Why mutual fund investors earn less than their funds

Investors need someone to be the voice of reason, but not all advisors act that way

Why mutual fund investors earn less than their funds
Recent news and regulatory changes in the investment industry have tightened investors’ focus on performance. But while many might assume that advisors are there to chase outperformance, another service they offer is far more valuable.

“The performance of a mutual fund, exchange-traded fund or other financial asset is typically calculated as if you put all your money in at the beginning and kept it there, without adding or withdrawing anything, until the end of the measurement period,” said columnist Jason Zweig in a recent piece on the Wall Street Journal.

“But investors add and subtract money at will along the way — often at the worst possible times, when they are in the grip of greed or fear,” he said.

Such buying and selling results in what’s called the “behaviour gap,” which is a discrepancy between the performance of an investment fund and that of its investors. Citing various studies, Zweig said mutual fund investors earn around 1% to 1.5% less per year on average compared to their funds. Hedge fund investors fare worse, falling behind their vehicles by up to 7% annually.

Theoretically, behaviour gaps arise due to mistimed, emotional trades — which advisors should protect clients against. “Advisors provide a human element that gives clients confidence and comfort in not deviating from a plan,” said Dave Butler, co-chief executive of US-based Dimensional Fund Advisors. “The reaction to markets can be completely different when the adviser is in the loop.”

Investors need someone to be the voice of reason, but not all advisors act that way. As an example, Zweig cited Fidelity Select Biotechnology, a portfolio worth US$8.6 billion that largely serves self-directed investors, which averaged 14.1% annually over the past 10 years. Its investors, predictably, didn’t do as well, averaging just 10.1% annually.

But professional advisors did even worse. The Fidelity Advisor Biotechnology Fund I, a US$1-billion portfolio that’s nearly identical to the Select fund, is geared toward financial advisors. It gained an average of 13.6% annually over the past decade, but the typical investor in the fund earned only 0.7%.

“Here, it seems, so many advisers may have bought high and sold low that their clients made next to nothing,” Zweig said, noting that annual fees advisors might charge to clients are not yet considered in the numbers.

The takeaway is clear: while clients may be tempted to hire advisors who aim for investment outperformance, they’re generally better off hiring those who help organize finances, prioritize goals, minimize tax exposure, and keep them on track with regards to retirement and estate planning.

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