When investment funds underdeliver – new research findings


Your managed fund posts great results but your return doesn’t match it. Amy Arnot from US-based investment research firm Morningstar explains what might be going on.

Key Points


  • Research has found fund returns may not reflect actual returns to individual investors
  • Poorly-timed investment in and redemptions from funds can affect returns
  • Dollar-cost averaging can mitigate against return volatility

Why would investors earn less than the funds they invest in? It all comes down to timing. The Firstlinks '2021 Mind the Gap' study of dollar-weighted returns finds investors earned about 7.7 per cent a year on the average dollar they invested in equity funds over the 10 years (ended 31 December 2020). This was about 1.7 per cent less than the total returns their fund investments generated over that time span.

This shortfall, or ‘gap’, stems from inopportunely timed investment in and redemptions from funds, which cost investors nearly one-sixth of the return they would have earned if they had simply bought and held.

The persistent gap makes cash flow timing one of the most significant factors – along with investment costs and tax efficiency – that can influence an investor's end results.

What is the gap between investor returns and total returns?


To use a simple example, let's say an investor puts $1,000 into a fund at the beginning of each year. That fund earns a 10 per cent return the first year, a 10 per cent return the second year, and then suffers a 10 per cent loss in the third year, for a 2.9 per cent annual return over the full three-year period. But the investor's dollar-weighted return in this simple example is negative 0.4 per cent, because there was less money in the fund during the first two years of positive returns and more money exposed to the loss during the third year. In this case, there was a 3.3 per cent per annum gap between the investor's return (negative 0.4 per cent) and the fund's (2.9 per cent).

In our study, we estimate the gap between investors' dollar-weighted returns and funds' total returns in the aggregate. This allows us to assess how large the gap is and how it's changed over time.

What to do to improve investor returns


The persistent gap between investors' actual results and reported total returns may seem disheartening, but investors can take away a few key lessons about how to improve their results.  

The study's results suggest:

  1. Keep things simple and stick with plain-vanilla, broadly diversified funds.
  2. Automate routine tasks such as setting asset-allocation targets and periodically rebalancing. 
  3. Avoid narrowly-focused funds for long-term investing, as well as those with higher volatility. 
  4. Embrace techniques that put investment decisions on autopilot, such as dollar-cost averaging. 

These findings shine more light on the merits of keeping things simple. In particular, funds that offer built-in asset class diversification, such as balanced funds, help investors keep more of their returns. 

Finally, we found that investors' trading activity is often counterproductive. Investors can improve their results by setting an investment plan and sticking with it for the long term. Investors who follow a consistent investment approach and avoid chasing performance will likely reap rewards over time. 

This is an extract of an article by Amy Arnot of US-based investment research firm Morningstar was first published in Firstlinks and represents the author’s views only.  

This article is general information and does not consider the circumstances of any investor. It has been edited by Firstlinks from the original US version for an Australian audience. 

Source: Firstlinks