Christopher Traulsen and Christine Benz explain how, through fund-hopping, investors frequently miss out on good performance, causing investor returns from a particular fund to differ greatly from the fund's annualised total return
Do your clients own a fund that has done particularly well over the past decade? If so, how much of that gain did they receive? The question is not academic. While some investors will have participated in the full return of a fund over the stated period, many will not. That is because the unfortunate natural tendency of investors is to want to chase performance - many are attracted to funds that have strong past performance, and tend to bail out in the face of big losses. As a result, they earn substantially less than they could from their funds.
To help investors and advisers gauge the extent of damage such behaviour can cause, Morningstar will soon introduce its 'investor return' concept to the UK. Investor returns offer a new way of measuring fund performance. In contrast to the usual total return metric, investor returns shed light on the extent to which investors' timing affects their returns. If our experience in other markets is any guide, investor returns should tell a story about the effect volatility has on shareholders and reveal something about a fund house's stewardship of investor assets.
Morningstar Investor Return, also known as asset-weighted return, factors in the timing of investors' purchases and sales. It takes into account the fact that not all of a fund's investors bought it at the beginning of a period and held it until the end. Therefore, investor return depicts the return earned by the fund's typical investor. To use a simple example, assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year's first quarter. If investors added substantial sums of money to the fund after its first-quarter run-up, the fund's investor return for that year would be lower than the fund's 10% total return.
Evidence supporting poor timing
In the US market, where investor returns have been run for some time, there is solid evidence to support the anecdotes about investors' poor timing. Although most Morningstar US fund categories' total returns and investor returns were fairly close to one another over the past three and five-year periods, the gap between the two widened substantially over the trailing 10-year period. That is likely because the 10-year period encompassed the late 1990s TMT bull run, as well as the bear market, and both extremes tended to stimulate poor decision-making.
In fact, in all but six of the 69 Morningstar fund categories in the US, 10-year investor returns lagged the total returns of the funds. The divergence was, in several cases, quite striking. For example, technology-sector funds on average generated annualised 10-year total returns of 7.2% - not great, but not absolutely terrible, either. But investors have, in aggregate, had a terrible experience in these funds, losing an average of 3.6% on an annualised basis over the past 10 years. In other words, the typical technology fund investor over the past 10 years fell short of the category's total return by more than 10 percentage points per year. It was a similar story for growth funds, which generally posted 10-year investor returns that fell far short of their total returns. Ditto for Latin America, communications and healthcare funds.
A closer look at ING International SmallCap C (a US-sold offering) reveals an all too familiar pattern. The fund has an impressive 10-year total annual return of 17.33%, but its 10-year investor return shows the typical investor in the fund endured an annualised loss of 0.24%. The fund's net cashflow tells the story of the discrepancy. Investors piled into the fund during its run-up in 1999 and early 2000, and then fled as the fund's returns plummeted in ensuing years. Investors were still leaving as it rebounded and were not around to recoup their losses.
The disastrous investor returns of high-octane growth and technology funds led to a closer look at the role played by fund volatility even within the same category. That is, do the investor returns of funds that invest in the same area of the market correlate with their volatility levels? In an effort to determine whether high-volatility funds tend to stimulate poor investor decision-making, all of the funds in each of the US Morningstar categories were grouped into quartiles based on their standard deviations.
From there, it was determined whether the low-risk quartile posted better investor returns over the past 10 years than the high-risk quartile. The answer was a resounding yes. In every diversified domestic equity category, the investor returns of the low-volatility group trounced those of the high-volatility group. It is worth noting that in many cases the low-volatility group had better total returns (that is, not accounting for asset inflows and outflows) than the high-volatility group, so naturally the investor returns of the former are also better than those of the latter.
But even where the high-volatility funds had better total returns than the low-volatility funds, the low-volatility group produced superior investor returns. The link between high volatility and poor investor returns (and lower volatility and better investor returns) makes intuitive sense. After all, high-volatility funds often exhibit large short-term gains, which in turn entice investors. But such offerings often take outsized risks to score those gains and when performance drops off, investors often sell at just the wrong time. Low-volatility funds, by contrast, tend not to attract fickle short-term investors with explosive gains and also do a better job of protecting shareholders' capital during downturns. In turn, they inspire investors to hang on - or perhaps even add more to their holdings - during the lean times.
In fact, a fund's investor return can say a lot about its stewardship. While a fund company has no direct control over how investors use its funds, it can certainly exert significant influence. Some fund houses put out lots of trendy funds that tend to attract investors chasing whatever is hot, and otherwise do little to encourage a long-term investment perspective. Those are not particularly shareholder-friendly trends and they tend to result in relatively poor shareholder returns.
On the other hand, most funds with consistently superior investor returns are from shops that encourage long-term investing and discourage short-term trading.
The table below shows a sample of popular fund families in the US, ranked by asset flows, and their corresponding investor and trailing total returns for the past 10 years. A 'success ratio' is created by dividing investor return by total return - the higher the success ratio, the better the overall investor experience. The table also lists the range of stewardship grades (a measure assigned by Morningstar qualitative analysts to reflect the degree to which the fund's management appears to focus on delivering a good investor experience) of the funds within each fund house. Notably, houses with A and B grades tend to have high success ratios.
Also evident in this table is the correlation between a strong success ratio and asset flows. The fund families that have been attracting large amounts of net asset flow are ones that provide a strong investor experience. Conversely, fund families with net outflows are also those with a very low investor yield. After so many investors felt burned by the early 2000s, it appears that many are now favouring investor-friendly fund families that consistently produce superior investor returns.
So should investors automatically avoid funds with poor investor returns relative to their total returns? Not necessarily, but poor investor returns can be a red flag that a fund may be too volatile to use to advantage. On the flipside, the funds with the best investor returns use prudent, low-risk strategies and place a premium on not losing money. Investor returns do not paint a complete picture, but they can help provide context for setting client expectations and clearly show the risks of chasing past performance. For more on Morningstar Investor Return, download the methodology paper at http://advisor.morningstar.com/uploaded/pdf/ir.pdf.
- Christopher Traulsen is Morningstar UK's director of fund research, and Christine Benz is Morningstar's director of fund analysis.
- Because of timing, investor experience tends to lag performance numbers;
- Focusing on investor return can help investors avoid losses.
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