Unfortunately, all fund manager presentations are good

When good defensive investments go bad

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.