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Speaker 1: Bloomberg Audio Studios, podcasts, radio news.

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Speaker 2: What would you say if I told you that most

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Speaker 2: investors underperform not only the benchmarks, but their own investments.

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Speaker 2: That's the conclusion of an annual study by morning Star

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Speaker 2: titled Mind the Gap. It examines the differences between returns

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Speaker 2: generated by investment funds and the actual returns investors experience.

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Speaker 2: The difference between the two, it's a substantial performance gap,

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Speaker 2: driven in large part by investor behavior. I have the

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Speaker 2: perfect person to discuss this with. Jeffrey Pattak is the

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Speaker 2: managing director at morning Star. Previously he was the chief

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Speaker 2: ratings officer there. He joined morning Store way back in

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Speaker 2: two thousand and two. So, Jeffrey, let's start with the basics.

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Speaker 2: What is the investor return gap and how large is it?

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Speaker 3: Yeah, so, first off, thanks so much for having me.

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Speaker 3: I'm a big fan of the podcast. So the investor

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Speaker 3: return gap is the difference between our estimate of the

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Speaker 3: average return of a funder or a group of funds

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Speaker 3: and that funds. It's total return, it's stated return. What's

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Speaker 3: the difference between the two of those things. The former

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Speaker 3: takes into account the timing and magnitude of cash flows

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Speaker 3: that have come and gone to and from the fund

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Speaker 3: over time, whereas a total return, which most of us

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Speaker 3: are familiar with from popping out up Bloomberg dot com

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Speaker 3: or Morningstar dot com assumes an initial lump sum investment.

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Speaker 3: And so when you compare the two of them, you

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Speaker 3: can derive a sense of the impact of the timing

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Speaker 3: and magnitude of buys and sells over time. To cut

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Speaker 3: to the chase, when we estimated that for the trailing

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Speaker 3: ten years and to December thirty first, twenty twenty four,

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Speaker 3: we found that there's a one point two percentage point

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Speaker 3: annual return gap compared to the funds aggregate total returns. So,

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Speaker 3: in essence, what that meant is that the timing and

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Speaker 3: magnitude of cash flows basically cost investors around fifteen percent

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Speaker 3: of their aggregate total returns.

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Speaker 2: That's unbelievable. That's a giant, giant shortfall. How do you

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Speaker 2: calculate that gap? How do you figure out? I mean,

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Speaker 2: it's easy to figure out what a fund, an ETF,

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Speaker 2: a mutual funds is actually generating. How do you figure

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Speaker 2: out the shortfall that individual investors are suffering?

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Speaker 3: Yeah, great question. It's akin to an internal rate of return. Estimate.

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Speaker 3: So we pull all US open end fund and ETF

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Speaker 3: assets together, so that's their beginning that assets. They're monthly flows,

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Speaker 3: so that's one hundred and twenty monthly netflows that we

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Speaker 3: impound into the calculation, as well as their ending net assets.

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Speaker 3: We dump all of that into a calculation that derives

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Speaker 3: essentially the concert return that would reconcile the beginning assets

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Speaker 3: to the ending assets after taking those cash flows into account.

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Speaker 3: All the data we use is data that morning Star collects.

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Speaker 3: So funds support their assets as well as their flows,

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Speaker 3: and so we scoop that up and we plug it in.

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Speaker 2: So what sort of funds does this include? I assume

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Speaker 2: this is mutual funds and ETFs. Anything else in the package.

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Speaker 3: You got it. It encompasses US open end mutual funds

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Speaker 3: as well as ets. It wouldn't include things like closed

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Speaker 3: end funds. In all, there were around twenty six thousand

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Speaker 3: individual funds and ETFs that together held around twenty five

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Speaker 3: trillion dollars in assets by the end of our study period,

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Speaker 3: so it's quite a comprehensive study.

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Speaker 2: I'm fascinated by the difference between timewaighted rate of returns

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Speaker 2: for funds and acid weighted returns. Explain the two, because

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Speaker 2: really that makes a giant difference, doesn't it It does.

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Speaker 3: Indeed, yes, your listeners are probably familiar with time weighted

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Speaker 3: returns because that's what they'd encounter in their normal affairs.

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Speaker 3: So I mentioned earlier, if they were to pop on

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Speaker 3: to Bloomberg dot com or Morningstar dot com pull up

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Speaker 3: a funds performance, those are time weighted return figures. The

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Speaker 3: more popular parerlance is total returns and a time weighted return.

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Speaker 3: It assumes an initial lump sum investments that's left untouched

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Speaker 3: until the end of the period. It's sort of your

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Speaker 3: classic buy and hold. Where's a dollar weighted return that

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Speaker 3: takes the timing and magnitude of investors purchases and sales

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Speaker 3: into account. It doesn't assume people invest in initial lump

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Speaker 3: sum and hold it to the end like a total

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Speaker 3: return does. And so that's essentially the difference between the

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Speaker 3: two measures.

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Speaker 2: I've seen some interesting studies on hedge funds and on

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Speaker 2: some ETFs where the timeway to return makes it look

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Speaker 2: like a manager has done really well, and then when

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Speaker 2: you see the dollar way to return, most of the

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Speaker 2: assets tend to flow in after they've had a big

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Speaker 2: run up after the media has focused on them. Some

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Speaker 2: hedge fund managers that look like they have great track

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Speaker 2: records in terms of how well they've done for their

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Speaker 2: investors are actually net losers over time. Do you see

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Speaker 2: things that extreme when you're looking at this data?

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Speaker 3: We do, indeed, unfortunately, I will say in aggregate, on

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Speaker 3: balance investors have gotten better, and we can talk about

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Speaker 3: some of the reasons for that, about capturing more of

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Speaker 3: their funds total returns than was formerly the case. But yes,

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Speaker 3: we do see some of these vivid examples of investors

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Speaker 3: Schematically they're buying high end selling low. You know, it's

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Speaker 3: sometimes it's chasing behavior where investors pile in just as

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Speaker 3: you describe after a fund goes in a strong run,

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Speaker 3: only for performance to roll over, at which point they

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Speaker 3: bail out, you know, and that can work in reverse

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Speaker 3: where they sell before performance impruse. Both of those things

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Speaker 3: would dent their dollar weighted returns compared to the fund's

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Speaker 3: total return.

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Speaker 2: So it sounds like behavioral factors are a cause for

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Speaker 2: investors suffering actually lower returns than their fund's total return.

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Speaker 2: What other behaviors do you see that are a net negative?

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Speaker 3: You know, I mean I think that you sometimes it

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Speaker 3: can be quite mundane where you will see an investor

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Speaker 3: or someone you know representing them decide that they want

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Speaker 3: to change the asset mix. And so it might not

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Speaker 3: be in response to a particular funds performance. It could

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Speaker 3: be that for whatever reason, they just decide that they

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Speaker 3: want to be positioned differently, and so maybe they put

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Speaker 3: more exposure on in an area that's outperformed and take

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Speaker 3: some weight off in an area that's underperformed, only to

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Speaker 3: see that wrong foot them over subsequent periods. And so

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Speaker 3: those are the sorts of decisions behaviors that can give

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Speaker 3: rise to gaps.

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Speaker 2: Yeah, version is a cruel mistress. What about different types

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Speaker 2: of funds when we look at market cap size or

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Speaker 2: geography US versus international? How does the gaps form in

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Speaker 2: those types of things?

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Speaker 3: Great question, Barry. Those are some of the dimensions that

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Speaker 3: we look at as part of the study. Sector equity

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Speaker 3: funds have chronically suffered the widest gaps in absolute terms.

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Speaker 3: In our most recent study, the average dollar invested in

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Speaker 3: sector equity funds lagged the funds total returns by one

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Speaker 3: and a half percentage points a year over the over

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Speaker 3: the decade ended December thirty first, twenty total, which meant

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Speaker 3: that investors failed to capture around twenty percent of those

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Speaker 3: funds aggregate returns. By contrast, we've seen the narrowest gaps

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Speaker 3: among allocation funds in the most popular example of which

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Speaker 3: are target date strategies. Those funds barely had an investor

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Speaker 3: return gap over those ten years ended December thirty first,

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Speaker 3: twenty twenty four. So the other thing, I would notice

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Speaker 3: that ETFs had wider gaps than traditional open end funds.

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Speaker 3: We include both in the study. Over the ten years

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Speaker 3: out of December twenty four, the average shower invested in

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Speaker 3: ETFs lag the ets aggregate total return by around one

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Speaker 3: point seven percentage points annually, which is equivalent fron eighteen

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Speaker 3: percent of the ETF's total returns. Open end funds, by contrast,

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Speaker 3: data narrower one point two percentage point per year gap

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Speaker 3: over that timeframe. So ETFs are great in a lot

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Speaker 3: of different ways. We just want to make sure that

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Speaker 3: we use them in the most prudent fashion.

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Speaker 2: That makes sense. ETFs are a trading vehicle for some people,

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Speaker 2: and we know what the long term results of most

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Speaker 2: people's active trading is. Like, I'm curious how do the

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Speaker 2: international funds stack up against domestic funds in terms of

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Speaker 2: the gap?

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Speaker 3: Very good question. The gap was slightly wider for international

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Speaker 3: funds than it was for domestic equity funds. So we

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Speaker 3: found that there was a one point one percentage point

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Speaker 3: annual gap, whereas for US equity it was about half

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Speaker 3: that was it was about half a percentage point zero

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Speaker 3: point six percentage points to be precise.

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Speaker 2: And what role does market volatility play in this gap widening?

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Speaker 2: I recall earlier this year when the tasks were rolled

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Speaker 2: out in April, we saw a lot of frenetic activity.

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Speaker 2: You can help but look at that and imagine very

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Speaker 2: few people got that right.

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Speaker 3: Yeah, right, you are. Our research has found a correlation

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Speaker 3: at a couple levels. At an overall market macro level,

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Speaker 3: as you allude to, market fluctuations do tend to push

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Speaker 3: investors buttons. They're much likelyer to make changes to their

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Speaker 3: holdings and this can work to their detriment and dollar

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Speaker 3: weighted terms. We also look at this at an asset

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Speaker 3: class level, you know, so US equity, international equity, taxable bonds,

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Speaker 3: and on and on. We also find there that the

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Speaker 3: more volatile funds of a particular type have been harder

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Speaker 3: for investors to successfully use them less volatile funds, and

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Speaker 3: so there are wider gaps with those hotter to handle,

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Speaker 3: too hard to handle funds that you would find in

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Speaker 3: say US equity or taxable bond as compared to their

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Speaker 3: more sedate counterparts within those asset classes. And so that's

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Speaker 3: been another sort of perennial finding from the study is

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Speaker 3: that volatility pushes investors' buttons, and when it does so,

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Speaker 3: they tend to capture less of their funds total returns.

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Speaker 2: You mentioned target date funds. I tend to think of

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Speaker 2: target date funds or balance funds typically in four to

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Speaker 2: oh one K or retirement plans where most people have

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Speaker 2: a tendency to set and forget and just dollar cost

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Speaker 2: average on a regular basis with each paycheck. Generally speaking,

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Speaker 2: do we see less of a gap in retirement funds?

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Speaker 2: Is it because of the specific long term nature of

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Speaker 2: target date funds or the fact that it's a in

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Speaker 2: a four to oh one K or four H three B.

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Speaker 2: What's the advantage balance funds target date funds have, YEP.

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Speaker 3: I would say there's two principal advantages. One is contextual,

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Speaker 3: the other is related to the attributes the characteristics of

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Speaker 3: those strategies. Let's talk context first. They're most often used

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Speaker 3: in the context of a retirement plan. It's a gilded

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Speaker 3: cage of sorts. It's really meant for investors to go

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Speaker 3: in and save and compound over time, not for them

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Speaker 3: to wheel around as they might in a brokerage account.

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Speaker 3: Then let's talk about the characteristics of those vehicles. As

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Speaker 3: you reference, they're highly automated, They take care of rebalancing,

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Speaker 3: they adjust the asset mix as time goes on. They

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Speaker 3: are as you put it, set it, and forget it,

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Speaker 3: and that has worked to investors benefit. We found that

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Speaker 3: investors in allocation funds they captured essentially all of their

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Speaker 3: funds total returns. That is, there was almost no gap

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Speaker 3: among allocation funds over the ten year study period that

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Speaker 3: we were focused on. And so I think that's one

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Speaker 3: of the most heartening stories to come out of our

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Speaker 3: research is the fact that it seems that investors in

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Speaker 3: retirement plans are specifically those who invest in allocation funds,

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Speaker 3: have enjoyed some of the greatest success and that's crucial

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Speaker 3: to their retirement security.

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Speaker 2: So give investors some practical advice, what sort of steps

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Speaker 2: can they take to minimize the gap capture more of

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Speaker 2: their investing funds long term returns.

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Speaker 3: Yeah, it's a great question. So it might sound a

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Speaker 3: bit tripe, but I would say, have a plan and

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Speaker 3: automate as much of it as you can. Investors, they

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Speaker 3: tend to get themselves in trouble when they engage in

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Speaker 3: off cycle discretionary ad hoc type of trading. You know

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Speaker 3: what might that happen is you can probably imagine it's

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Speaker 3: likelier to occur when there's some sort of market disruption

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Speaker 3: or tumult or a minimania. But if you have a

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Speaker 3: plan and you've appropriately allocated your assets based on that plan,

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Speaker 3: you know, widely diversifying across asset, then you have an

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Speaker 3: anchor or a point of orientation, whereas without it you

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Speaker 3: might feel like you're at c You know, also, because

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Speaker 3: you've spread out for the plan diversifying, why you're less

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Speaker 3: likely to experience the brunt of a sell off and

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Speaker 3: experience the kind of ruin US outcome that might induce panic.

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Speaker 3: Automating is the other key. I would say. You know

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Speaker 3: what we know about target date funds is they're held

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Speaker 3: in retirement plans. Yes, but also they obviate the need

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Speaker 3: for investors to take action to rebalance or to adjust

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Speaker 3: the asset mix as they were near the retirement date.

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Speaker 3: And that's because those features are built in, so, you know,

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Speaker 3: I think one of the other clear takeaways from the

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Speaker 3: research is that automation narrows gaps.

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Speaker 2: So to wrap up, investors can avoid the investor gap.

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Speaker 2: They can avoid underperforming their own mutual funds and ETFs

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Speaker 2: by simply having a couple of common sense steps put

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Speaker 2: into place. Don't let volatility distract you. Don't try and

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Speaker 2: buy or sell when markets get frothy, don't think you're

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Speaker 2: going to be able to time the market. And perhaps

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Speaker 2: most important of all, you have to have a plan

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Speaker 2: and you have to be able to keep your emotions

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Speaker 2: at bay, otherwise you're going to fall into the unfortunate

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Speaker 2: fate of underperforming your own investments. I'm Barry Ridolts. You're

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Speaker 2: listening to Bloomberg's At the Money