A word to the wise for clients, based on Morningstar research: Returns for investors who trade too often lag those generated by the mutual funds and exchange-traded funds in their portfolios.
Investors on average missed about 15% of U.S. funds' total returns annually in the decade ended Dec. 31, largely due to the timing and size of their trades, Morningstar found in its recent annual "Mind the Gap" report.
Specifically, the average dollar invested in U.S. funds generated 7% a year over that decade, while the funds in aggregate earned 8.2% a year, according to Morningstar. That 1.2 percentage point annual gap amounts to roughly 15% of the funds’ total return, the research found.
"The findings ... illustrate the potential peril of chasing returns, which investors are likelier to do when it comes to more-volatile funds, given the funds’ wider return amplitudes," the report says.
Investors who chase returns hurts themselves in two main ways, according to Morningstar: "First, they transact more often, and we have found that the more investors traded, the less of their funds’ total returns they captured. Second, they fall prey to buying high — after a burst of performance — and selling low, as returns erode and investors give chase to a different highflyer."
On the other hand, investors who hold the line on trading earn a bigger piece of their funds' total returns, according to Morningstar. They can accomplish this "by keeping discretionary trades to a minimum and automating other routine tasks, like rebalancing, to the greatest extent possible," the report says.
"It's advisable for investors to be deliberate about the necessity, timing and nature of transactions, with a goal of keeping discretionary purchases and sales to a minimum," the report says.
Morningstar looked at additional factors this year and found other significant pressures on investor returns compared with the funds they hold.
Researchers explored the degree to which funds’ returns diverged from a style-appropriate benchmark, that is, a tracking error, and estimated gaps by the volatility of funds’ cash flows, which is a proxy for trading activity.
" Strikingly, we find that the more funds deviated from their index, or the more investors transacted, the wider the gaps between investor returns and total returns grew," the report says.
This suggests that investors have a harder time succeeding with funds that "go their own way" than with funds that performed more predictably compared to their index, Morningstar said in a release.
Gaps were wider among ETFs than open-end mutual funds, especially in the international equity and sector equity categories. This suggests that "while ETFs have increasingly become the managed investment of choice thanks to their low cost, tax efficiency and ease of use, they still can be prone to misuse associated with overtransacting, negating some of the advantages they enjoy compared with standard open-end funds," Morningstar found.
Among other key findings that may help clients are the following:
- Investors in allocation funds captured the largest share of their holdings' aggregate total return, while the opposite was true for investors in specialized strategies like sector equity funds. "This suggests that investors benefit from simplicity and automation of all-in-one solutions, while they struggle with narrower standalone strategies," Morningstar said in a release.
- It could make sense to build a margin for error into the return forecasts that investors might use in their spending and savings plan, slightly trimming projections.
- While cheaper funds had smaller gaps than pricier funds, it would be too simplistic to conclude that investors in inexpensive funds will capture more total returns than those in costlier funds. The gaps for active and passive funds showed that "passive fund investors were almost as susceptible, and in some cases more prone, to mistiming their transactions than investors in costlier active funds."
- "The findings somewhat upend the notion that risk and return are joined at the hip. While it stands to reason that more-volatile assets like stocks will out-earn less-volatile investments like bonds over longer horizons, it’s not necessarily the case that a more volatile equity fund will out-gain a less volatile stock fund, which the study’s results seem to highlight."
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