Why your investment results differ from what the fund reports
You buy into a mutual fund or exchange-traded fund and expect to earn the same investment result. But invariably that doesn’t happen, and investors usually are the ones coming up short.
This lag in performance can be sizable, as researcher Morningstar discovered in its latest “Mind the Gap” study. If your stock fund earns 8% one year, for example, your own results might be closer to 6% or 7%.
How can you underperform the exact same fund that you own? Poor decisions explain a big part of it. Simply put, many people don’t just buy into a fund and then leave their money alone. Instead, they buy and sell along the way.
For the most part, “It boils down to the timing of purchases and sales into and out of funds,” said Jeffrey Ptak, Morningstar’s chief ratings officer.
In other words, poor timing decisions can easily chop one-fifth off of your return in a typical year.
Investors frequently buy or sell funds based on their reported total returns. These performance results for mutual and exchange-traded funds assume that a person has made a lump-sum investment on day one and held tight to the end, neither adding nor subtracting money. They also assume all dividends are reinvested, which might or might be the case for an investor in reality, and they assume management expenses and other costs have been deducted.
Giving up 1.7% a year
In Morningstar’s latest study, investors earned about 6% annually over the 10
years ending Dec. 31, 2022. The funds themselves generated an annualized average gain of 7.7%, including reinvested dividends and subtracting costs.
The lag of 1.7 percentage points is similar to gaps of 1.5% to 1.7% that Morningstar calculated in four previous studies spanning earlier 10-year periods.
“In my opinion, this is one of the most important studies Morningstar publishes, because it shows that what you see isn’t always what you get when it comes to fund returns,” said Amy Arnott, a portfolio strategist with the company.
Timing mistakes, along with investment expenses and taxes, are among the critical factors that can influence a person’s end results. And unlike actual gyrations in the stock and bond markets, they are something over which investors exert at least some control. (Regarding taxes, there are ways to minimize the bite, and with expenses, it is easy to find low-cost products.)
Returns for investors almost always will differ from a fund’s reported results unless a person makes no additions or subtractions during the entire holding period, Morningstar said. The more volatile a fund, the more difficult it typically is for investors to maintain a hands-off approach.
Responsible, disciplined strategies can lag, too
Sometimes, even sound approaches like investing on a regular basis can backfire, at least comparatively speaking.
Suppose you want to dollar-cost average by staking $1,000 into the same fund at the beginning of each year, for three years. Suppose, further, that the fund goes on to earn 10% the first year and 10% the second year before dropping 10% in year three. For the fund, that works out to an annualized return of 2.9%. But the investor sustains an overall loss of 0.4%. The reason?
“There was less money in the account during the first two years of positive returns and more money exposed to the loss during the third year,” Morningstar said.
A strategy of investing money on a regular basis, as when diverting a portion of your paycheck into a workplace 401(k) retirement account, is a laudable behavior, Ptak said. Still, it will give you a different end result compared with the fund in which you’re placing money. So, too, with regular, ongoing withdrawals.
Investor returns rarely will match a fund’s results exactly, since few people can buy and hold for years. But the performance-gap study shows several ways to improve your results.
One is to avoid adding a lot of money after a fund has had a nice rally. Another is to avoid selling at a price that could be near the market bottom. In addition, investors should consider automating tasks like rebalancing as much as possible, perhaps by doing it on the same day each year. (Rebalancing involves adding a little money to lagging funds while taking some chips off the table with funds that have performed especially well, to keep your overall mix or allocation in line with your objective.)
The type of fund can matter
Also, investors should consider sticking with more widely diversified funds and avoiding sector portfolios that hold fewer stocks, typically in one or a few industries like technology. These funds bounce around a lot more, making it harder to resist the urge to buy and sell. Conversely, more diversified funds such as asset-allocation portfolios, which typically spread their holdings among stocks, bonds, cash and perhaps other areas like real estate, deliver a smoother ride, making them more suitable for a long-term, buy-and-hold approach, Morningstar said.
In fact, investors suffered their lowest performance gap with asset allocation funds, among the categories that Morningstar studied, and the highest amount of lagging performance with sector portfolios.
Because of their smoother rides, assetallocation and other widely diversified funds “do seem to be the easiest for investors to use,” Ptak said.
Reach the writer at russ.wiles@ arizonarepublic.com.