An annual report from Morningstar found that fund investors earned a 6.3% per year dollar-weighted return over the past 10 years—a roughly 1.1 percentage point annual gap compared to the total returns generated by those funds.
In general, investors mistiming the market—adding funds right before returns decline or withdrawing assets and missing out on improving returns—accounts for the gap between investors’ dollar-weighted returns and fund total returns.
Morningstar found the gap persisted in all 10 of the study's calendar years but was most pronounced in 2020, when the margin was -2.0%. In that year, investors were adding money to funds as late as January 2020, but when COVID emerged, many investors withdrew funds in the spring, only to miss out when markets began to rebound. By the time some investors reallocated, they had missed some of the rally.
One takeaway from the report is that diversified, all-in-one allocation funds have the best track record of investors capturing the greatest percentage of funds’ total returns.
“Less is more,” said Morningstar Chief Ratings Officer Jeffrey Ptak, the report’s primary author. “Investors seem to be more successful opting for simpler, encompassing strategies instead of using building blocks. Why is that? There is less they need to do. There are fewer moving parts. There is less maintenance required.”
Things like target-date funds automatically rebalance and require less transacting from investors. In addition, such vehicles encourage investors to buy and hold rather than try to time the market.
“You can also think about investor success as a function of context,” Ptak said. “Where do we see allocation funds being used the most? It’s in the context of retirement plans. Think of 401(k)s as a gilded cage. It’s a more controlled setting. It’s not designed for people to go in and make frequent trades. It’s set up to make regular contributions and leave your money alone so it can compound. So, in a sense, allocation funds are the beneficiary of that.”
Broken down by category, U.S. stock funds fared the best, earning a 10.0% per year dollar-weighted return (a -0.8% gap). Alternative funds were the only category group in which the average dollar lost money over the decade, as it posted a -0.4% annual investor return vs. a 1.0% total return.
The category with the greatest gap was “sector equity” funds, where investor returns trailed total returns by 2.6 percentage points.
“More narrow and volatile strategies are inherently more difficult for investors to use,” Ptak said. “They rattle around more. And what we have found is that investors have a harder time coping with that sort of volatility. ... Sometimes, with these more volatile strategies, they will pop off a huge return, and you will salivate over that, but it’s worth keeping in mind there’s a flip side to that type of performance. And one thing we have observed is that investors have struggled to navigate those peaks and valleys and so they have not captured those strategies’ total returns.”
For the first time, Morningstar separately evaluated the investor returns of open-end funds and ETFs. The firm found that open-end funds posted a 6.1% investor return per year (for a -1.0% gap) while ETFs posted a 6.9% return for ETFs (-1.1% gap).
The study also found that there was not a strong link between fees and investor return gaps. That suggests “cost can be subordinate to other factors—like a fund’s simplicity, the context in which it’s used, and the maintenance it requires—when it comes to capturing a fund’s full return,” according to the report.
“We have seen examples of very cheap categories of funds where, for various reasons, investors have mistimed purchases and sales, resulting in a large shortfall,” Ptak said. “So, yes, pinch pennies but don’t expect that alone will prevent you from shortfalls.”
Morningstar’s “Mind the Gap” study compares funds’ dollar-weighted returns with their time-weighted returns to see how large the gap, or difference, has been over time. The firm uses a portfolio-based methodology for combining fund flows to an aggregate level. This method combines all the monthly flows and assets from a given category or category group into one portfolio to better capture investors’ asset-weighted returns.
