Investor Returns

We've all heard horror stories that illustrate investors' tendency to buy high and sell low. But just how bad is investors' timing, really? To answer that question, we took a look at investor returns, also known as asset-weighted returns, which Morningstar recently began calculating for funds in its database.

By factoring in the timing of investors' purchases and sales, investor returns depict the returns earned by the typical investor. In aggregate, the data show that investor returns have generally lagged those of funds' published total returns, which assume a buy-and-hold strategy.

Are the anecdotes about investors' poor timing overblown, based on Morningstar investor returns? No. Although most fund categories' total returns and investor returns were fairly close to one another over the past three- and five-year periods, the gap between the two widened substantially over the trailing 10-year period. That's likely because the 10-year period encompassed the late 1990s' bull run as well as the bear market, and both extremes tended to stimulate poor decision-making.

[10/13/09] CGM Focus (CGMFX) and T. Rowe Price Equity Income (PRFDX) illustrate how volatility affects investor behavior. Both are run by excellent managers (Ken Heebner and Brian Rogers, respectively) who have beaten their peers over the long term. Focus' 10-year annualized return of 19.6% thumps Equity Income's 3.7% yearly return through the end of September 2009--as it should, because Heebner takes much bigger risks than Rogers. Heebner makes huge sector bets, holds only about 20 stocks, and even sells short stocks that he thinks are primed for a fall. Rogers aims for a steady ride by focusing on reasonably priced, dividend-paying stocks.

But consider what investors actually earned. Rogers' clients have kept nearly all of the fund's meager gains, earning an average of 3% annualized over the past 10 years. Heebner's have somehow turned their fund's terrific reported results into an annualized loss of 14%. They managed that feat by piling into CGM Focus after its extraordinary 80% gain in 2007, only to get pummeled when Focus plunged 48% in 2008.

[7/27/12] Among the most interesting data points available on Morningstar.com is investor returns, which reflects actual investor experience with a fund as opposed to how the fund itself performed in isolation.

A fund's total return depicts whatever returns its basket of securities earned from one given point in time to another. But not every investor was on board the fund for the whole time period, and that's what investor returns attempts to capture. We calculate investor returns by using fund inflow and outflow data and applying it to fund performance. We can then see how the average investor fared relative to the fund.

To illustrate how total and investor returns can differ, consider a fund that gains 12% in the first three months of the year, then remains flat for the remainder. Its gain for the entire year is 12%. But what about the investor who, seeing the fund's hot early performance, jumps in during month number four? His or her return for the year is zero. As you can see, the difference between investor return and a fund's total return can be quite dramatic.

Two common themes that emerge here are investors piling into funds with excellent track records that are unable to repeat those strong performances, and investors abandoning funds after sharp downturns and thus missing out on the subsequent rebound.