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Better Timing and Market Conditions Led to Solid Investor Returns

Times have been good lately for investors, with proof not only in strong market returns but also solid investor returns, according to Morningstar’s 2018 “Mind the Gap” study.

Among the key takeaways from this year’s report are that the gap improved for U.S. equity, balanced and municipal bond funds, while it worsened for international equity and taxable bonds. In addition, target-date funds continue to stand out for “producing outstanding results for investors,” while alternatives funds stand out for providing “little to no returns for investors,” according to the study.

“Similar to last year’s Mind the Gap study, we found that investors have largely succeeded in using balanced funds, such as target-date funds, where the behavior gap was narrow,” says Russel Kinnel, chair of Morningstar's North America ratings committee and editor of Morningstar FundInvestor. “On the flipside, investors fared poorly with alternative funds, which had the worst dollar-weighted returns, reflecting the funds’ generally lousy performance.”

The firm’s annual study of investor returns – which measures the performance of the average dollar invested in a fund and estimates the impact investor behavior had on investment outcomes – shows that the gap between official total returns and those actually experienced by investors across all mutual funds shrunk to 26 basis points for the 10 years ended March 2018.

The average dollar invested in open-end funds gained 5.53% per year over the 10 years, while the average fund returned 5.79%. The authors note that this is the narrowest gap recorded since the first issue of the study in 2005.

“Investors tend to buy high or sell low when markets are volatile, potentially missing out on a fund’s gain. However, with the last bear market far in the rear-view mirror, investors’ steady investment contributions over the last 10 years appear to have paid off,” says Kinnel.

In addition, the typical investor (asset-weighted investor returns) in diversified domestic equity funds earned an 8.32% annualized return for the decade, compared with 8.93% for the average fund, making for a shortfall of 0.61 percentage points – a modest improvement over the previous report, which ran through December 2016.

The authors note that the gap would be different if ETFs were included in the study. They explain that it is hard to know whether short-term traders in ETFs generated strong returns, but long-term investors have been building positions in low-cost large cap equity funds and the gap across open-end funds and ETFs could be smaller if those long-term flows were included.

Balanced funds – which include allocation funds, TDFs and traditional balanced funds – saw a positive gap of 0.30 percentage points annually for the decade ended March 31, 2018, with the average investor realizing a 5.93% annualized return. This improvement reflects the continued strength of TDFs, both in terms of investor behavior and strong gains among well diversified funds, the report notes.

The gap for municipal bond funds shrank to a 1.26-percentage-point annualized shortfall based on asset-weighted investor returns of 2.23%. This still represents more than a third of the returns the average fund earned over this span, reflecting the impact of media headlines over the past decade, such as the Puerto Rico debt crisis, driving investors away at the wrong time, the authors note.

Meanwhile, the gap widened in some asset classes, including international equity and taxable bond. Regional funds dedicated to European and Asian stocks saw wide behavior gaps, as did funds in the Foreign Large Growth category, suggesting that investors struggled to use these investments successfully, the report explains.

Alternatives had the worst investor returns but the best investor returns gap. According to the report, the investor return was nine basis points annually over 10 years. Yet, this was still nearly 140 positive basis points per year better than the average alternative fund’s 1.3% reported annual loss.

Finally, the study notes that the five-year investor return gaps are generally much narrower than the 10-year numbers. In fact, the average dollar invested in U.S. open-end funds returned 7% per year, outgaining the average fund which earned 6.6% annually.