Morningstar Magazine - August/September 2017 - 39

for individual investors has diminished, as they can
still do as much harm to their portfolios as before.

is understated because many high-cost failures are
eliminated by fund companies.

less-responsible investors and fund companies in
the high-cost zone.

The Do-Nothing Portfolio

We sorted the results in two ways. First, we
sorted relative to Morningstar Category, and then
we sorted relative to the broad mapping group.
For example, the category sort ranked all
U.S. large-blend funds against each other and
placed them into quintiles. For the broad mapping
groups, we compared U.S. large-blend funds
against all other diversified equity funds. This is
a useful exercise particularly for markets where
the relative-to-category rankings were less helpful
because there was a limited data set of funds
with sufficient data in a category. In last
year's U.S. Mind the Gap paper, we did something
similar, but only for standard deviation, as it
appeared that volatility relative to the broad group
was more meaningful than within a more narrow
peer group. Sorts such as fees and Morningstar
Risk make the most sense on a category level,
while standard deviation and manager tenure fit
better with our broad mapping groups.

Manager tenure results were quite similar across
markets. They showed no trend whatsoever
when we grouped funds by manager tenure. This
isn't a surprise, as manager tenure hasn't shown
much of a link with returns or risk. Manager
tenure does not equate to experience, and more
importantly, it does not account for quality
of experience.

To determine how investors would fare had they
left their portfolios untouched, we created
the Do-Nothing Portfolio, which uses fund total
returns that are asset-weighted at the beginning
of the time period. This allows us to isolate
the changes investors made during the time
period in question by comparing the typical
investor return (as measured by investor returns
that are asset-weighted using an average
for the entire time period in question) with the
Do-Nothing Portfolio.
We created Do-Nothing Portfolios in five
regions around the globe (shown in E X H I BI T 1 ).
Performance for this measurement was
mixed, but in the United States, it performed
surprisingly well. In the U.S., the portfolio
weighted with beginning-of-the-period assets
produced better results than either investor returns
or a straight average of returns in each asset
class. The typical diversified-equity-fund investor
would have had a return of 5.31%, topping
the 5.15% average fund return and the 4.36%
average investor return. For U.S. bond funds,
the Do-Nothing return was 4.3% compared with
2.99% for the average investor return and
3.72% for the average fund return. For allocation
funds, the Do-Nothing return was 4.98%,
decisively beating the average investor return
(4.31%) and the average fund return (4.26%).
The reason, as stated above, is that targetdate funds are a fast-growing segment of the
allocation group.
Factor Sort Results

For our factor tests, we grouped funds into
quintiles based on the data at the beginning of the
time period, and we ranked within the mapping
group. For example, we ranked fees within
concentrated equity from five years ago and then
tracked investor returns for each quintile's
subsequent results. Funds of funds were excluded,
so the data set for the factor tests was slightly
different from the broad asset-class gap figures.
The number of funds to survive the time period
declines sharply as we move to higher-cost groups.
As a result, the negative impact of higher costs

The data was fairly clear for fees and manager
tenure. When we tested fees, we generally
saw investor returns decline as we moved from
low-cost to pricey expense quintiles. In addition,
the gap usually grew as we moved up in price. In
markets with strong survivorship bias, these
results were likely understated because high-cost
funds that fail are often eliminated. In addition,
five-year figures tend to show less of an effect
because there is less time for the fee to compound
and drag down returns.
Still, the trend is clear. In Luxembourg's diversified
equity group, the five-year investor return in
the category rank steadily eroded as fees rose. In
the U.S., investor returns shrunk and the gap grew
with each step to higher fee levels (EXHIB IT 2 ).
The impact appears to exceed the stated expense
ratio. There are likely two additional factors
at work. First, higher-cost funds frequently take
on greater risks to overcome their lofty fees.
Thus, they may be more prone to inspiring fear and
greed in investors, leading to poor timing decisions
in both directions. Second, we likely have a
meeting of savvy investors and responsible fund
companies in cheap funds and a meeting of

We saw mixed results for standard deviation
and Morningstar Risk, which is similar to standard
deviation except that it penalizes downside
volatility more ( EXHIB IT 2 ). In the past, we've
found a fairly strong suggestion that more-volatile
equity funds lead to worse investor returns
because they are harder to time and trigger
emotional responses. Some markets showed this
relationship, but others did not. It could be that
a relatively smooth market environment in the past
five years has rewarded volatility and, therefore,
understates the effect, but that's just a guess. In
any case, the least-volatile quintile generally fared
better than the most-volatile quintile, but the
quintiles in between did not follow a neat stairstep pattern down the way fees did. Thus, the
link between volatility and investor returns remains
but appears to be weaker than in past studies.
Follow the Gap

More important than the size of the gap are the
characteristics of funds that deliver strong
investor returns. They suggest where the fund
industry needs to go. Clearly, low costs are vital,
and advisors would do well to steer investors away
from the highest-risk funds, as such funds tend
to have poor investor returns. Also, it appears that
simple tactics to prevent performance chasing,
such as dollar-cost averaging and automatic
rebalancing, help investors stick to their plan. K
Russel Kinnel, is director, manager research with
Morningstar Research Services.
David Blanchett, Wing Chan, Simon Dorricott, Andy
Jung, Annette Larson, Matias Mottola, Tim Murphy, and
Arthur Wu contributed to this report.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
