Why Investors Earn Less Than Their Funds, and the Small-Cap Surge

0:04Jeff Ptak:Why investors earn less than their funds and the small cap surge. This is the Saturday personal finance edition of Motley Fool Money.

0:19Jeff Ptak:I'm Robert Brokamp and this week I speak with Morningstar's Jeff Ptak about research which finds that fund investors earn lower returns than the funds themselves. But first, let's hit a few highlights from last week in money. You know, the overall stock market has spent the past year and a half hitting new all-time highs. It did run into a significant speed bump earlier this year, but then rebounded and hit even higher new highs. But not all stocks have been setting new records, most notably small-cap stocks. That is, until recently. On September 18th, the Russell 2000 finally eclipsed its previous high set in 2021.

0:52Jeff Ptak:It rose a bit higher on Monday of this past week, then ended the week lower. But there's no doubt that smaller stocks have closed out the summer strong. Since August 1st, the Vanguard 500, which of course tracks the S &P 500, has returned 6.2%. The Invesco QQQ ETF, which tracks the NASDAQ 100, has returned 7.2%. Meanwhile, the Vanguard Russell 2000 ETF has returned 11.3%. And the iShares Microcap ETF, which tracks the Russell Microcap Index, has returned 15.7 % as of the market's close on September 25th. Now, the reason for this outperformance could be just valuations. Just about any type of stock is cheaper than U.S.

1:34Jeff Ptak:large caps, especially of the growthier and techier variety. According to Yardini Research, the forward P.E. ratio for small caps is 15.7 compared to 22.6 for the S &P 500 and 30.3 for the Magnificent 7. But it's also likely due to the belief that rate cuts from the Fed will benefit smaller companies, which tend to rely more on credit. The companies are often too small to issue bonds, so they have to turn to banks to get loans with floating rates, which will likely head lower since the Fed cut the target for the Fed funds rate last week, as had been expected, and suggested we could see a couple of more cuts this year.

2:10Jeff Ptak:For our next item, we turn to a provision of the one big beautiful bill that was passed on July 4th, and that is the no tax on tips. As is often the case when a bill becomes law, the folks at the Treasury Department have to spend some time sort of hammering out the details. And they recently released some preliminary regulations. So for those of you who earn tips or, you know, may have noticed how we're all asked to give tips, here's what we know about who's getting a tax break. Eligible workers will be able to deduct up to$25 ,000 in qualified tips per tax return. They won't need to itemize their deductions.

2:42Jeff Ptak:They can take the standard deduction and still deduct the tip income. but married folks will have to file jointly to get the deduction. Note that the deduction will just reduce federal income taxes, not payroll taxes, so Social Security or Medicare taxes. And individual states may or may not go along with Uncle Sam in offering this deduction. Eligibility for the deduction begins to phase out and adjusts the gross income of$150 ,000 for singles,$300 ,000 for married folks filing jointly. So, you know, those limits are pretty high. Most workers will be eligible. In fact, according to the Yale Budget Lab, 37 % of tipped workers earn so little that they don't even owe any federal income taxes, so this new provision won't really benefit them.

3:20Jeff Ptak:Only tips that are voluntarily given are eligible, so any tip that is automatically added to a bill is not. Most jobs that regularly receive tips will qualify. If you're curious if yours made the cut, check out the preliminary list of 68 qualifying occupations that the Treasury Department published at treasury.gov. By the way, podcasters are eligible, just saying. Keep in mind that these are proposed regulations. The final rules will be issued after a period of public comment, but they're not expected to change much, if at all. And now for the number of the week, which is 0.75%. That is the difference, or spread, in yields between investment-grade corporate bonds and treasuries of comparable maturities.

4:01Jeff Ptak:That is the smallest spread since 1998. What does it mean? Well, corporate bonds are riskier than treasuries, and investors normally require extra yield to compensate for that risk. The fact that investors aren't really requiring that much extra yield is a sign that they're very optimistic, perhaps even exuberant. Practically speaking, it might suggest that you should tilt your portfolio more towards treasuries if you feel that the extra yield from corporates isn't worth it, especially for bonds held outside of retirement accounts and you pay state income taxes because income from treasuries is not taxable at the state level.

4:34Jeff Ptak:But there's another possible explanation for such a narrow spread. Perhaps bond investors no longer see treasuries as safe as they used to be, and they're now getting priced closer to investment-grade corporates. Next up, which investors are least likely to capture their fund's actual returns when Motley Fool Money continues?

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6:02Jeff Ptak:When evaluating a fund, one of the first sets of numbers you'll likely look up is its past returns, but those may not be the returns that the owners of the fund actually earned. That's one of the lessons from Morningstar's annual Mind the Gap study. And here to talk about it is Jeff Patek, Managing Director for Morningstar Research Services. Jeff, welcome to Motley Fool Money.

6:20Robert Brokamp:Well, thanks so much for having me. It's a real pleasure.

6:23Jeff Ptak:So let's start with you explaining what the Mind the Gap study is attempting to measure.

6:28Robert Brokamp:Absolutely, yeah. So the familiar total returns that you just referenced, what that assumes is an initial lump sum investment. It's made at the beginning of horizon, held to the end of the horizon, and basically you're measuring the difference between the ending and the beginning value. Dollar-weighted returns are different. They take into account the timing and magnitude of cash flows along the way. And in that sense, they're a little bit more real life. As we know, we don't necessarily go and dump all of our money in at the beginning of some horizon. We might leg in or just circumstances might lend themselves to a more regular set of cash flows in and out of an investment.

7:08Robert Brokamp:And so what we're trying to measure with a dollar-weighted return is the return of the average dollar that's invested in a given investment. And then we can compare that to the time-weighted return, the total return that we're all familiar with. And the difference should give us a sense of the impact of the timing and magnitude of cash flows, buys and sells along the way.

7:27Jeff Ptak:How is it calculated? I imagine it's very complicated because you looked at more than 25 ,000, both traditional open and traditional mutual funds and ETFs. So how do you figure all that out?

7:38Robert Brokamp:That's a great question. So it's complicated and it isn't. It's complicated in the sense there's a lot of funds, as you mentioned, to corral. But once we've corralled them, then you're really talking about three numbers. The beginning net assets of that aggregate of funds, the cash flows, so inflows and outflows on a monthly basis over the period of time that we examine. In the case of our most recent study, it was the 10 years ended December 31st, 2024, and then the ending assets. So it's what those funds held by the end, December 31st, 2024. And with those three numbers, you are estimating the internal rate of return, which is a calculation that probably some of your listeners are familiar with.

8:19Robert Brokamp:You know, through their different walks of life, it's probably most sort of familiar in sort of a private equity context rather than a mutual fund context. But that's the calculation that we're running to try and estimate the constant rate of return of the beginning assets, the intervening cash flows to arrive at the ending assets.

8:38Jeff Ptak:So 30 ,000-foot view here, what are the results of the most recent version of the study?

8:43Robert Brokamp:Yep, good question. So we found that there was a little bit more than a one-percentage point gap between the return of the average dollar invested in funds and those funds' aggregate total returns. And so, you know, you sort of do the math on that. It works out to around 15 % of the total returns weren't captured. And why is that? I mean, we can only infer, but it boils down to the timing and magnitude of cash flows. I would say that if we wanted to think of it in sort of the most kind of caricaturized way, it's sort of buying high and selling low. As we might talk about, it can be circumstantial.

9:22Robert Brokamp:There could be reasons why people buy in the quantities and at the times that they do. And it might not reflect sort of impulse or the sorts of behaviors that we would frown upon. Could just be sort of the situation that they're in and things not quite going their way. and therefore them not capturing all their funds total returns. But that's the way the math work for purposes of our most recent study.

9:43Jeff Ptak:So as you say, it's a little over 1%. The gap was actually specifically 1.2%.

9:47Robert Brokamp:You got it.

9:48Jeff Ptak:And some people might think, well, that's no big deal. But as you say, it reduced total return by 15%. You compound that over, and that's over 10 years, compound that over 20, 30 years, you're talking about not having anywhere from 20 to 30 % as much because the returns are lagging, sometimes for obvious reasons, but sometimes it could be because people are making, shall we say, suboptimal decisions about when to get in and out of a fund. Exactly. It's real money. It's real money. All right. So let's get into some of the areas where you found the biggest gaps, starting with the volatility of the cash flows.

10:21Robert Brokamp:There's a lot of different lenses that we look at funds through and trying to get a sense of what it is that might have been affecting investors and keeping them from capturing as much of their funds total returns as they possibly could. One of those dimensions is cash flow volatility. Basically, what you're looking at is the standard deviation of inflows and outflows to a group of funds. We grouped them from the funds that had the most volatile cash flows to those that had the least volatile cash flows. Cash flows in this context was proxying for trading activity. The most volatile cash flows we would associate with the most trading activity and the opposite for those that had the least volatile cash flows.

10:58Robert Brokamp:What we found is there was a meaningful difference even controlling for a number of factors between funds that had the most volatile cash flows and those that had the least volatile cash flows, those that had the most volatile cash flows, there was a much larger gap between those funds, dollar-weighted returns and their total returns, whereas we found with funds that had more stable cash flows, investors were more successful in capturing their funds' total returns. And so, from that inference, we can infer something else, which is the more investors do, in this case, in a transactional sense, the more buying and selling they do, the less they tend to earn of their fund's total returns.

11:35Robert Brokamp:And so, if there's a takeaway there, do less, stay still, try to hold the line on transacting. Transacting is an inevitability for a lot of us, just things happen. But what can be particularly hazardous is discretionary ad hoc trading. That's where people can really get themselves into trouble with buying high in selling low in the stereotypical sense.

11:57Jeff Ptak:So you looked at the volatility of the money that's coming in and out of the funds, but you looked at the volatility of the funds themselves. Exactly. And how did that seem to correlate to the gap between the total returns and the investor returns?

12:09Robert Brokamp:Yeah, it's a real good question. It was a similar sort of story. The more volatile a fund's returns were, the more trouble, the more difficulty investors had in capturing its total returns. If we think about it, sort of stepping back, One of the things that volatility can do is push our buttons as investors. And it's not just in fleeing it. It's also in certain cases, you have a volatile fund. Maybe it puts up a big number. You chase its performance. In effect, you buy high. You're buying just before performance rolls over. When you see those wider amplitudes of performance, I think that there's just a greater propensity for investors to act in ways that we might consider to be rash or inadvisable.

12:50Robert Brokamp:And so those funds that had the more volatile returns, there were significantly wider gaps between the dollar-weighted returns, that is the return of the average dollar invested in those funds and those funds' aggregate total returns, and then the opposite for funds that were less volatile. Even after controlling for a number of factors, investors appeared to have more success in capturing those funds' total returns. And what is that about? It's the absence of noise. It's them tending not to push buttons. There can be some other circumstantial factors that explain it, but I think that's the main thing.

13:22Jeff Ptak:What's interesting about what you also found is that the more volatile equity funds did not necessarily have higher returns. In fact, on average, they had lower returns, which is kind of the opposite of what you expect, right? You know, return and risk go hand in hand, but that's actually not what you found.

13:39Robert Brokamp:That's right. And, you know, it's one of the contradictions that, you know, you would find, at least in the context of our study. Another is seemingly that having a little bit more freedom to transact, which I think in the abstract we would think of as that's a great thing, that people have greater ability to sort of take control of their finances and take the decisions that they want to take at the appointed times. That didn't necessarily work to their benefit. This is somewhat tied in with the work that we did on cash flow volatility. If you look at things like ETFs, for instance, we did find that there were wider gaps with ETFs after controlling for a number of variables than there were for comparable open-end mutual funds.

14:22Robert Brokamp:That doesn't mean that ETFs are inferior. It just means that there can be circumstances in which investors buy and sell suboptimally, and that results in wider gaps between the return of their average dollar and those ETFs total returns.

14:35Jeff Ptak:Let's move on to fees here. When you looked at the relationship between fees and the gap, what did you find?

14:40Robert Brokamp:It was a little bit noisier. I wouldn't say that it was as clear cut as you found with some of the other variables, notably cash flow volatility and return volatility, or even the type of vehicle open-end fund versus ETF. have. And I think this points to a number of things. You had some cross currents. One of the things that we know is that ETFs, which became a bigger and bigger part of our study universe as time went on, they tend to be cheaper. But also we saw that investors tend to transact suboptimally and them don't earn as much of their funds total returns as they can. The contrary to that is that you've got a number of very low cost popular funds that are commonly used in the context of a retirement plan.

15:20Robert Brokamp:So think about opening an index fund that's maybe part of a target date fund that's featured in your defined contribution plan. We tended to find those types of vehicles. There were very narrow gaps there. So a little bit of the cross current that somewhat, I would say, lowered the correlation that you would have seen between expenses and the gaps between investors' dollar-weighted returns and their funds' total returns. It's a little bit more of a bank shot.

15:47Jeff Ptak:If we take a little detour from the Mind the Gap study and highlight that you also have an excellent sub stack basis pointing, and you recently basically took a look at funds and their expenses. You broke them up into quintiles, cheapest to pricest, calculated who is more likely to outperform their category. And the takeaway is pretty clear, right? Lower cost funds tend to do better. It's been demonstrated over and over again, but I always think it's important to reemphasize.

16:16Robert Brokamp:You got it. I think that's excellent advice. Starting with cost is the way to go. And as you allude to, there was a piece that I ran recently. I think it was called It's So Simple on my sub stack, which you're kind to mention. And it was almost a perfect stair-step pattern of outperformance from cheapest to priciest, even after you controlled for a number of different variables, Morningstar category, asset class, and the like. It really works to keep fees low on average. You're going to end up with a better result than others, even in comparable funds that charge more.

16:52Jeff Ptak:Any other areas where you found that a larger gap was particularly interesting or instructive or maybe the other way when there wasn't much of a gap?