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

Decoding an ETF's DNA

Five stocks that have worked well in our portfolios

Unfortunately, all fund manager presentations are good

banner

Most viewed in recent weeks

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Part 2: Hamish Douglass on not swinging for the fences

Markets don't seem normal, but Magellan is criticised for its caution. Higher interest rates to control inflation could create a recession and some of today's investing will turn out a mass delusion of modern history.

10 big investment themes to watch in 2022

Are markets on a road to recovery or a path of potholes? Leading portfolio managers were asked for the theme that most excites or worries them in the year ahead, and what they will especially watch for.

Latest Updates

Investment strategies

Despite the focus on ETFs, unlisted funds still dominate

ETFs gain the headlines as issuers are skilled at promoting their growth and new funds. Yet ETFs are tiny compared with managed funds, which advisers prefer on platforms. Which will be the long-term winner?

Latest from Morningstar

10 lessons from Larry Fink's 2022 Outlook

At a 2022 Outlook event, the influential BlackRock (largest fund manager in the world) CEO spoke about consumer behaviour and its impact on prices, the pandemic, ESG trends and likely equity returns for 2022.

Strategy

If rising inequality leads to social unrest, we all suffer

Feeling financially stressed? The entry level for the world's richest 1% is $1.5 million including the family home. If this is not enough to fund a ‘comfortable’ lifestyle, consider that 99% of people have less.

Shares

Sharemarket falls: seven things for investors to consider

Stockmarkets have fallen in recent weeks on the back of worries about inflation, monetary tightening, Omicron disruption and the risk of a Russian invasion of Ukraine. It’s too early to say markets have bottomed.

Retirement

The importance of retirement 'conditions of release'

Retirement 'conditions of release' vary by age in stages before 60, over 60 and over 65. Super tax benefits may accrue if gainful employment ceases after age 60 but a person may still return to the workforce.

Investment strategies

We need to limit retail investor harm from CFDs

A Contract for Difference (CFD) is a highly-leveraged investment used for speculative and gambling activities by retail investors without the knowledge to take such risks. ASIC is struggling to control the product.

Superannuation

It's time to assess your super fund’s carbon footprint

We face a huge economic transformation that is not a priority for politicians. Yet a typical super portfolio emits about 28 tonnes of CO2 per annum through its equities ownership, more than the average household.

Sponsors

Alliances

© 2022 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.