How to control anti-return behaviour

In investment management, we only have a limited number of performance levers. Most of the variables that propel portfolios (performance of the stock market in general and individual stocks in particular, changes in interest rates and inflation, monetary policy, etc.) are unpredictable over short and medium periods. Because the stock market often has great winning streaks, investors sometimes get a false sense of control, which goes up in smoke when the bear market hits. This explains the distress of many investors during the stock market turmoil. However, there is one variable that investors can control: their behaviour. This is because poor decisions such as trading frequently, buying funds after they have appreciated strongly, and selling in panic after market declines can reduce investor returns.

In a recent report–whose headline “Mind the Gap 2021” evokes the automated voice of the London Underground–research firm Morningstar offers its assessment of the shortfalls incurred by mutual fund holders in the United States due to their own anti-return behaviours.

The report analyzes the difference between the return produced by mutual funds and that actually obtained by investors. Here’s how analysts do it. They first calculate the performance of all funds using the time-weighted method. This method, which is the standard certified by the CFA Institute, calculates the return completely independently of the inflow and outflow of funds, since managers have no control over the latter. Then they recalculate the return, this time using the asset-weighted method, which is sensitive to cash inflows and outflows, and as such are controlled by investors. If investors manage to add value through their buy and sell decisions, the “gap” will be positive. If, on the other hand, the decisions subtract from the value, the “gap” will be negative.

According to the report, U.S. mutual funds produced a return of 9.4% over ten years, but in the end investors only obtained 7.7%, that is to say a net shortfall of 1.7%. In other words, investors tend to buy and sell at the wrong time, which subtracts a significant portion of the return.

This shortfall, or gap, stems from inappropriate buying and selling of fund shares, which cost investors almost a sixth of the return they would have earned if they had simply bought and held.

– Morningstar

According to the authors, the fund categories with the worst shortfalls are sector funds and alternative strategy funds, with an underperformance of around 4%. In contrast, the category that suffers the least loss is the balanced asset allocation funds, which underperformed by less than 1%. The authors explain that the latter, because of their diversification, are generally more stable, which reduces the effect of emotions in investment decisions. They also point out that balanced asset allocation funds are widely used in retirement savings accounts offered by employers, whose contributions are based on a percentage of salary. This ends up stabilizing the movement of capital in these funds and helps to reduce the “gap.” The attached table provides detailed results.

Annualized return by fund category in the United States (2011-2020)

Source: Morningstar

The authors also analyzed the investor gap as a function of fund volatility. In most fund categories, the least volatile funds are where investors perform the best. In fact, we would expect investors to be less inclined to speculate on funds whose ratings fluctuate little. The less actively you trade, the better you capture returns. The exception, however, is balanced asset allocation funds: investors have done better with more volatile funds than with less volatile ones. According to the authors, this is because investors who choose balanced funds are more tolerant of risk and less inclined to speculate.

One last finding from the report made me jump: funds with passive management displayed a much larger gap than those with active management. The authors claim, however, that the reason for this discrepancy is the surge in popularity of passively managed funds in the United States for more than a decade. Large capital inflows during a sustained bull market, they say, weighs down the return calculated using the asset-weighted method, and, therefore, the investor “gap,” Nonetheless, I believe this suggests that holders of passively managed funds are not immune from the temptation of active trading.

Still, the report offers some tips for investors to maximize their returns and minimize their “gap.” First, the authors suggest holding a small number of broadly diversified funds. They also advise to focus on simplicity and avoid excessively specialized funds such as sector and thematic funds. Finally, they recommend investing with funds that automate the management process as much as possible. I believe that for Canadian investors, balanced asset allocation mutual funds and ETFs represent an interesting alternative, as these funds are well diversified and execute portfolio rebalancing automatically.