An annual report from Morningstar found that fund investors earned a 6.3% annual dollar-weighted return over the past 10 years — an annual gap of about 1.1 percentage points compared to the total returns generated by those funds.
In general, investors who abuse the market—adding funds immediately before returns decline or withdrawing assets and missing out on improving returns—account for the gap between the investors' dollar-weighted returns and the funds' total return.
Morningstar found that the gap persisted in all 10 calendar years of the study, but was most pronounced in 2020, when the margin was -2.0%. In that year, investors were adding money to the funds until January 2020, but when COVID appeared, many investors pulled the funds in the spring, only to lose when the markets started to recover. By the time some investors reallocated, they had lost 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 largest percentage of total fund returns.
“Less is more,” said Morningstar chief ratings officer Jeffrey Ptak, lead author of the report. “Investors seem to be more successful by choosing simpler, inclusive strategies rather than using building blocks. Why is that so? There is less for them to do. There are fewer moving parts. Less maintenance is required.”
Things like target date funds rebalance automatically and require fewer transactions from investors. In addition, such vehicles encourage investors to buy and hold rather than trying to time the market.
“You can also think of investor success as a function of context,” Ptak said. “Where do we see the allocation funds being used more? It is in the framework of pension plans. Think of 401(k)s as a gilded cage. It's a more controlled environment. It is not designed for people to come in and make frequent trades. It's designed to make regular contributions and leave your money alone so it can compound. So, in a sense, the allocation funds are the beneficiaries of that.”
Broken down by category, US equity funds fared best, earning a 10.0% annualized dollar-weighted return (a -0.8% gap. Alternative funds were the only category group in which the dollar average lost money during decade, as it posted an annualized return of -0.4% to investors versus a total return of 1.0%.
The category with the largest gap was “sector equity” funds, where investor returns dwarfed total returns by 2.6 percentage points.
“Narrower, more volatile strategies are inherently more difficult for investors to use,” Ptak said. “They shake more. And what we've found is that investors have a harder time dealing with that kind of volatility. … Sometimes, with these more volatile strategies, they'll have a big return and you'll be salivating over it, but it's worth bearing in mind that there's another side to that kind of performance. And one thing we've noticed is that investors have struggled to navigate those peaks and valleys and so they haven't captured the total returns of those strategies.”
For the first time, Morningstar separately evaluated the returns of open-end fund and ETF investors. The firm found that open-end funds posted an annual investor return of 6.1% (for a -1.0% gap) while ETFs posted a 6.9% return for ETFs (-1.1% gap).
The study also found that there was no strong relationship between fees and investor return gaps. This suggests that “cost may depend on other factors – such as the simplicity of a fund, the context in which it is used and the maintenance it requires – when it comes to capturing a fund's full return,” according to the report.
“We've seen examples of very cheap fund categories where, for various reasons, investors have mistakenly bought and sold, resulting in a huge shortfall,” Ptak said. “So yes, grab the pennies, but don't expect that alone to prevent you from missing out.”
Morningstar's Mind the Gap Study. compares the funds' dollar-weighted returns to their time-weighted returns to see how large the gap or difference has been over time. The firm uses a portfolio-based methodology to combine fund flows at an aggregate level. This method combines all monthly flows and assets from a given category or group of categories into a portfolio to better capture investors' asset-weighted returns.