How you missed the best of your mutual fund returns

In general, the more volatile the asset class, the bigger the gap between investor and mutual fund returns.
In general, the more volatile the asset class, the bigger the gap between investor and mutual fund returns.


  • Investors lose out due to return chase and early exits, finds Morningstar study

Consider UTI Mastershare, India’s oldest equity mutual fund, launched in 1986. Its annual return since inception till 30 September 2022 is a juicy 15.6%. This might sound like an eye-popping return for a 36-year period.

However, very few investors are likely to have invested at the start, and held the units for three decades. India’s mutual fund industry has blossomed only in the recent years. So, the average UTI Mastershare investor's return is probably different from this figure. Some investors in the scheme would have also entered and exited at different points of time. In fact, investors generally enter mutual funds when past returns look rosy and exit when things go south.

Such investor behaviour may cause actual investor returns to differ from the mutual fund's return. Research firm Morningstar India analysed data on monthly flows in and out of mutual funds to calculate this gap, and published its findings in a report called ‘Mind the Gap - India.’

The lesson from the study is to stay invested over the longer term and build a well-diversified portfolio.
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The lesson from the study is to stay invested over the longer term and build a well-diversified portfolio.

Why is there a gap?

According to Morningstar, the gap can be understood with a simple example. Let's say an investor puts 1,000 into a mutual fund at the beginning of each year. That fund goes on to earn total returns of 10% the first year, 10% the second year, and negative 10% the third year. The fund’s return works out to 2.9% CAGR. But the investor's return is actually negative 0.4%, because there was less money invested in the fund during the first two years of positive returns and more money exposed to the loss during the third year.

This example takes the case of a relatively disciplined investor, putting the same amount every year. In reality, inflows shoot up after a fund has shown good returns and slow down when returns diminish. Hence, the gap between fund and investor return works out to a substantial amount.

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According to the study, the total return on equity funds over the past five years was 10% CAGR (as of 30 June 2022), but the investor return was 7.2%. Morningstar used its estimates of net investor flows across fund categories to see how investor behaviour impacted their returns.

In debt, the total fund return was 6.2% and investor return was 4.6%. In the case of hybrid funds, the total fund return was 9.2%, while the investor return was 6.2%. There are similar gaps for three- and ten-year periods.

Bigger gaps

In general, the more volatile the asset class, the bigger the gap. For example, while the gap between fund and investor return is 3 percentage points for flexicap funds over the past five-year period, it is a whopping 21.8 percentage points for technology sector funds. This means that a lot of money entered such funds after they had rallied and not before.

“Most of the investor flows in technology sector funds came after these funds had seen a run-up in 2020 and 2021. So, most of the money is sitting now on negative returns," points out Kaustubh Belapurkar, director, fund research, Morningstar Investment Advisor India.

International fund category is another case in point, where the gap between fund and investor returns is 7.2 percentage points over past five-year period. “Again, money went in when US outperformed, and now India is relatively outperforming," says Belapurkar.

The gap between investor and fund returns is 3.6 percentage points in healthcare sector funds, slightly higher than small cap funds, where the gap is 3.2 percentage points.

Gold investments

On gold investments, the study had some interesting findings.

While investor returns were less than fund returns over three- and five-year periods, by 7 percentage points and 5 percentage points, respectively, investor returns were higher by 1.7 percentage points over a ten-year period.

So, over the longer period, investors who were able to time their gold investments had favourable outcomes. But the study says it would have been extremely difficult for investors to get the timing right.

Lessons for investors

Investors often want to chase returns, and opt for funds that are outperforming in their respective fund category, or sector and theme funds that have seen a sharp run-up.

Frequent switching from underperforming funds to outperforming funds can significantly eat into investor returns, as the study shows. Investors may end up entering a fund after the fund’s portfolio companies have already reached their peak valuations, and exit an underperforming fund when the valuations of its portfolio companies have turned attractive.

The lesson from this study is to stay invested over the longer term and build a well-diversified portfolio, as different asset classes and different investment styles tend to do well at different points in time. Even in the same fund categories, investors can look for funds with different investment styles.

If an investor really wants to allocate to a sector or thematic fund, she can do so using systematic investment plans (SIPs). SIPs take away the timing factor from investing, as investments are made at a pre-decided date every month.

When markets decline, SIPs fetch more units at lower prices, and when markets appreciate, SIPs buy less units at higher prices. Over the long run, this will average out your cost of purchase, lessening the impact of short-term market fluctuations on your investments.

On average, mutual fund investors are bad market timers -- investing and pulling out money at the wrong time. Investors can avoid these behavioural biases by linking investments to financial goals, withdrawing only when goals are near and using SIPs to invest in a disciplined manner.

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