Morningstar data shows a persistent performance gap for fund investors, but DALBAR says the problem is much worse.
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By John Rekenthaler | 03-15-17 | 06:00 AM | Email Article

Bad Timing
Mutual fund investors chase success. They sell funds that have been losing and buy those that have been winners. Those facts can be verified.

John Rekenthaler is Vice President of Research for Morningstar.

For one, we can track fund flows into and out of Morningstar Categories. When we do, we see that the better-performing asset classes generally attract new investments, while the weaker performers are redeemed. For example, U.S.-stock funds attracted new shareholders through the bull market of the mid-2000s, then suffered outflows following the 2008 crash.

There is also movement within fund categories, best summarized by that most famous of intracategory measurements, the Morningstar Rating for funds (aka the star rating). The top relative performers of the previous few years receive 5-star ratings, as well as the bulk of investor inflows. In contrast, the 1-star funds are almost always in net redemptions.

(Note: While it's tempting to link the sales directly with the purchases, to conclude that the investors who sold their stock-fund shares in 2009 used those proceeds to purchase then-fashionable alternatives funds, or that those who sell 1-star funds use those monies to buy 5-star funds, that's just speculation. The data indicate the amount of fund inflows and outflows, but not from whence the money came, nor to where it will go.)

Such behavior does fund investors no favors. Selecting a category's best-performing funds doesn't present an overall problem (in some time periods and with some categories the 5-star funds shine, in others 1-star funds do better; overall, it's something of a wash). However, selling asset classes low and buying them high is damaging. As reported during the past 25 years by Morningstar's "Buy the Unloved" series, mutual fund categories that are currently disliked by investors tend outgain the popular categories during the next few years.

The Investor Gap
How damaging, you ask? At a high level, this is how Morningstar attempts to answer the question (further details are available here).

  1. Determine the "neutral return" for mutual funds. The neutral return is defined as the return earned by a hypothetical investor who presumes to know nothing. The portfolio is equally weighted such that every fund receives the same initial investment and there is no market-timing. The investor who knows not what the future will bring is content to buy and hold.

  2. Determine the "investor return" for that same pool of funds. In contrast with the neutral return, which measures the hypothetical, investor return intends to capture what actually happened. If fund shareholders, in aggregate, identified and purchased superior funds, and then timed the market effectively, the investor return will be higher than the neutral return. If the reverse, then the investor return will be lower.

    There are various ways to calculate investor return. Morningstar opts for a standard financial calculation, internal rate of return, to measure the effect of fluctuating cash flows into and out of funds. The IRR calculation rewards a fund's investor returns if that fund has a relatively large asset base during the bull markets but is smaller during the downturns. Conversely, it penalizes funds for being diminutive during bull markets, then picking up new assets before the bear arrives.

    The investor return for a pool of funds is the asset-weighted average of the annualized investor return for the individual funds. Thus, if one fund has an investor return of 10% annualized, a second is 8%, and third is 3%, with the first two funds being of the same average size during the time period and the third being twice as large, then the investor return for the group of funds would be ((10+8+ (2*3))/4 = 8%.

  3. Calculate the "investor gap" for mutual funds by subtracting the neutral return from the group-average investor return. A positive gap indicates successful investor decisions, while a negative gap suggests that the collective investor choices--in selecting which funds to own, and in moving into and out of asset classes--have been unwise. Dumb, if you like.

The size of the investor gap varies by the type of fund studied, and by the time period that is used (a statement that holds true of almost any topic of mutual fund research), but, roughly speaking, it lands somewhere near 1 percentage point per year, when measuring performance during the trailing decade. Occasionally the gap is positive, such that the investor return beats the neutral return. Occasionally the gap is as large as 2 percentage points. But for the most part, it hovers somewhere between 0.5 and 1.5 points.

Completely Different
Morningstar is not the only company to calculate a version of investor returns. An organization called DALBAR has published an ostensibly similar figure entitled "average equity mutual fund investor" (our name is catchier), which can readily be compared with the S&P 500's returns. DALBAR's conclusion is very, very different. For the 20-year periods ending in the years 2003 through 2015, DALBAR found investor gaps (to use Morningstar's lingo) that range from a low of 3.5 percentage points per year to as much as 9 points.

Wait now. How could two organizations come up with such different answers?

Some of the divergence occurs because DALBAR and Morningstar use different definitions of "neutral return." For a pool of equity funds, DALBAR defines the S&P 500's performance as neutral, while Morningstar uses the average of those equity funds' returns. As the S&P 500 usually beats the average equity fund, DALBAR's choice leads to a modestly larger investor gap.

So far, so good. Morningstar and DALBAR can each justify their choices, and while the two paths don't end at the same place (which is somewhat unfortunate for users), they at least remain within the same county. If the neutral return were the only source of difference between the two firms, their results would be broadly similar.

However, such is not the case. As we saw, there is a huge discrepancy between the two sources, and the reason is how investor returns are determined. What this discrepancy is, I do not know. I've never been able to understand how DALBAR arrives at its numbers and cannot do so from the company's most recent report, either.

Last week, Wade Pfau of The American College of Financial Services claimed that he had figured out DALBAR's approach and that its "math is wrong." This is Dr. Pfau's article; whether his assertion is correct I leave for you to decide. (I write that partially to recuse myself, having had a hand in creating Morningstar's investor return calculation, and partly because I have trouble following some of Pfau's argument.)

In short: Two companies attempt to judge the wisdom of mutual fund investors by measuring flows into and out of mutual funds, as well as the total return for those funds, and then using this information to isolate the effect of investor decisions. After doing all this work, one company concludes that investors are mildly mistaken. They lean in the wrong direction, but their efforts are not greatly harmful. The other company concludes that fund investors make horrendous decisions.

This isn't very satisfying for you, the consumer of such information, and the user (whether as an investor or advisor) of mutual funds. Perhaps this column will help. I have outlined how Morningstar goes about its business, and linked to the document that describes the calculation in detail. Maybe DALBAR can follow suit and explain where and why its approach differs from Morningstar's.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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