Paper Tigers
A decade ago, Morningstar popularized the existence of the "investor gap": the difference between how funds perform on paper and how they perform for their owners.
If a $10 million fund gains 15% per annum for four years, is rewarded at the start of its fifth year with $50 million in sales, and then declines 15% over the next 12 months, its official five-year total returns will be 8.2% annualized. That number will be printed in the prospectus and on morningstar.com. In aggregate, though, that fund will have lost more dollars for its shareholders than it made. The return on the average dollar in the fund, aka Morningstar Investor Return, will be negative.
That, of course, is a dramatic example, simplified for illustration purposes. In real life, few funds with healthy, positive total returns outright lose money for their shareholders. More likely, a fund with an 8.2% annualized gain has an investor return that falls modestly short of that mark--for example, landing at 7.2%. Morningstar calls the difference between the former and the latter--the space between the official total return and the investor return--the investor gap. In this example, the gap is negative 1%.
The investor gap isn't a very useful indicator for single funds because it's unstable. In the initial example, the investor gap quickly shifted from zero (the fund's first four years, when money was neither flowing in nor out) to deeply negative (after year five). Had the fund enjoyed a fifth straight bull year by gaining 20%, though, the investor gap would have been positive. Thus, for a reason that is out of shareholders' control--the fund's performance in year five--the investor gap can fluctuate widely. The gap is, however, fairly instructive for larger groups of funds, where the instability is dampened. Below are the gap's lessons:
1. In Aggregate, Investors Mistime Their Trades
For either investment categories or fund families, the investor gap is almost always negative for longer time periods. A negative figure means that, on the whole, investors are getting their trades wrong. They are buying when they should be selling, or selling when they should be buying. Of course, there are many exceptions, but the general pattern consistently holds true.
2. The Problem Owes More to Asset Allocation Than to Fund Selection
If investors were poor at selecting funds of a given investment category, then the category's largest funds, where most investors have placed their bets, would lag smaller funds. However, the opposite holds true. In most years and in most categories, the asset-weighted average, which is dominated by the giant funds, outperforms the conventional equal-weighted average. Big funds fare well.
Unfortunately, investors are betrayed by their restless allocation decisions. Allocation trades take two forms. One is the active version, when an investor sells off a losing fund and reinvests into a winner. Generally, this is a closet asset-allocation decision, as the new and old funds occupy different investment categories. The other is the passive version, when investors put cash to work--all too often in a hot investment sector that subsequently cools.
We see evidence of this behaviour in Asia. Investors here have ploughed money into fixed income; US fixed income in particular, in recent years after a period of strong performance in these markets and historically compressed yields. In contrast they have shunned emerging markets and Asian equities, due to recent historical performance lagging developed markets. Asian investors don’t appear to be an exception to the generally observed market behaviour of buying asset classes which have had a strong run and selling those with poor returns. The recipe for a poor investor return.
3. The Gap Generally Is Larger for Riskier and/or More Specialized Funds
Volatility begets action. Stable, predictable fare such as target-date funds, high-quality bond funds, and blue-chip stock funds tend to be bought and held. Sector funds, emerging-markets funds, and gold funds, on the other hand, are frequently traded. Sometimes that's because they were bought speculatively with the intention of being flipped. Other times, the investor truly intended a long-term purchase but sold early after being spooked by a heavy loss.
4. The Gap Grows With Uncertainty
Nothing sparks redemptions like unexplained poor performance. It's one thing to watch a fund's net asset value slide when the reason is understood, as with an index fund that follows its benchmark downward during a bear market. (Greater transparency is one reason index stock funds have lower redemption rates than do actively run stock funds.) It's another thing altogether to suffer through a mystery slide. Investors bail rapidly from funds with opaque portfolios, such as bond funds with large derivative positions. They also show little patience for funds following complex alternative strategies.
5. The Size of the Gap Varies by Fund Family
Fund companies cannot eliminate the investor gap, but they can do things to minimize its effect:
- Offer relatively conservative funds
- Close hot funds
- Consistently promote the entire family lineup rather than a handful of popular funds
- Encourage a long-term holding period
- Improve transparency and shareholder communications
Each of these steps reduces shareholder turnover, which in turn reduces the size of the investor gap.
That final item cuts both ways. Fund families that have low investor gaps tend to be fund families with happy shareholders, as their shareholders have enjoyed good investment experiences by capturing nearly all their funds' paper profits. Happy shareholders beget additional fund purchases and also lead to positive word of mouth that brings in new business. In other words, fund companies that do well for others do well for themselves.
