The start of a new year is the perfect time to take a fresh look at your financial goals and investment strategies. The recent Morningstar study, “Mind the Gap 2024,” highlights why this annual review isn’t just a good habit—it’s essential for maximizing your investment returns.
When you are working hard to fund a financial plan you want to extract every available basis point of financial return you can, leaving nothing on the table.
That’s not the reality for many investors, and this is why…
The gap between investor and fund returns
Here’s a reality check: over the decade ending December 31, 2023, the average investor in US investment funds and ETFs earned about 6.3% annually. This is about 1.1 percentage points less than the average fund’s total return of 7.3% each year. In other words, investors missed out on roughly 15% of the returns their funds generated.
This difference, known as the “investor return gap,” was consistent throughout the study period. It’s a clear indication that even in a strong market, investor emotions and timing can significantly impact potential gains.
Key reasons for underperformance
1. Poor Timing of Purchases and Sales
The study showed that investors often made bad timing decisions, buying when prices were high and selling when they were low.
For example, in 2020, the pandemic induced many investors to pull out of their investments as the news broke. Collectively, they pulled out nearly half a trillion dollars as markets fell.
What we now know is that the market fell sharply and then rebounded just as strongly, so without perfect timing, investors the subsequent recovery.
The report states, “Investors particularly struggled to navigate 2020’s turbulence.” This illustrates how our emotional reactions to market volatility can lead to costly mistakes.
2. Performance Chasing in Volatile Sectors
Sector equity funds had the largest gap between investor returns and total returns, with a negative 2.6% gap annually.
These funds follow a theme and are often known as ‘thematic’ funds. Promoters position these funds as forward-looking, enabling investors to leverage demographic and technology trends.
Some examples are: Asian Technology Tigers ETF, Digital Health ETF, Global Robotics & AI ETF EV and Autonomous vehicles ETF, Global Cybersecurity ETF.
While these ETF’s all invest in legitimate technologies they are highly speculative and more likely to be traded.
The Morningstar research suggests investors are prone to chasing performance in more volatile sectors, often to their detriment. It’s like trying to jump on a moving train—exciting, but potentially risky.
3. Excessive Trading in ETFs
Interestingly, index ETFs had a wider gap (negative 1.1% annually) compared to index mutual funds (negative 0.2% annually). This suggests that the ease of trading ETFs might encourage overtrading.
Just because investors can trade, doesn’t mean they should.
It’s similar to having a fully stocked fridge—sometimes the convenience makes us indulge more than we should.
Strategies for improvement
1. Keep It Simple and Diversified
The study found that allocation funds, which spread assets widely across asset classes, had the smallest gap (negative 0.4% annually).
This suggests investors are better off in diversified portfolios with different asset classes, with good portfolio hygiene. Regular rebalancing, limited trading and low-cost are three sure-fire ways to maximise return relative to market.
Sometimes, the simplest approach is the most effective.
2. Stay Disciplined
Dollar-cost averaging, or making regular, consistent investments regardless of market conditions, could help reduce the impact of poor timing decisions. It’s like setting up a regular exercise routine—consistency often beats intensity.
When things get turbulent on markets, do as the pilot says, return to your seat and fasten your seatbelt. Turbulence is uncomfortable but it always passes.
3. Be Cautious with Narrow Strategies
The research shows that the more specific the investment strategy, the harder time investors had in capturing its total return. This underscores the importance of maintaining a broadly diversified portfolio rather than chasing performance in niche sectors. It’s like having a balanced diet instead of following the latest food trend.
4. Think Long-Term
The persistent nature of the investor return gap across all ten years of the study period emphasizes the importance of maintaining a long-term perspective. Avoid making reactive decisions based on short-term market movements. Think of your investment strategy as a marathon, not a sprint.
Jeffrey Ptak, Chief Ratings Officer at Morningstar, sums it up well: “If there’s only one lesson to take away from ‘Mind the Gap,’ it’s that investors seem to have enjoyed greater success using widely diversified funds.”
As you start this new year, take some time to review your investment strategy. Consider whether your current approach aligns with the lessons from Morningstar’s research. Are you diversified enough, making emotionally-driven decisions, or trading too frequently?
Remember, the goal isn’t just to choose good investments, but to be a good investor.
By adopting a disciplined, long-term approach and regularly reviewing your strategy, you can work towards closing your personal investor return gap and potentially capture more of the returns your chosen funds generate. It’s a New Year’s resolution that could pay off for years to come.
I’m interested in your thoughts, and if your portfolio needs a second opinion, let me know.
