Investor return gap
Much is made of league tables of best and worst performing investments in the industry. A lot of ink is spilt over whether active funds outperform passive or growth investments outperform value. But surprisingly little research is done on how these returns translate to the portfolios of actual investors.
But Morningstar do an analysis of funds in the US where they compare the fund’s average returns over time to the money weighted returns of the average investors in that fund. In this way they estimate the return gap due to investors timing (or mistiming) the market.
They find that, on average, investors subtract value with market timing. And these return gaps are very large and persistent compared to the return differences that are typical of different funds within categories. The table below shows the results over the 10 years to 2020.
The average return gap is -1.68% per annum across the categories, which is significantly more than most advisers would charge. And this analysis would only capture the effect on investors who do actually invest at some point. We’ve known a number of advisers with some clients who never fully implement their portfolios because of fears about different assets. So the true return gap is probably much larger than this.
It’s also interesting to note that the biggest return gaps are in sector equity funds and alternative assets. In our portfolio reviews for our clients we see a continuing theme of pro-cyclicality — investing in sectors or styles that have been performing well. We generally think about investing the other way — invest more in good quality assets that are cheaper than normal and go underweight investments that are more expensive. The gap figures above are consistent with this pattern of behaviour.
Sector funds are more volatile, as the stocks within them tend to move in a group, and sectors that are well regarded today often return to market valuation levels over the long run. Alternatives tend to capitalise on pricing differences or trends in different markets, so it’s not unusual to see a burst of good performance from a fund when several of its trades go well at once followed by several months of lacklustre returns as the fund managers search for new opportunities. And most alternatives funds have performance fees based on long term performance over a benchmark or high water mark, so the effective fee of a fund is likely to be higher after a period of outperformance. So it’s no surprise that these sectors are the ones with the biggest return gap.
Part of the reason why we think a lot about downside protection in portfolios is that we’ve seen investors deviate from their strategies when markets are difficult and miss out on the strong returns after markets stabilise. By designing the portfolios to be protected from drawdowns we make it easier for investors to stick to their strategy and avoid the return gap.
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This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.
Please note that past performance is not a reliable indicator of future performance.
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