Why do investors miss big returns? The data shows that average investors lag behind the returns of the average fund they invest in. The data also appears to be counter intuitive, but it brings to light one of the most important aspects of mutual fund investment.
The fact is that investors tend to get into funds after they’ve already shown big returns, making it less likely for those returns to be repeated after the investor gets in on the action. This experience highlights questions about whether fund returns are the best way for investors to measure a fund’s importance at all.
Over at Morningstar.com, Russel Kinnel examined this problem and has come up with an interesting solution. Kinnel says that a big responsibility of financial planners and fund companies is to make sure that investors' experience matches up with what funds publicize as their returns.
According to Kinnel’s mathematics, the average investor’s returns lagged the average fund returns by 0.95% annualized over the last decade. The average fund returned 7.05% in the last ten years, while the average investor ended up with an annualized return of just 6.1%.
The metric is even more interesting when examined by asset class. Doing this allows us to see exactly where investors went wrong, and why they ended up lagging funds, or sticking close to them, in the last ten years.
The biggest discrepancy was in funds that invest in International equities. Funds in the sector managed to return 10% in the last decade, while the average investor netted just 6.8%. That’s a huge gap of 3.2%.
The reason for this gap, according to Kinnel, is the headline pressures that cause investors to get into, and pull out of, international equity funds in the first place. Emerging market equities are volatile. Investors tend to get in on them when they hear they’ve been producing good returns, and get out after they’ve been doing badly for a while.
The funds themselves have the benefit of staying in a market for longer, and they have advance analysts at their disposal. They can make guesses about when a market is going through a small rough patch, or when it’s heading for a prolonged downturn.
The second biggest discrepancy was in Municipal bonds. In the last ten years funds in the asset class returned 4.1%, while the average investor returns came to just 2.7%. The reason for the lag in that sector was, according to Kinnel, the scare surrounding Municipal defaults in 2010 and 2011. This caused investors, who removed huge chunks of cash from funds, to miss out on big returns in 2012 and 2011.
The lessons offered in this analysis are difficult to pin down. First of all, there is an implied level of risk as an investor, related to personal ability to get in and out of markets on time. This means that investors need to rigorously analyze their own performance, and get a measure of their ability to invest with funds.
It also means that average annual returns are not the only metric to judge a mutual fund by. If investors are unwilling or unable to come up with a metric of their own performance, or find that they are particularly prone to headline pressure, it is probably better for them to judge mutual funds on their average return to investors, rather than their average annualized return.
Past performance may not be a guarantee of future performance, but looking at the figures it seems that fund performance is not a guarantee of investor performance either. Investors untrained in mathematics and analysis might be better off ignoring headlines, it just might lead them to better returns.