1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #68!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In our podcast today we will review the Morningstar U.S. Mind the Gap 2024 report which highlights how investor mistiming the market has an impact on their performance.
Enjoy!
2) PROOF THAT INVESTOR BEHAVIOR HAD A NEGATIE IMPACT ON THEIR PERFORMANCE:
François Doyon La Rochelle:
For our topic today, we will look at the results of the latest Mind the Gap report from Morningstar. This report analyzes the difference between the returns reported by U.S. mutual funds and exchange-traded funds compared to the returns obtained by investors. The latest report, released on August 15th, covers the 10 years ending on December 31, 2023.
James Parkyn:
Francois, I think our listeners will find this topic very useful. We alluded to it at the end of our podcast #63. In that podcast, we covered the performance results of actively managed funds against their respective passive counterparts, and we touched upon the spectacular growth in the market share of passive funds.
François Doyon La Rochelle:
Correct, and back then I mentioned that I thought it was encouraging to see the growth in the market share of passive management and the continued outperformance of the passive versus active funds. However, I concluded that investors needed to make good use of the tools and invest in a disciplined manner with an eye on the long term. This warning stems from the fact that investor behavior has a meaningful impact on performance whether someone uses active or passive funds.
James Parkyn:
You are right Francois, investor behavior has a meaningful impact on performance since emotions often drive investment decisions. It usually comes down to fear and greed. When markets are rising investors get greedy and want to buy more. When markets are falling, investors want to sell as they fear losing money which in extreme cases can lead to panic sell-offs. Our listeners may find it interesting to know that Carl Richards, an American Financial Planner and New York Times columnist, is credited with coining the term Behavioral Gap in a personal finance book he wrote by the same name. The term behavior gap coined by Mr. Richards refers to the difference between real investor returns and average investment returns.
François Doyon La Rochelle:
Yes, and this difference is precisely what the Morningstar Mind the Gap report is trying to quantify. Unlike the returns calculated for the funds themselves, the returns calculated for investors consider cash inflows and outflows. If investors are adding value through their buy and sell decisions, the "gap" will be positive and if, on the other hand, their decisions subtract value, the “gap” will be negative.
James Parkyn:
So, François, with that being said, what are the results of the Morningstar 2024 report?
François Doyon La Rochelle:
Well, James, the report highlighted that, once again, the returns earned by investors were well below the returns generated by the funds themselves. For the ten years ended Dec. 31, 2023, Morningstar estimated that the average dollar invested in US mutual funds and exchange-traded funds, meaning the returns earned by investors, was 6.3% while the funds themselves earned about 7.3% per year. This difference, rounded up to negative 1.1% by Morningstar, means that investors lost about 15% per year of the returns that the funds generated over the decade.
James Parkyn:
This small difference of 1.1% per year over the lifespan of investing represents a huge impact on total assets when comes to the time to retire. Investors need to understand the effect that such a small difference can have on your portfolio over time.
Correct me if I’m wrong Francois but the gap experienced for the decade ending in Dec 2023 is similar to what was reported in prior year reports.
François Doyon La Rochelle:
You are right James, and if we look at the gap every year, the average investor return lagged the average total return of the funds in all of the 10 calendar years of the last decade. The lowest yearly return gap was a negative 0.7% in 2017 and the highest return gap was a negative 2.0% in 2020. According to Morningstar, the poor result of 2020 is due to bad timing by investors as they added assets early in the year before the market dropped and then withdrew funds during the meltdown just before the markets experienced a strong rally in the following months. This is concrete proof of investors’ poor behavior, impacting their investment results.
James Parkyn:
Francois, I’m not surprised by the results of the pandemic year 2020. It was very difficult that year to keep clients on track with their long-term investment policy. The COVID crisis was a big unknown, for all of us, but so were all the other crises before that. Like we have said before on this podcast, market timing is very difficult and a great way to dilapidate your capital. What’s important is time in the market and not timing the market. Francois, are there any other findings you would like to highlight in the 2024 report?
François Doyon La Rochelle:
Well, James if we look at fund categories, there are 8 of them, and investor returns lagged the total returns of the funds themselves in all 8 categories over the 10 years. The fund category with the smallest gap was the allocation funds, with a negative gap of only 0.4% per year. The investor return was 5.9% and the allocation funds return was 6.3%. The fund category with the widest gap was sector equity funds, with an investor return of 7.0% and a fund return for the category of 9.6%, for a negative gap of 2.6% per year.
James Parkyn:
Francois, I’m not surprised by the large gap for sector funds. I believe that this fund category is more often used by active investors who want to increase their exposure to a particular sector for its growth potential. They are also used by investors who want to position their portfolios differently depending on where we are in the economic cycle. Again, to me, these are all market timing decisions.
François Doyon La Rochelle:
Well, James, the report does not explain it like that, but if you interpret what it’s saying you are about right. The report says that the large negative gap for sector equity funds is due to fund flows being about twice as volatile as for allocation funds, meaning that investors are likely jumping in and out of those funds. The other reason is the fact that the returns in that fund category are 50% more volatile. The report states and I quote “the more volatile a fund's returns were compared with peers, the larger its investor return gap tended to be, on average. For instance, the average dollar invested in the most volatile quintile of sector equity funds lagged the buy-and-hold return by more than 7 percentage points per year.”
James Parkyn:
Wow, that’s a huge gap! So, Francois, I imagine the reverse is true then for asset allocation funds that automatically rebalance without investors’ input.
François Doyon La Rochelle:
Correct James, we can also say the gap is smaller for this category of fund because the fund flows are more stable and because the returns are less volatile.
James Parkyn:
This makes total sense to me François. When you invest in asset allocation funds, the returns are more stable because of the diversification benefits you are getting. For instance, these asset allocation funds likely will be holding bonds. The bonds will play the role of stabilizers. This in turn reduces volatility which leads to investors being more likely to stay the course in difficult markets.
François Doyon La Rochelle:
Correct, again, the less volatile the fund is, the better the investor is positioned to capture its return.
James Parkyn:
Is there anything else François that stood out to you, that we should highlight for our listeners?
François Doyon La Rochelle:
Yes, there are a couple more things. First, I would like to comment on the negative gap that exists for the Municipal bonds and the Taxable bonds groups. I’m surprised the report does not discuss this. Although their respective gaps are narrow at 1.3% and 1.0% respectively, I believe that these gaps are high relative to the performance of the funds in these asset classes. Since the Municipal bond group had a return of 2.8% and the Taxable bond group had a return of 2.2%, the negative gaps experienced by investors mean that they left roughly 46% of the returns from bonds on the table for the last 10 years.
James Parkyn:
That is a very good point you made François. It is surprising and counterintuitive because we assume that normally bond returns are less volatile. At the same time, I think we can attribute this to the historically high negative returns and high volatility experienced in the bond market in 2022 due to the spike in inflation and the subsequent increase in central bank rates.
François Doyon La Rochelle:
Perhaps, the other thing I would like to highlight is the poor performance of the Alternative funds category which includes hedge funds, and I think you will like this, James. I quote the report “Alternative funds earned the dubious distinction of being the only category group where the average dollar lost money over the decade, as it posted a negative 0.4% annual investor return.” The report goes on to say and I quote “This is somewhat ironic considering the sales pitch for some alternative funds is based on their ability to preserve capital”.
James Parkyn:
Wow, that puts a dent in their sales pitch. A negative return over a decade when U.S. equities have returned over 10%, you honestly have to question the merits of these funds for individual investors especially because no other fund category had negative returns over the period. To me, the likely explanation is that the outrageous fees of these alternative funds explain the poor performance.
Our regular listeners will remember from podcast #64, I quoted Jason Zweig of the Wall Street Journal “If Buffett had charged conventional hedge-fund fees, his investors would have earned only about 10% of the wealth they have enjoyed”. High fees reduce returns, but outrageously high fees destroy returns.
Is there Anything else to highlight François?
François Doyon La Rochelle:
Yes, my last point and this brings us back to our introduction when I said that investors needed to make good use of the passive tools at their disposition and invest in a disciplined manner. The report highlights that overall investor returns in passive funds were higher than in active funds and the that negative return gap was smaller for passive funds.
James Parkyn:
So this is good news for passive investors but not all investors use ETFs passively.
François Doyon La Rochelle:
Yes, the report highlights that when investors deviate from the U.S. equity and international equity categories and into other fund categories such as sector equity, and nontraditional equity, the negative investor gap widens quickly and is worse than the negative gaps experienced for investors in active funds. The report states and I quote “This suggests investors could be forsaking the cost advantage they enjoy in such funds in their zeal to trade.”
James Parkyn:
Francois, we have often shared with our listeners that one of our core beliefs is that: active trading reduces your chances of creating value. The Morningstar report supports this thesis. The behavioral gap results for sector equity and non-traditional equity are compelling. You have alluded to this in the past François. ETFs are great tools but must be used wisely.
François Doyon La Rochelle:
In addition, James, even when investing passively, capturing capital market returns of multiple asset classes is very hard to do, you get caught up in the latest news or latest fads and then your emotions get in the way, and you react by trading. Passive ETFs are great low-cost tools to capture market returns but they are also double-hedged swords because they can be traded easily when markets are open. To this point, some investors could be better served using index mutual funds than index ETFs because the negative return gap for index ETFs was a lot wider at a negative 1.1% versus index mutual funds at a negative 0.2%.
James Parkyn:
That statistic to me Francois is very compelling about investors’ behavior. I think it is fair to say that to narrow the negative Investor Gap, investors should hold a small number of broadly diversified funds in various asset classes. They should favor simplicity and avoid excessively specialized funds such as sectoral and thematic funds. Finally, they need to manage their behavior and the best way to do it is to have an investment plan and to stay the course in difficult markets.
François Doyon La Rochelle:
I could not agree more James and as Bill Berstein, neurologist, financial theorist, and author once said and I quote “To the extent that you succeed in finance, you succeed in finance to the extent that you can suppress the limbic system, your system one, which is the very fast-moving emotional system that we have. If you can’t suppress that, you’re probably going to die poor…”
James Parkyn:
That’s a great quote, Francois, I think it says it all.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn: for sharing your expertise and your knowledge again today.
James Parkyn:
My pleasure. François.
François Doyon La Rochelle:
That’s it for episode #68 of Capital Topics!
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