Investor Returns Trail "Regular" Returns

Earlier this month, Morningstar announced that it is going to begin reporting what they call "Morningstar Investor Return" in addition to the traditional time-weighted returns of mutual funds. Time-weighted returns are the returns that you usually read about. They are the return that you would have received on your investment had you put it in at the beginning of the the period, left it alone and reinvested the dividends along the way.

This contrasts with the Morningstar Investor Return, which is their term for dollar-weighted return. This measures what investors have actually achieved in the fund. The returns are weighted by the amount of money in the fund at the time. So, if a fund did really well when it had lower assets, attracted a lot of new money, and then didn't do so hot, its dollar-weighted return would be lower than its time-weighted return.

If investors are good at timing their moves into and out of funds (piling in money before a period of good performance and bailing out before a period of bad performance), the dollar-weighted return would exceed the time-weighted return.

So, what does the evidence show?

According to an interview by Mark Hulbert of Morningstar's managing director Don Phillips:

Phillips provided the following telling statistics, which were based on dividing all mutual funds in Morningstar's database into four groups according to the volatilities of their returns relative to comparable funds. Consider first the quartile of funds with the greatest relative volatilities: On average, their dollar-weighted returns were just 62% of their time-weighted returns.

In contrast, the quartile of funds with the lowest relative volatilities exhibited dollar-weighted returns that, on average, were 98% of their time-weighted returns.

So, the lowest-performing group had dollar-weighted returns 38% below time-weighted returns. The lowest volatility funds were only 2% below their time-weighted returns.

Interestingly, in a table accompanying the article, Hulbert looked at the top 25 funds in terms of assets and picked out the ones where the dollar-weighted returns trailed the time-weighted returns by more than 1% annually. What was notable to me is that two of these eight funds were index funds from Vanguard. This suggests that despite the buy-and-hold philosphy that often accompanies index investing, many people also try to move in and out according to when they think a particular index is overvalued or undervalued. As the numbers show, investors haven't been very succesful when they try to time the market.