Investors and their financial advisors often assume that a consistent investing approach based on regular contributions and dollar-cost averaging will lead to superior outcomes over time — and that pursuing the lowest-cost funds available will do the same.
However, according to research recently released by Morningstar, these widely lauded investing techniques are not actually associated with better returns. While helpful as far as they go, the analysis posits, such behaviors are also associated with some classic investing mistakes that wind up short-changing clients' portfolios.
As Jeff Ptak, Morningstar's chief ratings officer, explained during a recent webinar about the new research, investors should not assume that "mere penny-pinching or indexing" will necessarily translate to superior dollar-weighted returns.
"While it's laudable to keep costs to a minimum and invest passively through diversified index funds or ETFs, we didn't find that these practices necessarily prevented wide gaps from forming between these funds' dollar-weighted and total returns," Ptak explained.
Timing Issues
By total returns, Ptak is referring to the return that would be generated by an investment fund or strategy were it to be funded up front, with a lump sum that was left to ride out the full investment period and without additional trades or contributions.
"This suggests that timing issues plagued even those who had emphasized low costs and a passive approach," Ptak said. "Some of this owes to circumstance — that is, investors allocating capital to low-cost passive funds in a recurring way as part of a long-term strategy, only to see returns deteriorate."
But, according to Ptak, it appears likely that some of the performance gap experienced by those who invest based on recurring contributions owes to other preventable factors, such as investors' propensity to chase returns.
While he is not arguing that investors should abandon a contribution-based approach, given its practicality and other virtues, Ptak argued that advisors and their clients should nonetheless be mindful of the potential for poorly timed purchases and sales of fund shares to rob them of substantial returns.
The Problem With Dollar-Cost Averaging
Morningstar's study shows dollar-weighted returns (also known as investor returns) tallied roughly 6% per year on the average dollar invested in mutual funds and exchange-traded funds over the trailing 10 years ended Dec. 31, 2022.
This is about 1.7 percentage points less than the total returns their fund investments generated over the same period. This shortfall, or return gap, stems mainly from poorly timed purchases and sales of fund shares, according to Ptak.
The timing issues cause investors to miss out on roughly one fifth of the return they would have earned if they had simply bought and held, according to the analysis.
"When you stop and think about it, this performance gap almost seems inevitable for investors who are moving into a fund over time," Ptak explained. "If you have your assets flowing into the fund before returns accelerate, that's going to be good for your dollar-weighted returns. On the other hand, if you have an outflow before returns improve, the opposite happens."
