Morningstar Magazine - October/November 2016 - 14

Dispatches EXHIBIT 2 Investors Are Good at Fund Selection, Bad at Timing The Good Asset-Weighted Return (%) Equal-Weighted Return (%) Selection Gap (%) U.S. Diversified Stock 7.10 6.58 0.52 U.S. Sector 6.72 5.27 1.45 International Stock 4.41 3.91 0.50 Allocation 5.58 4.67 0.91 Taxable Bond 4.87 4.08 0.79 Municipal Bond 3.87 3.63 0.24 Alternatives 1.07 -1.50 2.57 Selection Gap (%) Expense Difference (%) Remaining Difference (%) U.S. Diversified Stock 0.52 0.40 0.12 U.S. Sector 1.45 0.44 0.81 International Stock 0.50 0.43 0.07 Allocation 0.91 0.43 0.48 Taxable Bond 0.79 0.31 0.48 Municipal Bond 0.24 0.34 -0.10 Alternatives 2.57 0.40 2.17 Investor Return (%) Equal-Weighted Return (%) Return Gap (%) U.S. Diversified Stock 5.84 6.58 -0.74 U.S. Sector 5.53 5.27 0.26 International Stock 2.67 3.91 -1.24 Allocation 4.50 4.67 -0.17 Taxable Bond 3.26 4.08 -0.82 Municipal Bond 2.31 3.36 -1.32 Alternatives 0.80 -1.50 2.30 Investors collectively chose funds well... ...And they selected cheaper funds... Source: Morningstar. 10-Year Returns through 12/31/2015. The Bad ...But their timing was poor. Source: Morningstar. 10-Year Returns through 12/31/2015. star's Russel Kinnel in his Mind the Gap series, and related on occasion in this column as well. Fund investors do well enough with their fund selection, but when it comes to deciding which asset classes to buy and sell, they have been far less successful. This can be seen anecdotally, in observing the tendency of fund 14 Morningstar October/November 2016 buyers to chase their tails by redeeming poor-performing investment categories and purchasing performance-leading assets, or it can be measured-albeit indirectly-by comparing the paper returns on funds with the profits they actually made for their owners. The latter is termed "investor return." I won't delve into the details of those calculations here, as they are covered in Kinnel's series. Suffice it to say that every gain humans make over monkeys with fund selection, they give back with their investment timing-and then some. The third table in E X H I B I T 2 shows the investor return, the equal-weighted fund return (that is, the return earned by the monkeys), and what Kinnel calls the return gap, the difference between what investors theoretically would have earned if they had put equal amounts of money in all funds and what they actually received. Not good. Once again, the puny alternatives and sector-fund groups are the exceptions, but that's scant consolation. Allocation funds fare better than the rest, because target-date funds have positive return gaps, but they are still negative. The other groups are even worse off. These results are even noisier than those leading to the selection gap. Investor returns are affected by many factors besides timing decisions. As skeptics of the measure have pointed out, shareholders who dollar-cost average into funds by investing the same amount each month will show a return gap (perhaps positive, perhaps negative). That's a fair criticism. On the other hand, Morningstar has generated its Mind the Gap research for a decade now, and the pattern is always the same. The result is unlikely to have occurred by accident. Less Is More Experienced investors and financial advisors, I believe, can improve their results by judiciously picking up bargain assets and trimming those that appear to have overheated. This column suggested energy pipeline stocks earlier this year, and I'm currently considering whether emerging-markets stocks and European banks might be timely. So, I am not a purist for strategic asset allocation. But it must be granted that most investors don't do well with their asset timing. They would be better off doing what they're already doing with their fund selection and keeping their asset allocation rigorously, strictly strategic. K John Rekenthaler is vice president of research with Morningstar.

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016

Contents
Morningstar Magazine - October/November 2016 - Cover1
Morningstar Magazine - October/November 2016 - Cover2
Morningstar Magazine - October/November 2016 - 1
Morningstar Magazine - October/November 2016 - 2
Morningstar Magazine - October/November 2016 - Contents
Morningstar Magazine - October/November 2016 - 4
Morningstar Magazine - October/November 2016 - 5
Morningstar Magazine - October/November 2016 - 6
Morningstar Magazine - October/November 2016 - 7
Morningstar Magazine - October/November 2016 - 8
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