Investors Still Need to Mind the Gap in Their Funds’ Returns

Key Concepts

• Total Return: The familiar return found on financial websites and fund filings, assuming an initial lump sum investment held to the end.
• Investor Return (Dollar-Weighted Return): A proprietary Morningstar metric that approximates the return of the average dollar invested by accounting for the timing and magnitude of cash flows into and out of an investment.
• Mind the Gap Study: An annual Morningstar study that measures the difference between investor returns and total returns for US mutual funds and ETFs.
• The Gap: The difference between total returns and investor returns, indicating how much of a fund's performance investors actually captured.
• Cash Flow Volatility: A proxy for trading activity, used to categorize funds based on how rapidly and in what magnitude investors move money in and out.
• Retirement Plans (e.g., 401(k)s): Often described as "gilded cages" due to their controlled environment, which can limit discretionary trading and benefit investors.
• Allocation Funds (including Target Date Funds): Funds that invest in multiple asset classes, often found in retirement plans, and tend to have narrower gaps.
• Sector Equity Funds: Narrowly focused funds that invest in specific industries, often more volatile and prone to wider gaps.

Mind the Gap Study: Investor Returns vs. Fund Performance

This summary details the findings of Morningstar's "Mind the Gap" study, which analyzes the discrepancy between the stated total returns of US mutual funds and ETFs and the actual returns experienced by investors over a 10-year period. The study's lead researcher, Jeff Patac, explains the methodology and key takeaways.

Methodology: Measuring Investor Returns

• Total Returns: This is the standard measure of fund performance, calculated assuming a single, initial lump sum investment held until the end of the period. It's the return typically found on financial platforms.
• Investor Returns (Dollar-Weighted Returns): This proprietary Morningstar metric is akin to an internal rate of return. It accounts for the actual timing and amount of money investors put into and take out of a fund over time. This provides a more accurate reflection of the average dollar's experience.
• Time Frame: The most recent study examined a 10-year period ending December 31, 2024.

Key Findings: The Persistent Gap

• Average Gap: Over the last 10 years, the average dollar invested in US mutual funds and ETFs earned 1.2% less per year than the funds' total returns.
• Significance of the Gap: This 1.2% difference, while seemingly small, represents approximately 15% of the aggregate total return that those funds earned over the period.
• Persistence: The study indicates that the "gap" is not disappearing and continues to persist year after year.

Factors Contributing to the Gap

While a common perception is that investors lose money by trying to time the market (buying high, selling low), the study suggests a more nuanced picture:

• Setting and Circumstance: The environment in which investments are held plays a significant role.
  • Controlled Environments (Retirement Plans): Funds commonly found in retirement plans, such as allocation funds and target-date funds, tend to exhibit smaller gaps. This is attributed to a more controlled setting where investors may be less prone to frequent trading.
  • Less Controlled Environments (Sector Funds): Sector equity funds, which are narrower and not typically found in retirement plans, tend to have bigger gaps. Their "streaky" nature and potential for misuse by investors contribute to this.

Performance by Fund Category

The study analyzed funds across different categories to identify where investors succeeded or fell short in capturing returns:

• Narrowest Gap (Best Investor Capture):
  • Allocation Funds: This category, which includes multi-asset funds like target-date funds, showed the narrowest gap. Investors in these funds earned approximately the same as the funds' total returns, indicating they did a good job of capturing performance.
• Widest Gap (Poorest Investor Capture):
  • Sector Equity Funds: These funds, characterized by their narrow focus and streakiness, exhibited the widest gaps. The gap for sector funds was around 1.5%, exceeding the overall study average. This reinforces the idea that narrower investment vehicles are more challenging for investors to manage effectively.

Investment Type: ETFs vs. Mutual Funds

• ETF Gap: ETF investors experienced a slightly wider gap compared to investors in traditional open-end mutual funds.
• Specific Areas of Wider Gaps for ETFs: Taxable bonds and international equity were areas where ETF investors saw a more pronounced gap.
• Exception: In US equity, ETFs actually showed a slightly narrower gap than traditional open-end funds.
• Potential Explanation: The wider gap for ETFs might be linked to their prevalence outside of retirement plans. Open-end funds are common in retirement accounts, which offer a more controlled environment. ETFs, being more accessible for individual trading, might be more susceptible to investor missteps when held in taxable accounts.

Management Style: Active vs. Passive Funds

• Slight Difference: There was a slight difference in the investor return gap between active and passive funds, but it was not dramatic.
• Reductive Conclusion: It would be overly simplistic to conclude that investors are less likely to capture returns with active funds compared to passive ones.
• Investor Behavior is Key: The study emphasizes that investors can make ill-advised decisions with low-cost index funds just as they can make advisable decisions with active funds. The critical factor is how investors choose to deploy their capital and the context in which they do so.

Trading Activity and Investor Returns

• Proxy for Trading: Morningstar uses the volatility of cash flows into and out of funds as a proxy for trading activity, as they do not have direct brokerage data.
• Most Volatile Cash Flows (High Trading): Funds with the most volatile cash flows, indicating rapid and significant investor entry and exit, showed the widest gaps.
• Most Stable Cash Flows (Low Trading): Funds with stable, steady cash flows exhibited narrower gaps.
• Magnitude of Difference: The gap was roughly three times wider for the most heavily traded cohort compared to the least traded cohort. This was identified as one of the most notable and striking findings.

Fees and Investor Returns

• General Principle: The study reinforces the importance of "pinching pennies" and keeping fees low.
• Fee Level Impact: Slightly wider gaps were observed with the most expensive funds and ETFs. Conversely, cheaper funds, which attract the majority of assets, tended to have narrower gaps.
• Correlation with Volatility: A potential reason for the correlation between higher fees and wider gaps could be that managers charge higher fees for strategies that are more niche, have higher volatility, or employ unorthodox approaches, which investors tend to handle less effectively.

Return Volatility and Investor Outcomes

• Persistent Finding: The relationship between return volatility and investor capture has been a consistent and striking finding over the years.
• "Hotter" Funds, Wider Gaps: Funds with more volatile returns (the "hotter" they are to handle) lead to investors capturing less of the fund's total returns.
• Investor Reaction: High volatility can rattle investors, leading to inopportune buying and selling, which widens the gap.
• Less Volatile Funds, Narrower Gaps: Conversely, less volatile funds or ETFs tend to have smaller gaps, as investors are more likely to capture their total returns.

Context Matters: Retirement Accounts vs. Taxable Accounts

• "Gilded Cage" Effect: Retirement plans are described as "gilded cages" because their controlled environment limits frequent, discretionary transactions. This lack of opportunity to trade often benefits investors.
• Automation: Features like automated rebalancing and asset allocation adjustments in funds like target-date funds remove the need for manual investor intervention. This automation helps prevent investors from making detrimental decisions during market turbulence.
• Striking Finding: The context in which a fund is utilized is as important as the fund type itself.

Conclusion and Actionable Insights for Investors

Jeff Patac's primary takeaway for investors is "less is more."

• Minimize Transactions: The more buying and selling investors engage in, especially discretionary trading during market turbulence, the likelier they are to experience wider gaps between their dollar-weighted returns and their investments' total returns.
• Automate: Automate as many investment tasks as possible to reduce the need for manual intervention.
• Favor Diversification: Opt for wide diversification.
• Avoid Streaky Funds: Be cautious of very narrow, sector-specific funds, as they have historically proven difficult for investors to use successfully.
• Deliberate Context: Be thoughtful and deliberate about the context in which investments are placed.