One of the intriguing paradoxes in investing is the
difference between a fund’s reported return, and the personal rates of return
for the people that own that fund. For
example, fund x may have earned 10% in the last 3 years on average, but, what
did the “average” investor in that fund earn over the same time period? The difference may be surprising to you.
Let’s look at a stalwart fund of the broker sold community:
The Growth Fund of America. If you look
up the fund on any internet based reporting service, you notice that its five
year return is 3.73% per year. Not bad
considering that time period held some of the 2008 downturn. But what does that number mean? That is not the return of the average
investor, it is simply the return of the fund.
For an investor to have earned that, they would have had to buy the fund
on day one, held it entirely, and still have been holding it at the end of the
five year period. As advisors and
investors, what concerns us is INVESTOR return, not fund return. The
average investor return over that same period was only 1.18%! That means that if we look at all of the
investors that held that fund during that five year period their average return
was only 1.18% per year.
How could that be?
Well, here again we see that investor behavior trumps the many other
factors that contribute to successful investing. Over that five year period, investors in that
fund continued to engage in many of the bad behaviors that investors fall prey
to, among them likely market timing and track record investing. But this is not something that we only see at
American Funds. Fidelity Growth company
has a five year return of 7.04%, while its five year “investor” return is only
3.86%. Here again, investor’s fail to
get their full rate of return because of a lack of discipline; discipline which
can only be acquired through a commitment on the part of the advisor and client
to lifelong investor coaching. Without it, investors do and will continue to leave
money on the table.
And now, for a truly amazing thing. Do you know that an investor in a fund can
actually earn MORE than the fund itself?
Take for example a fund that many of our clients own internally in their
own portfolio, DFA US Small Cap. Its
five year fund return is 9.44%, while the INVESTOR return over that period was
10.22%. Can you figure out how this can
possibly be? We’ll have the answer in
our next newsletter.
Investor returns are dollar-weighted. As such, if a higher amount of a fund’s total return is attributable to periods with higher than average net inflows over the reporting period, higher investor returns (as opposed to total returns) will be the result.
ReplyDeleteIt is important to note that investor return is not the actual return earned by each investor, rather it’s a weighted average used to illustrate investor psychology.
I don’t think this was intentional, but your comment about an investor (singular) potentially earning more than the fund they are invested in is a tad misleading and I think deserves some clarification.
ReplyDeleteThe “Investor Return” you reference in your post is a weighted-average performance metric that is used to determine performance of the average invested-dollar, it is not the return the individual investor actually experiences. In a sense, comparing the investor return metric to total return is an apples to oranges comparison seeing as total return is a point to point measure and more indicative of an individual’s investment experience. For instance, if an investor where to purchase a fund at point A and sell at point B, their actual return would be the total return of the fund as measured from point A to point B (assuming dividend reinvestment, and not including any advisory fees). The corresponding “investor return” from that same point A to point B would be independent of the individual investors experience and would be impacted by the buying and selling of other investors inside of the performance period.
I should also mention that it is technically possible to outperform the total return for the underlying fund an investor is invested in, but that would require the use of leverage and that is outside the realm for most retail investors.
Thank you for your comment Alpha.
DeleteI would agree it is not possible to exceed the return of the fund, but in a strict sense. True, if I invest in a fund once and hold it for a 10 year period, I can't outperform the fund. However, if over that 10 year period systematically sell or purchase shares my own personal rate of return could exceed that of the fund itself- or it could be less.
As for the above, the difference between a singular specific identifiable investor, and investors, plural, is not what I was trying to get at. True, as you mentioned the fund's return and the investor's return over a single time period with no other activity will be the same. But that is not the reality of investor behavior. How many investors purchase a fund right on January 2nd, and then makes no changes- ever? The investing patterns of retail investors are highly tied to market conditions and don't tie nicely to the predictable and measured performance reporting of mutual funds. And as for "investor returns" not being what the individual investor experiences, who then invests dollars in the funds? I am assuming it is not the dollars themselves. Behind the dollars are people, and although it may be difficult, or almost impossible, to drill down to one particular investor in general, we can get a good composite look at how investors, in general, did. If I didn't exactly explain things in the best way, the following article from Morningstar also talks about this phenomenon.
http://news.morningstar.com/articlenet/article.aspx?id=303206
“How many investors purchase the fund right on January 2nd, and then make no changes- ever?”
DeleteVery few I suspect, but I fail to see how this has any relevance being that it is not a necessary for an investor to have purchased the fund right on January 2nd to achieve the same total return as the fund over the calendar year. All that is required is that the investor be invested in the fund on or before January 2nd. So for any given fund, there are a large number of “buy-and-hold” investors whose holding period is far greater than any given year making calendar year total returns relevant for those investors (who had held their position over the respective year).
The better question is “Are investors, with a one year holding period, more likely to achieve the funds stated total return over that holding period, or Morningstar’s “Investor Return” over that same period?” As you’ve noted previously, total return would assume no systematic purchases or redemptions. So for those investors dollar cost averaging in or out, their personal rates of return would vary from the fund’s total return over that period. But even with that taken into account, there are still a large number investors who did not make additional purchases or redemptions who would certainly achieve the funds stated total return. How many would achieve Morningstar’s “Investor Return”? Basically zero. Although some investors might have an identical return, it would be the result of 100% pure coincidence. In order for an investor to replicate Investor Return they would need to match every single inflow and outflow from the fund (by every investor) in terms of both timing and magnitude to achieve that identical return. This is very unlikely, on par with a 6+ sigma event.
So to be clear, I’m not trying to imply that total return numbers are the greatest thing since Black-Scholes, since they obviously have their limitations which I think we’ve both outlined. But I have a bit of a deep seeded annoyance with Morningstar’s Investor Return, because I think it’s misleading and can distort investor expectations. Essentially what Morningstar did was take a money-weighted return measure, which is a fantastic tool and is how we derive personal rates of return, and then tried aggregating it with the rest of the investor pool. Outside of being able to illustrate that net inflows can affect rates of return, it has essentially no value. The formula is sensitive to large net inflows, so if an institutional investor makes a large purchase in the fund it will skew the results entirely. But there is no way to determine when this happens which is why I believe Invesotr Return is a dubious measure of how the average investor performed.
Investors should use time-weighted (I prefer risk-adjusted) return measures for comparative purposes when evaluating investment performance, and money-weighted returns to calculate their own personal rate of return.
That’s just my two basis points….
-Alpha