Morningstar Advisor - December 2012/January 2013 - (Page 66)

Gray Matters Exhibit 3 Strong Links Between Alternative Mutual Funds’ Investor Return Gaps and Volatility 1st-Quartile Volatility Return Gap (Annualized Percentage Points) 3rd-Quartile Volatility 2nd-Quartile Volatility 4th-Quartile Volatility funds. Larger funds are likely to have drawn more assets because of better performance and are also more likely to survive over the long run. But is it easier for investors to deal with larger investments than smaller offerings? To address this problem, we asset-weighted all alternative funds2, which means that large funds, such as Gateway GATEX (with $6.7 billion in assets as of Sept. 30) and Merger MERFX ($4.8 billion in assets), will carry more weight in the calculation than small funds such as ICON Long/Short IOLCX ($25 million in assets). Exhibit 4 demonstrates that the gaps between total returns and Investor Returns are virtually the same for large and small funds over the five- and 10-year periods but different over one- and three-year periods. The reason for asset-weighted gaps to be wider than equal-weighted gaps in the past oneand three-year periods is most likely because of the massive inflows into nontraditional bond funds (more than $48 billion from 2009 to 2011). Unfortunately, these giant funds had worse Investor Returns than other alternative funds in the past three years. Over a long timeframe, it becomes apparent that investors exhibit similar behavior regardless of fund sizes. Mind Investor Return 5.0 4.0 3.0 2.0 1.0 1-Year Gap 3-Year Gap 5-Year Gap 10-Year Gap Exhibit 4 Asset-Weighted Versus Equal-Weighted Return Gaps in Alternative Funds Return Gap (Annualized Percentage Points) Equal-Weighted Gap Asset-Weighted Gap 2.5 2.0 1.5 1.0 0.5 1-Year Gap 3-Year Gap 5-Year Gap 10-Year Gap The gaps are particularly prominent over the last five- and 10-year periods. For example, over a 10-year period, although the first quartile alternative funds achieved a total return of 6.33% annualized, the average investor in these funds only made a dismal 1.58% annualized, a 4.75 percentage point return gap. There are a couple of reasons Investor Returns could be worse in more-volatile funds. First, assuming investors are rational and do not attempt to time their investment, they still must enter and exit the fund at some point in time. In a more-volatile fund, these entry and exit points are more likely to coincide with peaks and troughs than in a less-volatile fund, making Investor Return worse. Second, more-volatile funds are more likely to attract irrational behavior and timing, as the potential for profits is larger. Asset-Weighted Investor Returns It is helpful for advisors and investors to keep an eye on Investor Returns, which demonstrate how other investors historically have been handling the fund. A large gap between Investor Returns and total returns should serve as a red flag—if so many investors failed to buy and sell the fund at right times, chances are your clients could make a similar mistake. K Terry Tian is an alternatives analyst with Morningstar. We also tested whether investors behave differently in large versus small alternative 1 For the three-year period, the least volatile quartile surprisingly got the highest Investor Return gap (1.77%). The primary reason is that the least volatile quartile has a good number of nontraditional bond funds. Some of these funds (launched in the second half of 2008) had extraordinary performance during the 2009 “junk rally” when they had small asset bases, but most investors flew into these funds after 2010 and thus missed the majority of the three-year returns. 2 We averaged the beginning fund size and ending fund size over the examined time period and assigned weights based on the averaged fund sizes. 66 Morningstar Advisor December/January 2013

Table of Contents for the Digital Edition of Morningstar Advisor - December 2012/January 2013

Morningstar Advisor - December2012/January 2013
Contents
Contributors
Letter From the Editor
What Stands Between Me and Stupid
Why Do You Use Dynamic Funds of Funds?
Serving Clients and Community
How to Pick an ETF Managed Portfolio Strategy
Tactical View of Risk
Investments á la Carte
Investment Briefs
Unbundling ETF Managed Portfolios
Risks Loom Over Telecom Industry
Outsourcing Asset Allocation
ETF Managed Portfolios on the Rise
Age-Based Options Take Over 529 Industry
How the Landscape for Advisors Is Changing
Mark Egan Embraces Volatility
Alpha, Beta, and Now … Gamma
Performance Gaps
Gains in Momentum
Companies Where Management Teams Add Value
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Once and Future King

Morningstar Advisor - December 2012/January 2013