Every year, financial data and research provider Morningstar produces a study named “Mind the Gap,” which examines the difference between investors’ actual returns and the total returns of their funds—a phenomenon known as the “return gap.” The 2024 study, released late this summer, once again shows that individual investors tend to hurt their own performance, earning less than their funds’ returns. This difference is primarily due to the timing of when investors decide to buy and sell. Let’s explore what this means and how to avoid it.
The Return Gap
According to the study, over the past decade, ending in December 2023, the average investor earned about 6.3% per year while their funds actually returned 7.3% annually. The 1.1% annual difference, while lower than the approximately 1.6% gap observed during the heightened volatility of 2020 to 2022, was in line with the historical average.
But why does this happen? It often comes down to poorly timed decisions—like buying into a fund when prices are high and selling when they’re low. For example, many investors reacted emotionally during the market turbulence in 2020 caused by the pandemic. They sold their investments after the steep selloff and had trouble getting back into the market. When they finally did, it resulted in an even larger gap of 2% that year.
Does the fund type matter?
Interestingly, but perhaps unsurprisingly, the return gap varies by fund type. Allocation funds (including target-date and blended funds), which invest in different instruments like stocks and bonds, had the smallest return gap (0.4%). Their built-in diversification and automatic adjustments likely make it easier for investors to stay invested without making frequent changes.
On the other end of the spectrum were sector equity funds (which invest in specific industries like technology or healthcare). These funds had the largest gap (2.6%). Being less diversified and more volatile, these funds generally tempt investors at just the wrong moment, leading to poor timing decisions.
It’s not the funds themselves that cause larger return gaps, but the way investors react to them that leads to underperformance.
What about mutual funds vs. ETFs?
For the first time, the 2024 study compared traditional mutual funds with ETFs (exchange-traded funds). Why is this significant? If you’re comparing an index mutual fund and an ETF in the same category, the only difference is that mutual funds are priced once a day after markets close, while ETFs can be bought or sold throughout the trading day, just like individual stocks.
This was the single most interesting piece of information in the entire report. Looking at the return gap between index mutual funds and ETFs, the performance was startling. While index mutual funds only had a 0.2% gap, their ETF counterparts had a 1.1% gap.
This was not only surprising because of how wide the gap was, but it most clearly illustrates the potential behavioral impact. Since ETFs can be traded immediately, this capability might tempt investors to react to short-term market movements, potentially harming long-term returns.
What can you do about it?
First and foremost, consider the benefits of working with a financial advisor. Just as you rely on professionals for medical or legal advice, a financial expert can provide personalized guidance to help you navigate the complexities of investing. They can assist in keeping your investment strategy aligned with your goals and help you avoid common pitfalls that lead to the return gap.
Nevertheless, if you’re intent on going the “DIY” route with your investments, there are a few critical takeaways from this study. First, keep things simple. You should likely choose funds that don’t need constant attention (think balanced/target-date type of funds). Selecting any other kind of fund (even index funds) will require you to, at the very least, keep an eye on the overall portfolio allocation.
Second, avoid trying to time the market. Resist the urge to buy when prices are soaring (a.k.a. FOMO) or sell when they plummet. Third, stick to a long-term plan. This will help you overcome the ups and downs and capture more of a fund’s returns. Fourth, try dollar-cost averaging by investing fixed amounts regularly, which can help mitigate the risks of bad timing. And fifth, if you own ETFs, just because you can trade at any time doesn’t mean you should. Try to limit unnecessary trades.
Whether you use an advisor or go it alone, this study shows that your behavior as an investor can significantly impact returns. As we’ve often said, focusing on a long-term investment strategy is vital to long-term success. Remember, when investing, patience and discipline often pay off more than trying to outsmart the market. Keep it simple and stay the course.
Economy
- Markets seem to be shaking off all the geo-political news in a continued march upward. The S&P was up 0.9%, the Nasdaq was up 0.8%, and the small-cap Russell 2000 was up 1.9%.
- Retail sales in the U.S. increased 0.4% MoM in September, well above a 0.1% gain in August and beating market expectations of a 0.3% rise.
- Housing starts in the U.S. eased by 0.5% from the previous month to an annualized rate of 1.354 million units in September, in line with market expectations.
Stocks
- U.S. equities were in positive territory. Utilities and Real Estate were the top performers, while Energy and Healthcare lagged. Value stocks led growth stocks, and small caps beat large caps.
- International equities closed lower for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield increased one basis point to 4.08% during the week.
- Global bond markets were in positive territory this week.
- High-yield bonds led for the week, followed by government and corporate bonds.
