At The Money: Don’t Underperform Your Own Investments!

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1:07and the actual returns investors experience. The difference between the two, it's a substantial performance gap driven in large part by investor behavior. I have the perfect person to discuss this with. Jeffrey Patak is the managing director at Morningstar. Previously, he was the chief ratings officer there. He joined Morningstar way back in 2002. So Jeffrey, let's start with the basics. What is the investor return gap and how large is it? Yeah. So first off, thanks so much for having me. I'm a big fan of the podcast. So the investor return gap is the difference between our estimate of the average return of a fund or a group of funds and that funds, it's total return, it's stated return.

1:56What's the difference between the two of those things? The former takes into account the timing and magnitude of cash flows that have come and gone to and from the fund over time, whereas a total return, which most of us are familiar with from popping it up, Bloomberg.com or Morningstar.com assumes an initial lump sum investment. And so when you compare the two of them, you can derive a sense of the impact of the timing and magnitude of buys and sells over time. To cut to the chase, when we estimated that for the trailing 10 years ended December 31st, 2024, we found that there's a 1.2 percentage point annual return gap compared to the fund's aggregate total returns.

2:35So in essence, what that meant is that the timing and magnitude of cash flows basically cost investors around 15 % of their aggregate total returns. That's unbelievable. That's a giant, giant shortfall. How do you calculate that gap? How do you figure out? I mean, it's easy to figure out what a fund, an ETF, a mutual fund is actually generating. How do you figure out the shortfall that individual investors are suffering? Yeah, great question. It's akin to an internal rate of return estimate. So we pull all US open end fund and ETF assets together. So that's their beginning net assets, their monthly net flows.

3:16So that's 120 monthly net flows that we impound into the calculation, as well as their ending net assets. We dump all of that into a calculation that derives essentially the constant return that would reconcile the beginning assets to the ending assets after taking those cash flows into account. All the data we use is data that Morningstar collects. So funds report their assets as well as their flows. And so we scoop that up and we plug it in. So what sort of funds does this include? I assume this is mutual funds and ETFs, anything else in the package? You got it. It encompasses US open and mutual funds as well as ETFs.

3:54It wouldn't include things like closed-end funds. In all, there were around 26 ,000 individual funds and ETFs that together held around$25 trillion in assets by the end of our study period. So it's quite a comprehensive study. I'm fascinated by the difference between time-weighted rate of returns for funds and asset-weighted returns. Explain the two, because really that makes a giant difference, doesn't it? It does indeed. Yes. Your listeners are probably familiar with time-weighted returns because that's what they'd encounter in their normal affairs. I mentioned earlier, if they were to pop onto Bloomberg.com or Morningstar.com, pull up a fund's performance, those are time-weighted return figures.

4:38The more popular powerlenses total returns. And a time-weighted return, it assumes an initial lump sum investments that's left untouched until the end of the period. It's sort of your classic buy and hold, Whereas a dollar weighted return that takes the timing and magnitude of investors purchases and sales into account, it doesn't assume people invest an initial lump sum and hold it to the end like a total return does. And so that's essentially the difference between the two measures. I've seen some interesting studies on hedge funds and on some ETFs where the time weighted return makes it look like a manager has done really well.

5:15And then when you see the dollar-weighted return, most of the assets tend to flow in after they've had a big run up, after the media has focused on them. Some hedge fund managers that look like they have great track records in terms of how well they've done for their investors are actually net losers over time. Do you see things that extreme when you're looking at this data? We do indeed, unfortunately. I will say in aggregate on balance, investors have gotten better. And we can talk about some of the reasons for that, about capturing more of their funds total returns than was formerly the case.

5:53But yes, we do see some of these vivid examples of investors schematically, they're buying high and selling low. Sometimes it's chasing behavior where investors pile in just as you described, after a fund goes in a strong run only for performance to roll over at which point they bail out, you know, and that can work in reverse where they sell before performance improves. Both of those things would dent their dollar weighted returns compared to the fund's total return. So it sounds like behavioral factors are a cause for investors suffering actually lower returns than their fund's total return.

6:32What other behaviors do you see that are a net negative? You know, I mean, I think that you sometimes it can be quite mundane where you will see an investor or someone, you know, representing them decide that they want to change the asset mix. And so it might not be in response to a particular funds performance. It could be that for whatever reason, they just decide that they want to be positioned differently. And so maybe they put more exposure on in an area that's outperformed and take some weight off in an area that's underperformed, only to see that wrong foot them over subsequent periods.

7:07And so those are the sorts of decisions, behaviors that can give rise to gaps. Yeah, mean reversion is a cruel mistress. That's right. What about different types of funds when we look at market cap size or geography, US versus international? How does the gaps form in those types of things? Yeah, great question, Barry. Those are some of the dimensions that we look at as part of the study. Sector equity funds have chronically suffered the widest gaps in absolute terms. In our most recent study, the average dollar invested in sector equity funds lagged the funds total returns by one and a half percentage points a year over the decade ended December 31st, 2020, which meant that investors failed to capture around 20 % of those funds aggregate returns.

7:55By contrast, we've seen the narrowest gaps among allocation funds, the most popular example of which are target date strategies. Those funds barely had an investor return gap over those 10 years ended December 31st, 2024. So the other thing I would note is that ETFs had wider gaps than traditional open-end funds. We include both in the study over the 10 years end of December 24. The average dollar invested in ETFs lagged the ETFs aggregate total return by around 1.7 percentage points annually, which is equivalent to around 18 % of the ETFs total returns. Open-end funds, by contrast, they had a narrower 1.2 percentage point per year gap over that timeframe.

8:35So ETFs are great in a lot of different ways. We just want to make sure that we use them in the most prudent fashion. That makes sense. ETFs are a trading vehicle for some people, and we know what the long-term results of most people's active trading is like. I'm curious, how do the international funds stack up against domestic funds in terms of the gap? Very good question. The gap was slightly wider for international funds than it was for domestic equity funds. So we found that there was a 1.1 percentage point annual gap, whereas for US equity, it was about half that. It was about half a percentage point, 0.6 percentage points to be precise.

9:18And what role does market volatility play in this gap widening? I recall earlier this year when the tariffs were rolled out in April, We saw a lot of frenetic activity. You can't help but look at that and imagine very few people got that right. Yeah, right you are. Our research has found a correlation at a couple levels. At an overall market macro level, as you allude to, market fluctuations do tend to push investors buttons. They're much liker to make changes to their holdings, and this can work to their detriment in dollar-weighted terms. We also look at this at an asset class level. So U.S.

9:57Equity international equity, taxable bonds, and on and on. We also find there that the more volatile funds of a particular type have been harder for investors to successfully use than less volatile funds. And so there are wider gaps with those too hard to handle funds that you would find in, say, US equity or taxable bond as compared to their more sedate counterparts within those asset classes. And so that's been another sort of perennial finding from the study is that volatility pushes investors' buttons. And when it does so, they tend to capture less of their funds' total returns. You mentioned target date funds.

10:36I tend to think of target date funds or balance funds typically in 401k or retirement plans, where most people have a tendency to set and forget and just dollar cost average on a regular basis with each paycheck. Jack, generally speaking, do we see less of a gap in retirement funds? Is it because of the specific long-term nature of target date funds or the fact that it's in a 401k or 403b? What's the advantage balance funds target date funds have? Yep. I would say there's two principal advantages. One is contextual. The other is related to the attributes, the characteristics of those strategies.

11:20Let's talk context first. They're most often used in the context of a retirement plan. It's a gilded cage of sorts. It's really meant for investors to go in and save and compound over time, not for them to wheel around as they might in a brokerage account. Then let's talk about the characteristics of those vehicles. As you reference, they're highly automated. They take care of rebalancing. They adjust the asset mix as time goes on. They are, as you put it, set it and forget it. And that has worked to investors' benefit. We found that investors in allocation funds, they captured essentially all of their funds' total returns.

12:00That is, there was almost no gap among allocation funds over the 10-year study period that we were focused on. And so I think that's one of the most heartening stories to come out of our research is the fact that it seems that investors in retirement plans, or specifically those who invest in allocation funds, have enjoyed some of the greatest success, and that's crucial to their retirement security. So give investors some practical advice. What sort of steps can they take to minimize the gap, capture more of their investing funds' long-term returns? Yeah, it's a great question. So it might sound a bit trite, but I would say have a plan and automate as much of it as you can.

12:40Investors, they tend to get themselves in trouble when they engage in off-cycle discretionary ad hoc type of trading. When might that happen is you can probably imagine it's likelier to occur when there's some sort of market disruption or tumult or a minimania. But if you have a plan and you've appropriately allocated your assets based on that plan, widely diversifying across asset, then you have an anchor or a point of orientation, whereas without it, you might feel like you're at sea. Also, because you've spread out, per the plan, diversifying widely, you're less likely to experience the full brunt of a sell-off and experience the kind of ruinous outcome that might induce panic.

13:21Automating is the other key. I would say what we know about target date funds is they're held in retirement plans, yes, but also they obviate the need for investors to take action to rebalance or to adjust the asset mix as they near the retirement date. And that's because those features are built in. So I think one of the other clear takeaways from the research is that automation narrows gaps. So to wrap up, investors can avoid the investor gap. They can avoid underperforming their own mutual funds and ETFs by simply having a couple of common sense steps put into place. Don't let volatility distract you.

14:02Don't try and buy or sell when markets get frothy. Don't think you're going to be able to time the market. And perhaps most important of all, you have to have a plan and you have to be able to keep your emotions at bay. Otherwise, you're going to fall into the unfortunate fate of underperforming your own investments. I'm Barry Ritholtz. You're listening to Bloomberg's At The Money.