At The Money: Don’t Underperform Your Own Investments! - Masters in Business Recap

Podcast: Masters in Business

Published: 2025-10-15

Duration: 14 min

Summary

Most investors underperform not only the market benchmarks but also their own investments due to behavioral factors. A study by Morningstar reveals a significant performance gap driven largely by timing and investor behavior.

What Happened

In this episode, host Barry Ritholtz speaks with Jeffrey Pattak, managing director at Morningstar, about the findings of their annual study titled 'Mind the Gap.' This study highlights the stark difference between the returns generated by investment funds and the actual returns experienced by investors. Pattak explains that the 'investor return gap' is the difference between the average return of a fund and its total return, which can significantly impact investors' overall performance. In fact, for the trailing ten years, this gap was estimated at 1.2 percentage points annually, meaning investors lost out on about 15% of total returns due to poor timing and cash flow management decisions.

The conversation delves into how this gap is calculated, noting that it involves analyzing monthly cash flows and how they affect fund performance over time. Pattak points out that the study encompasses around 26,000 individual funds and ETFs, accounting for approximately $25 trillion in assets, making it a comprehensive assessment of investor behavior. They also discuss various types of funds, revealing that sector equity funds have experienced the widest performance gaps, while target date strategies showed the narrowest. Pattak emphasizes that behavioral factors, such as buying high and selling low, play a crucial role in creating these gaps, and he notes that investors are becoming more aware of their behaviors, leading to gradual improvements in capturing total returns.

Key Insights

Key Questions Answered

What is the investor return gap?

The investor return gap is defined as the difference between the average return of a fund or group of funds and the total return of those funds. Jeffrey Pattak explains that it takes into account the timing and magnitude of cash flows into and out of the fund over time, which contrasts with the total return that assumes a lump sum investment. This gap provides insight into how investor behavior affects their overall performance, with the latest study indicating a 1.2 percentage point annual return gap, resulting in investors missing out on approximately 15% of total returns.

How is the investor return gap calculated?

To calculate the investor return gap, Morningstar aggregates data from all US open-end mutual funds and ETFs, which includes their beginning assets, monthly net flows, and ending net assets. Pattak mentions that they utilize around 120 monthly net flows to derive a return estimate that reconciles the beginning to the ending assets after accounting for cash flows. This method allows them to derive a return figure that reflects the actual experience of investors rather than just the fund's stated performance.

What types of funds are included in the study?

The study encompasses US open-end mutual funds and ETFs, specifically excluding closed-end funds. Pattak notes that it analyzed approximately 26,000 individual funds and ETFs, which collectively held about $25 trillion in assets at the end of the study period. This comprehensive approach allows for a robust understanding of how various fund types perform in terms of investor returns.

What are the differences between time-weighted and dollar-weighted returns?

Pattak explains that time-weighted returns, which most investors encounter, assume an initial lump sum investment that remains untouched until the end of the period. In contrast, dollar-weighted returns account for the timing and magnitude of an investor's purchases and sales. This distinction is crucial because it reveals how investors' behaviors, such as buying after a strong performance, can lead to lower returns compared to the fund's total return.

How do behavioral factors affect investor returns?

Behavioral factors significantly impact investor returns, often leading to decisions that result in buying high and selling low. Pattak notes that while investors are becoming more aware of their behaviors, they still frequently make mistakes, such as changing their asset mix based on performance trends rather than long-term strategies. These decisions can create performance gaps, as seen in the findings that sector equity funds have wider gaps compared to other fund types.