Wednesday, February 22, 2012

Why Mutual Fund Owners Earn Lower Returns Than The Funds They Own(!)

Mutual fund owners earn lower returns than their funds report. And, it's not because the funds are lying.

In an earlier post we saw that investors earn significantly less than the theoretical, published overall market returns. In this post we'll see that they also earn less than the published returns for the funds that they actually own! How can that be? Read on.

Mutual Fund Returns vs. Investor Returns (aka Dollar-Weighted Returns)

investor returns, asset-weighted and dollar-weighted returns

The graph above (click to expand) shows that between 1991 and 2010 the return for the average stock fund was 9.9% per year. For this same period, the average stock fund investor earned just
3.8% per year -- more than 6%/year less! This is not unusual.

To calculate published fund returns a hypothetical purchase is made at the beginning of the period being evaluated and sold at the end, reinvesting all interim distributions of dividends and capital gains. On the other hand, "investor returns," the second number, are dollar-weighted returns, and take into account the timing of fund purchases and sales by investors. Therein lies the problem.

Mutual Fund Flows vs. Fund Returns

investor returns, mutual fund money flows, hot money chasing performance
Mutual Fund Flows vs Fund Returns

In the chart above (click to expand), the tan line shows the yearly net flow of funds into U.S. domestic stock funds between 1997 and 2010 (as measured against the vertical axis on the right side of the chart). The bars show the yearly returns of those same funds (measured against the left vertical axis); blue bars show positive returns, red bars show negative returns. (Note: if you can't read the annotations, but would like to, see the appendix at the end of this post.)

"Buy low, sell high" is an oft-repeated investment adage that reminds investors that the way to maximize profits is to buy when stock prices are low (i.e., cheap), and sell when stock prices are high (expensive). However, the chart above shows that, as a general rule, mutual fund investors are doing just the reverse -- buying high and selling low.

Fund Money Flows: Greed & Chasing Performance=> Buying High

Notice that mutual fund inflows hit an all-time high in 2000, the year the market peaked. When stocks were doing well, money flowed into mutual funds; the higher the market went, the more expensive stocks became, the more investors bought. Investors' greed overcame their fear, and they chased after stocks looking to strike it rich.

Since investors bought high, they were poorly positioned for the collapse that followed the 2000 peak, and their returns suffered as a result. Note that investors "bought high" not only at the total market level, but also, for example, at the sector and fund levels -- chasing after the current hottest performers. For example, when technology was hot, money poured into technology funds. When emerging markets were on fire, money poured into emerging markets funds.

Fund Money Flows: Fear & Risk Avoidance=> Selling Low

To make things worse, when prices were low (i.e., when the market was "on sale") fund investors' fear overcame their greed and they tended not to buy -- or even to sell.

So, as the market went lower, and got cheaper, mutual fund in flows slowed to a trickle. Thus, relatively few fund dollars enjoyed the 30% return in 2003. Similarly, during the 2008 crash, inflows not only slowed, but turned negative. As a result, fund investors again had relatively few dollars invested to participate in the 30+% rebound -- and their returns again suffered.


If bananas are on sale for 25 cents a pound, shoppers rush to buy them; not so with mutual funds. If airfare is expensive, we hold off or try to find a substitute mode of transportation; again, not so with funds.

Fear and greed apparently conspire to encourage mutual fund investors to do just the wrong thing at just the wrong time. Newspapers, magazines and TV programs often contribute to the problem by "hyping" stocks (and other asset classes) most when their valuations are least attractive.

Finally, if you think about it, it's not surprising that investor returns fall furthest behind the "baseline" returns in the most volatile asset classes and funds. For example, the bulk of the inflows into a volatile fund tend to occur after the fund has made large gains -- in which the new investors do not participate. This at least suggests that choosing a mutual fund solely because it has the largest short-term returns is not necessarily the way to go....

Valuation matters.

Appendix: Annotations on chart #2
1. Stocks deliver strong returns and euphoric investors push flows to an all-time high right before the collapse.
2. After a period of poor returns, fearful investors become cautious and miss the recovery.
3. After a terrible 2008, despondent investors pull money from stocks in record amounts and miss double-digit returns.

Related Materials

More on Difference Between Published Returns and What Investors Earn
Real World Expenses Reduce Published Market Returns: How just 2%/year in expenses could reduce your retirement portfolio by 50%!
The Easiest Way to Increase Investment Returns? Reduce Expenses!: explains why small differences in expenses have such a huge impact.
The Biggest Fund Cost You Can Control: More on investor returns from Morningstar.
My Favorite Personal Finance Books includes several interesting books on behavioral finance -- the psychology of investing.

Sample Posts on the Importance of Valuation
Dow Price/Earnings Ratio Impact on Future Returns, in Dollars: Returns of purchases made when p/e is high compared to returns of low p/e purchases. Impact in $$$.
Stock Market Rolling Returns vs Price to Earnings (P/E) Ratio Graphs: Rolling returns plotted against initial p/e ratio.
Starting P/E Ratio vs. 10-Year Stock Market Returns: scatter diagram with trend line demonstrating relationship between initial P/E and subsequent returns.

My source for these graphs was The Wisdom of Great Investors, on the Clipper Fund's website. The original source for the first graph is Quantitative Analysis of Investor Behavior by Dalbar, Inc and Lipper; for the 2nd, it's Strategic Insight and Morningstar.
For lists of other popular posts and an index of stock market posts, by subject area, see the sidebar to the left or the blog header at the top of the page.
Copyright © 2012                        Last modified: 2/2/13

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  1. Great information, but it is difficult to read the charts (even when expanded). Any way you could update with a higher resolution image or post ones with less compression artifacting?

    1. All seems to be legible now except the annotations on chart 2. I've put those in the appendix.


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