Investors work hard to select great funds. But spotting great investments doesn't help much if you bought near the top, sold at the bottom, or both. Humans often "follow the herd" by piling assets into funds that have recently done well, often missing the best returns, and then end up disappointed and sell at a loss.
Since its first edition in 2005, the Morningstar Mind the Gap study has thoroughly documented and discussed these biases. A key takeaway is that different types of funds nudge investors to behave differently. Markets also differ in how well investors can control their bad tendencies, depending on the products they can access and the type of advice they are receiving – and how advisers are incentivised to promote funds. Investors can easily end up buying yesterday's winners.
To measure investors' timing, this study contrasts two types of returns to find the "behaviour gap" between them. Total returns reflect the growth of a fund's value between the start and end of a period that can be earned with a buy-and-hold investment. Investor returns show the effect of flows by incorporating the amount of assets at the fund in different periods into the return calculation. When investor returns lag total returns, the average dollar or pound in the fund has earned less than what a hypothetical investor would have earned by staying invested for the entire period (with some caveats).
In the UK, investors lost 32 basis points of annualised return from the timing of their inflows and outflows, but that's the lowest among the six geographies the report looked at. Equity, bond, and allocation funds all saw mildly negative gaps in the UK, while alternatives sprang to a small positive gap. By contrast, in our last study from 2019, we had found investors had generated a 27-basis-point annualised gain from timing over rolling five-year periods used in that study.
UK Funds Scrutinised
UK investors saw the clearest change in fortunes. From a slight 0.16 positive gap within equity funds in our previous study, this time around, the return gap fell to a negative 0.40 percentage points over the five-year period. Allocation funds saw a similar-size gap to equities, while in fixed income, the gap was 0.26 percentage points – all moderately low gaps compared with other markets in this study.
Within alternatives, there was a positive gap to the tune of 0.33 percentage points, with investors particularly in macro trading seeing more positive investor return outcomes than the uninspiring returns of many products. One of the contributors was the fall from grace of the abrdn Global Absolute Return Strategies (GARS) fund. The lackluster performance profile started to see investors exit, but the bulk of outflows occurred at the start of the period, and most investors thus avoided the larger losses incurred in the most recent years (2022, 2023).
Assets under management in the UK-domiciled version of the fund stood at £17.1 billion at the start of the analysis period (June 30, 2018) and five years on capitulated to £860 million. The firm has since announced it will be merging the fund’s remaining assets into another strategy. Within global equities, investment styles had different return gaps. While value stocks saw a torrid time over the analysis period, global value funds' investor returns were not too much behind total returns (an investor return gap of 28 basis points).
This indicates that, encouragingly, investors didn't capitulate at the nadir. In contrast, within growth, the return gap was larger at 67 basis points.
Growth as a style had worked extremely well for many years. As often happens when investors have been watching a period of strong performance from the sidelines, they finally pull the trigger to buy, perhaps on a "fear of missing out". Those who invested in the post-Covid-19 run would have endured high paper losses as a result of the 2022 crash for growth stocks.
In a comparison between UK's equity asset managers, Baillie Gifford is among the managers with an overall negative gap. It is also one of the houses running funds that typically has higher volatility than its peers.
Counterintuitively, however, the company's most volatile fund, Baillie Gifford Long Term Global Growth, in fact had a positive gap. The fund had outflows in each of the last five calendar years. Its investor base is biased toward institutions and pension funds, and the largest outflows came in the second half of calendar-year 2020.
As outflows continued in 2022, a much smaller proportion of assets went through the near-40% drawdown in 2022. In contrast, two Baillie Gifford funds, International and Global Alpha Growth, saw gaps deep in negative territory. Their performance profile was similar to the Long-Term Global Growth fund, but the flows profile was strikingly different: positive flows in 2020 were loaded toward the latter part of the year when performance started to turn, and large inflows continued in 2021 despite the sharp decline in these funds' values. A similar story was seen in UK equities, where the most volatile area, small-cap stocks, had clearly negative flows, while in UK large caps, investor returns beat total returns.
Lower Risk Narrows the Gap
The period of July 2018 to the end of June 2023 has been trickier for investors to navigate, as shown in the generally larger gaps between total returns and investor returns, than the period covered in our previous 2019 study. There are multiple cases where a fund suddenly became popular and saw a rush of inflows – just before, or even after, its returns plateaued. Still, there were bright spots.
In some markets like the UK, investor return gaps remained modest in light of the extreme market conditions. But in this global study, what broad lessons can be learned?
For one, investors tend to do the least harm through the timing of buys and sells when investing in less volatile offerings. Allocation funds, which are typically well-diversified core holdings for many long-term investors, showed some of the lowest gaps in this study. High-risk categories such as sector funds are often difficult to navigate. Returns come often in lumps, and investors throw money into these funds only after they have already seen a good chunk of their performance run. Similarly, within each category, we find that investors are often better off selecting the least volatile funds compared with the highest-risk products.
The most volatile funds often have high active risk that can lead them to either out- or underperform by a large margin. This can cause uneasiness, and in tough times, investors may be prone to sell too early. The markets with the smallest gaps were Australia and the UK, where financial advice is more focused on investors' total portfolios than individual products. By staying focused on long-term goals and allocations, investors can reduce the temptation of performance-chasing and disproportionately high stakes in big-risk funds.
The report's authors are Mattias Mottola, Evelyn Garrido, Zunjar Sanzgiri, Bryan Cheung, Mara Dobrescu, Francesco Paganelli, Jonathan Miller
