(PUB) Investing 2016

2

Mind the Gap 2016 Continued From Cover

Trailing 10-Year Average Annual Returns and Asset-Weighted Investor Returns (as of December 2015)

and they consistently show investor returns that are superior to time-weighted returns. For one, target- date funds have sufficiently moderate returns to avoid scaring shareholders away while not attracting hot money. In addition, target-date funds are mostly held in 401 (k) accounts where investors buy with every paycheck. Although they could still panic and sell at the wrong time, most investors ride out the downturns. You don’t have to be in a target-date fund, though, to invest like those who do. Systematic investing and rebalancing is a great way to stick to your plan through thick and thin. Before I started running these figures, I would not have guessed that boring old muni-bond funds could be so misused, but it has been going on for a while. The problem here is that you have some very risk-averse investors and a sector with scary headlines. You won’t see many headlines about how nearly all muni issuers are making their payments on time or how once-troubled states like California have improved their balance sheets dramatically. Rather, you hear about Puerto Rico’s crushing debt and Meredith Whitney’s ill-informed doomsday call. Those news events spurred muni investors to sell, and that led to a drop in muni-bond prices and a spike in yields. Thus, they created a buying opportunity just as investors were fleeing. This speaks to the down- side of trying to time the market and the benefit of staying focused on the long term. Oddly, sector funds did quite well as investors had good timing in some real estate, utilities, and communications funds. What Factors Are Linked to Investor Returns? Expenses are strongly linked to investor returns. Cheapest-quintile funds have significantly higher investor returns and smaller gaps while both figures progressively get worse as you move up in fee quintiles. In fact, the differences are much greater than the fee differences themselves. There are two reasons. First, low costs lead to better returns and therefore investors are in a positive feed- back loop that makes them more likely to stay with their fund. Second, investors in low-cost funds tend to be better-informed investors who will use their funds correctly more often. The other factor is volatility, whether measured by Morningstar Risk

p Average 10-Yr Total Return (%)

p Asset-Weighted 10-Yr Investor Return (%)

Returns Gap (%) in white numerals

8

6.58 5.84

-0.74

6

5.27 5.53

+0.26

4.88 4.35

-0.53

4.67 4.50

-0.17

4.08

-0.82

3.91

4

-1.24

3.63

-1.32

3.26

2.67

2.31

2

0

U.S. Diversified Funds

U.S. Sector Funds

Intl Equity Funds

Allocation

Taxable Bond

Municipal

All Funds

most obvious lessons for what we should look for in a fund and what behavior can be self-destructive.

What the Data Say For the 10 years ended December 2015 , the investor returns gap shrank from the average over recent years. For U.S. equity funds, the gap was 74 basis points, but international funds had a much wider gap of 124 basis points. Municipal-bond funds continue to be the most confounding group, with a big 132 -basis-point gap, while taxable-bond funds had a more moderate 82 -basis-point gap. As usual, allocation investors fared the best, with a gap of just 17 basis points. More telling than the latest batch of data is the average annualized gap for 10 -year periods ended 2012 to 2015 : negative 1 . 13% . That smooths out some of the issues with end-date bias to illustrate just how much we cost ourselves through bad timing moves. Flows were strong across the board at the beginning of the 10 -year period. Flows were particularly strong into foreign and domestic equity because equities had rallied off the lows of the bear market that ended in 2002 . Some of that money later left in 2008 and 2009 as skittish investors sold near the bottom, but that initial wave of good flows and a return to equities after 2009 seemed to have ensured pretty good results. Allocation funds enjoyed steady inflows throughout, so, while some dumped their equity funds at the wrong time, many maintained and added to equity exposure through allocation funds. In addition, target-date funds are part of the allocation group,