Morningstar Advisor - April/May 2013 - (Page 61)

investors are usually on the lagging end of the gap because of their poor timing of when they buy and sell their funds. Mutual Funds’ Average Annualized Total Return and Investor Return: Category Fund companies, financial planners, and brokers exist to help investors meet their goals. A key part of that equation is narrowing the returns gap. It’s not an easy task. Greed and fear are emotions hard-wired in our brains. And, of course, it isn’t just individual investors making these mistakes. Institutional investors are guilty of the same behaviors. Just follow the boom-and-bust cycles of private equity and venture capital, or performance chasing of hedge-fund buyers. As Morningstar researcher John Rekenthaler puts it, “The big money looks a whole lot like the small money.” 3-Yr Total Return U.S. Stock 5-Yr Investor Behavior Return Gap* Looking at an individual fund’s investor returns can be insightful. Morningstar research has found that highly volatile funds have worse investor returns than those of low-volatility funds. This makes sense: Investors see a fund with large short-term gains and rush in, only to lose their nerve and bail out when the fund tanks. We’ve found investors in alternatives funds exhibit the same behavior. But if we pull back and compare the investor returns of broad categories to average returns, we can get a better view of how investors behaved. The table above shows the past three-, five-, and 10-year periods through Dec. 31, 2012. Investor Behavior Return Gap* Total Return Investor Behavior Return Gap* 10.04 9.80 0.24 1.55 0.75 0.80 7.89 6.88 1.01 Sector Stock 9.28 8.26 1.02 1.54 1.07 0.47 9.44 9.07 0.37 International Equity 5.18 5.10 0.08 –2.43 –3.01 0.58 9.95 6.84 3.11 Balanced 7.49 7.72 –0.23 2.08 2.49 –0.41 6.37 5.53 0.84 Taxable Bond 6.94 5.75 1.19 5.80 5.16 0.64 5.63 4.76 0.87 Municipal Bond 5.91 4.49 1.42 4.71 3.33 1.38 4.06 2.71 1.35 All Funds 7.59 7.36 0.23 2.02 1.49 0.53 7.05 6.10 0.95 *Total return minus investor return. Data as of Dec. 31, 2012 Seeing the Bigger Picture To give advisors and investors a view of how shareholders in a fund are actually faring, and to prepare them for the kind of experience they might have in the fund, we created Morningstar Investor Returns, which weight returns based on asset inflows and outflows. In essence, investor returns are closer to a bottom line for investors than the fund’s stated returns. By comparing a fund’s investor returns to its official returns, we can see how well investors timed their investments. The wider the gap, the more they mistimed their investments. Total Return 10-Yr First, the big picture: The average fund investor lagged the average fund over the past 10 years by a total of 0.95% annualized. The average fund returned 7.05%, but the average investor netted 6.1%. That’s a good chunk of the return investors failed to capture and evidence that investors overall made poor choices in the past decade. Next, let’s break down the gaps by asset class. Some interesting details start to emerge. The biggest gap by far was in international stocks. The typical international fund returned 9.95% annualized over the past 10 years versus 6.84% for the average investor. Why the huge gap? Emerging markets are volatile, and some investors are prone to buying after rallies and selling after downturns. It probably also reflects the fact that investors are mostly in diversified foreign funds, where emerging markets take up a small portion of assets. These funds trailed emerging markets’ 10-year return because developed markets lagged over that time. More intriguing was the asset class that had the second-biggest gap: municipal-bond funds. Munis are probably the least volatile asset class in the fund world (short of money market funds), yet the average fund’s 4.06% 10-year return shrunk to 2.71% for the typical investor. Looking at the returns of the muni-long category, we see very little reason for fear or greed. In the past 10 years, there was one year in the red (2008), two years of double-digit gains (2009 and 2011), and generally modest single-digit gains in the remaining years. Even the one year of loss was negative 9.5%—not a big blow. Unlike equities, investors were not scared off by the losses in 2008. Asset inflows into munibond funds rose from $10 billion in 2008 to nearly $73 billion in 2009. In other words, investors had great timing. But then came a warning of massive defaults in late 2010 and early 2011, when everyone became worried about governments defaulting. That’s when some investors bailed to the tune of $11 billion in 2011. However, the defaults never came, and municipal bonds gained a robust 10.6% return in 2011 and 8.9% in 2012. Since 2008, flows into municipal-bond funds have followed headlines more than performance, and this is a case where it really hurt investors (not that chasing performance is the way to go, either). While it’s certain that some advisors couldn’t persuade their clients to refrain from bailing out of equities in 2008, they ought to have been able to explain that the muni fears were overblown in 2010. MorningstarAdvisor.com 61 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013