Why There's a 15% Gap Between Investor and Fund Returns

Advisors looking to persuade clients to avoid trying to time the market might point them to a new Morningstar report estimating that investors missed about 15% of their funds’ total returns for the decade ended December 2023.

Even thoughtful, steady investors can experience a lag between their total returns and fund performance, the research firm noted.

Morningstar estimates that the average dollar invested in U.S. mutual funds and exchange-traded funds earned 6.3% a year over that period, underperforming the average fund by 1.1 percentage points per year, assuming an initial lump-sum investment. Fund holdings generated about 7.3% a year, which Morningstar calls the buy-and-hold return.

The firm attributed the gap to mistimed buying and selling of mutual fund and ETF shares.

“In other words, investors failed to capture around 15% of their funds’ total returns, with that shortfall owing to the timing and magnitude of their purchases and sales,” Morningstar said in its annual “Mind the Gap” report, released last week.

“The gap was persistent. We found shortfalls between the average dollar’s return and the average buy-and-hold return in all 10 of the calendar years that comprised the 10-year study period,” Morningstar said.

“Investors particularly struggled to navigate 2020′s turbulence, adding monies in late 2019 and early 2020, then withdrawing nearly half a trillion dollars as markets fell, only to miss a portion of the subsequent rally.”

The gap reached negative 2% in 2020, Morningstar said.

Index mutual funds, meanwhile, produced almost no gap.

Consistent with prior findings, Morningstar found that allocation funds, which diversify assets widely across classes, produced the narrowest gap, at negative 0.4% a year. This suggests that investors have had more success using simple funds that automate routine tasks like rebalancing, the firm said.

“That means less transacting, and less transacting appears to have conferred higher dollar-weighted returns than otherwise,” Morningstar wrote.

Allocation funds are often used in defined-contribution plans, which mechanize investing, avoiding the potentially large timing costs investors can incur when making large, ad hoc transactions, the firm concluded.

“Conversely, sector equity funds had the widest gap — negative 2.6% gap annually — with at least some of that gap owing to the funds’ higher volatility, which our research suggests can trip up investors,” Morningstar said.

Comparing active funds with index funds, the firm found the gap was slightly wider for the average dollar invested in active funds — a negative 1.2% gap per year — than index funds, which produced a negative 0.8% gap.

“While index mutual funds had almost no gap, the average dollar invested in index ETFs lagged the buy-and-hold return by more than 1 percentage point a year, a difference worth monitoring,” Morningstar said. The firm questioned whether ETFs’ convenience in the ability to buy and sell them like stocks comes at a cost.

The study spanned more than 20,000 fund share classes that accounted in aggregate for more than $12 trillion in net assets at the start of the 10-year period and nearly $21 trillion by the end. Investors withdrew a net $1.9 trillion in net assets from the funds included in the study over the decade ended Dec. 31.

Among other findings:

• U.S. stock funds earned the highest investor return, 10.0% per year, a negative 0.8% gap, and alternative funds the lowest at negative 0.2% annually, a negative 0.6% gap.
• Among the largest fund categories by assets, the foreign large-blend category boasted the narrowest gap, 0.0% per year, and large-value funds the widest, a negative 0.9% shortfall annually.
• Open-end funds earned a 6.1% investor return per year — a negative 1.0% gap — versus 6.9% for ETFs — a negative 1.1% gap.
• Gaps were generally narrower for open-end funds than ETFs even when Morningstar controlled for asset class.
• The average dollar invested in index funds earned a 7.6% annual return — a negative 0.8% gap — compared with 5.5% per year in active funds — a negative 1.2 % gap.
• While there was a 0.2% annual gap for index mutual funds over the 10-year period, that wasn’t true of index ETFs, where the average dollar earned 1.1% less per year than the buy-and-hold return.

Poorly timed investor moves aimed at timing market highs and lows weren’t the only factors involved in the lag between fund and investor returns, Morningstar said.

“… Even laudable practices like investing a portion of every paycheck or regularly rebalancing can open a gap between investor results and reported total returns,” the firm wrote. ”Given that nuance, it’s not advisable to view this study’s findings as a parable of ‘dumb money’ or evidence of individual investors’ fallibility.”

Investors redeemed assets amid improving performance or added assets as returns eroded more often they did the reverse, Morningstar said.

“For instance,” according to the report, “investors appear to have incurred heavier timing costs in 2020, adding assets before the market slid and then withdrawing monies only for markets to rally over the ensuing months.”

In theory, dollar-cost averaging won’t usually lead to better results compared with buying and holding “because market returns are positive more often than not. Given that, it’s not too surprising that investor returns lagged total returns in most category groups when we assumed that the investor dollar-cost averaged,” Morningstar said.

Morningstar also found that timing costs appeared to be loosely correlated with fund fees, while the firm saw a stronger connection with fund volatility.

“The more volatile a fund’s returns were compared with peers, the larger its investor return gap tended to be, on average,” the report said. “The average dollar invested in the most volatile quintile of sector equity funds lagged the buy-and-hold return by more than 7 percentage points per year.”

Morningstar’s findings are largely in line with the four previous rolling 10-year periods in prior studies.

The study excluded any funds launched after Jan. 1, 2014.

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