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Why Investors Earn Less Than Their Funds, and the Small-Cap Surge
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- [00:00]
Jeff Patek
Foreign.
- [00:05]
Robert Brokamp
Investors earn less than their funds and the small cap surge this is the Saturday personal finance edition of Motley fool money. I'm Robert Brokamp, and this week I speak with Morningstar's Jeff Patak about research which finds that fund investors earn lower returns when than the funds themselves. But first, let's hit a few highlights from last week in money. You know the overall stock market has spent the past year and a half hitting new all time highs. It did run into a significant speed bump earlier this year, but then rebounded and hit even higher new highs. But not all stocks have been setting new records, most notably small cap stocks. That is, until recently. On September 18, the Russell 2000 finally eclipsed its previous high, set in 2021. It rose a bit higher on Monday of this past week, then ended the week lower. But there's no doubt that smaller stocks have closed out the summer strong since August 1. The Vanguard 500, which of course tracks the S&P 500, has returned 6.2%. The Invesco QQQ ETF, which tracks the Nasdaq 100, has returned 7.2%. Meanwhile, the Vanguard Russell 2000 ETF has returned 11.3%. And the iShares Microcap ETF, which tracks the Russell Microcap Index, has returned 15.7% as of the market's close on September 25. Now, the reason for this outperformance could be just valuations. Just about any type of stock is cheaper than US Large caps, especially of the growthier and techier variety. According to Yardeni research, the forward PE ratio for small caps is 15.7 compared to 22.6 for the S&P 530.3 for the Magnificent Seven. But it's also likely due to the belief that rate cuts from the Fed will benefit smaller companies, which tend to rely more on credit. The companies are often too small to issue bonds, so they have to turn to banks to get loans with floating rates, which will likely head lower. Since the Fed cut the target for the fed funds rate last week, as had been expected, and suggested we could see a couple of more cuts this year. For our next item, we turn to a provision of the one big beautiful bill that was passed on July 4th, and that is the no tax on tips. As is often the case when a bill becomes law, the folks at the Treasury Department have to spend some time sort of hammering out the details, and they recently released some preliminary regulations. So for those of you who earn tips or, you know, may have noticed how we're all Asked to give tips here's what we know about who's getting a tax break Eligible workers will be able to deduct up to $25,000 in qualified tips per tax return. They won't need to itemize their deductions. They can take the standard deduction and still deduct the tip income. But married folks will have to file jointly to get the deduction. Note that the deduction will just reduce federal income taxes, not payroll taxes. So Social Security, Medicare taxes, and individual states may or may not go along with Uncle Sam in offering deduction. Eligibility for the deduction begins to phase out at an adjusted gross income of $150,000 for singles, $300,000 for married folks filing jointly. So you know those limits are pretty high. Most workers will be eligible. In fact, according to the Yale Budget Lab, 37% of tipped workers earn so little that they don't even owe any federal income taxes, so this new provision won't really benefit them. Only tips that are voluntarily given are eligible, so any tip that is automatically added to a bill is not. Most jobs that regularly receive tips will qualify. If you're curious if yours made the cut, check out the Preliminary list of 68 qualifying occupations that the Treasury Department published@treasury.gov By the way, podcasters are eligible. Just saying. Keep in mind that these are proposed regulations. The final rules will be issued after a period of public comment, but they're not expected to change much, if at all. And now for the number of the week, which is 0.75%. That is the difference or spread in yields between investment grade corporate bonds and Treasuries of comparable maturities. That is the smallest spread since 1998. What does it mean? Well, corporate bonds are riskier than Treasuries, and investors normally require extra yield to compensate for that risk. The fact that investors aren't really requiring that much extra yield is a sign that they're very optimistic, perhaps even exuberant. Practically speaking, it might suggest that you should tilt your portfolio more towards Treasuries if you feel that the extra yield from corporates isn't worth it, especially for bonds held outside of retirement accounts. And you pay state income taxes because income from Treasuries is not taxable at the state level. But there's another possible explanation for such a narrow spread. Perhaps bond investors no longer see Treasuries as safe as they used to be, and they're now getting priced closer to investment grade corporates. Next up, which investors are least likely to capture their fund's actual returns when Motley Fool Money continues.
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Robert Brokamp
When evaluating a fund, one of the first sets of numbers you'll likely look up is its past returns. But those may not be the returns that the owners of the fund actually earned. That's one of the lessons from Morningstar's annual Mind the Gap Study. And here to talk about it is Jeff Patek, Managing director for Morningstar Research Services. Jeff, welcome to Motley Fool Money.
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Jeff Patek
Well, thanks so much for having me. It's a real pleasure.
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Robert Brokamp
So let's start with you explaining what the Mind the Gap Study is attempting to measure.
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Jeff Patek
Absolutely, yeah. So the familiar total returns that you just referenced, what that assumes is an initial lump sum investment, it's made at the beginning of horizon, held to the end of the horizon, and basically you're measuring the difference between the ending and the beginning value. Dollar weighted returns are different. They take into account the timing and magnitude of cash flows along the way. And in that sense they're a little bit more real life. As we know, we don't necessarily go and dump all of our money in at the beginning of some horizon. We might leg in or just circumstances might lend themselves to a more regular set of cash flows in and out of an investment. And so what we're trying to measure with a dollar weighted return is the return of the average dollar that's invested in a given investment. And then we can compare that to the time we return, the total return that we're all familiar with. And the difference should give us a sense of the impact of the timing and magnitude of cash flows, buys and sells along the way.
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Robert Brokamp
How is it calculated? I imagine it's very complicated because you looked at more than 25,000, both traditional open end, traditional mutual funds and ETFs. So how do you figure all that out?
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Jeff Patek
That's a great question. So it's complicated and it isn't. It's complicated in the sense there's a lot of funds, as you mentioned to corral, but once we've corralled them, then you're really talking about three numbers. The beginning net assets of that aggregate of funds, the cash flows. So inflows and outflows on a monthly basis over the period of time that we examine. In the case of our most recent study, it was the 10 years ended December 31, 2024 and then the ending assets. So it's what those funds held by the end December 31, 2024. And with those three numbers, you are estimating the internal rate of return, which is a calculation that probably some of listeners are familiar with through their different walks of life. It's probably most sort of familiar in sort of a private equity context rather than a mutual fund context. But that's the calculation that we're running to try and estimate the constant rate of return of the beginning assets, the intervening cash flows to arrive at the ending assets.
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Robert Brokamp
So 30,000 foot view here. What are the results of the most recent version of the study?
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Jeff Patek
Yep, good question. So we found that there was a little bit more than a 1 percentage point gap between the returns return of the average dollar invested in funds and those funds aggregate total returns. And so you sort of do the math on that. It works out to around 15% of the total returns weren't captured. And why is that? I mean, we can only infer, but it boils down to the timing and magnitude of cash flows. I would say that if we wanted to think of it in sort of the most kind of caricaturized way, it's sort of buying high and selling low, as we might talk about. It can circumstantial. There can be reasons why people buy in the quantities and at the times that they do. And it might not reflect sort of impulse or the sorts of behaviors that we would frown upon. Could just be sort of the situation that they're in and things not quite going their way and therefore them not capturing all their funds total returns. But that's the way the math work for purposes of our most recent study.
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Robert Brokamp
So as you say, it's a little over 1%. The gap was actually specifically 1.2%.
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Jeff Patek
You got it.
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Robert Brokamp
And some people might think, well, that's no big deal. But as you say, it reduced total return by 15%. You compound that over, that's over 10 years, compound that over 20, 30 years. You're talking about not having anywhere from 20 to 30% as much because the returns are lagging sometimes for obvious reasons. But sometimes it could be because people are making, shall we say, suboptimal decisions about when to get in and out of a fund.
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Jeff Patek
Exactly. It's real money.
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Robert Brokamp
It's real money. All right, so let's get into some of the areas where you found the biggest gaps, starting with the volatility of the cash flows.
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Jeff Patek
There's a lot of different lenses that we look at funds through and trying to get a sense of what it is that might have been affecting investors and keeping them from capturing as much of their funds total returns as they possibly could. One of those dimensions is cash flow volatility. So basically what you're looking at is the standard deviation of inflows and outflows to a group of funds. And so we grouped them, you know, from the funds that had the most volatile cash flows to those that had the least volatile cash flows. And cash flows in this context was proxying for trading activity. So the most volatile cash flows we would associate with the most trading activity in the opposite for those that had the least volatile cash flows. And what we found is there was a meaningful difference, even controlling for a number of factors between funds that had the most volatile cash flows and those that had the least volatile cash flows. Those are the most volatile cash flows. There was a much larger gap between those funds, dollar weighted returns and their total returns. Whereas we found with funds that had more stable cash flows, investors were more successful in capturing their funds total returns. And so from that inference, we can infer something else, which is the more investors do in this case in a transactional sense, the more buying and selling they do, the less they tended to earn of their funds total returns. And so if there's a takeaway there, do less, stay still, try to hold the on transacting. Transacting is an inevitability for a lot of us, just things happen. But what can be particularly hazardous is sort of discretionary ad hoc trading. That's where people can really get themselves into trouble with buying high and selling low in the stereotypical sense.
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Robert Brokamp
So you looked at the volatility of the money that's coming in and out of the funds, but you looked at the volatility of the funds Themselves.
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Jeff Patek
Exactly.
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Robert Brokamp
And how did that seem to correlate to the gap between the total returns and the investor returns?
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Jeff Patek
Yeah, it's a real good question. It was a similar sort of story. The more volatile a fund's returns were, the more trouble, the more difficulty investors had in capturing its total returns. If we think about it, sort of stepping back, one of the things that volatility can do is push our buttons as investors. And it's not just in fleeing it, it's also in certain cases, you have a volatile fund, maybe it puts up a big number, you chase its performance. In effect, you buy high, you're buying just before performance rolls over. When you see those wider amplitudes of performance, I think that there's just a greater propensity for investors to act in ways that we might consider to be rash or inadvisable. And so those funds that had the more volatile returns, there were significantly wider gaps between the dollar weighted returns, I.e. the return of the average dollar invested in those funds and those funds aggregate total returns. And then the opposite for funds that were less volatile. Even after controlling for a number of factors, investors appeared to success in capturing those funds total returns. And what is that about? It's the absence of noise, it's them tending not to push buttons. There can be some other circumstantial factors that explain it, but I think that's the main thing.
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Robert Brokamp
What's interesting about what you also found is that the more volatile equity funds did not necessarily have higher returns. In fact, on average they had lower returns. Which is kind of the opposite of what you expect. Right. Return and risk go hand in hand. But that's actually not what you found.
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Jeff Patek
That's right. And it's one of the contradictions that you would find, at least in the context of our study. Another is seemingly that having a little bit more freedom to transact, which I think in the abstract we would think of as that's a great thing, that people have greater ability to take control of their finances and take the decisions that they want to take at the appointed times, that didn't necessarily work to their benefit. This is somewhat tied in with the work that we did on cash flow volatility. If you look at things like ETFs, for instance, we did find that there were wider gaps with ETFs after controlling for a number of variables than there were for comparable open end mutual funds. That doesn't mean that ETFs are inferior. It just means that there can be circumstances in which investors buy and sell suboptimally and that results in wider gaps between the return of their average dollar and those ETS total returns.
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Robert Brokamp
Let's move on to fees here. When you looked at the relationship between fees and the gap, what did you find?
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Jeff Patek
It was a little bit noisier. I wouldn't say that it was as clear cut as you found with some of the other variables, notably cash flow volatility and return volatility or even the type of vehicle open end fund versus etf. And I think this points to a number of things. You had some cross currents. One of the things that we know is that ETFs which became a bigger and bigger part of our study universe as time went on, they tend to be cheaper. But also we saw that investors tend to transact suboptimally and then don't earn as much of their funds total returns as they can. The contra to that is that you've got a number of very low cost popular funds that are commonly used in the context of a retirement plan. So think about opening an index fund that's maybe part of a target date fund that's featured in your defined contribution plan. We tended to find those types of vehicles. There were very narrow gaps there. So a little bit of the cross current that somewhat I would say lowered the correlation that you would have seen between expenses and the gaps between investors dollar weighted return and their funds total returns. It's a little bit more of a bank shot.
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Robert Brokamp
So you take a little detour from the mind the gap study and highlight that you also have an excellent substack basis pointing. And you recently basically took a look at funds and their expenses. You broke them up into quintiles cheapest to pricest calculated who is more likely to outperform their category. And the takeaway is pretty clear, right? Lower cost funds tend to do better. It's been demonstrated over and over again. But I always think it's important to reemphasize.
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Jeff Patek
You got it. I think that's excellent advice. Starting with cost is the way to go. And as you allude to, there was a piece that I ran recently, I think it was called it's so simple on my substack which you're kind of mentioned. And it was almost a perfect stair step pattern of outperformance from cheapest to priciest. Even after you controlled for a number of different variables, Morningstar category, asset class and the like, it really worked. Works to keep fees low on average. You're going to end up with a better result than others. Even in comparable funds that charge more.
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Robert Brokamp
Any other areas where you found that a larger gap was particularly interesting or instructive or maybe the other way? There wasn't much of a gap.
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Jeff Patek
Really good question. So I think that one of the clearest takeaways for myself and my colleagues as we've done this study over a period of years is how successful allocation fund investors have been in capturing as much of their funds total returns as possible. Allocation funds in our parlance. What does that mean? So it's things like target date funds that's probably the most popular example of an allocation fund. These are multi asset class all in one, automated strategies of some sort. And why is it investors succeeded in those, whereas they maybe fell a little bit short on other types of funds? I think it's the fact that they are so automatic and they allow for hands off investing and so investors don't have to go in and monkey with their even things as mundane as rebalancing or adjusting your asset allocation, as time goes on, your circumstances change. It obviates the need to do those things. It takes care of them for you. The less you do, the more you earned is the clear takeaway for us from the study based on what we're able to infer from it. The other thing, and this is again a bit of a bank shot, but one thing that we do know about allocation funds is they tend to be used most often in the context of a retirement plan. In a retirement plan, it's a gilded cage of sorts. It's really set up for people to put their money in and then leave it alone. Whereas if we were to extend that metaphor a bit, we can think of the rest of our investing outlets. That's kind of the wild. And we're left to our own devices and we have to fend for ourselves and we might be more given to discretionary ad hoc trading decisions. And it's a really marked contrast. You see people that are using these in that more helpful context doing better than perhaps they do in some of these other settings where they can sort of buy and sell at will. And so that's been another sort of useful takeaway for us. I think some readers of the study.
- [18:48]
Robert Brokamp
I'm a big fan of using calculators, retirement tools, for example. That was the topic of our episode last week. I mean otherwise, how do you figure out whether you're on track to meet your goals? And whenever you use a retirement calculator or any tool like that, you have to put in some sort of assumed rate of return. And one of the recommendations of your report. And I'm just going to use a quote, it can also make sense to build a margin of error into the return forecast one might incorporate as part of a spending and savings plan, end of quote. So talk a little bit about that.
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Jeff Patek
Yeah, so this might be me at my most pessimistic, I suppose, but one of the clear takeaways from doing the study over the course of a number of years, and this goes back to Russ Kinnell, my colleague here, really pioneered the research in this area. We keep finding gaps. And so one of the takeaways I think for me and perhaps for others who read the study is it may not make sense just to assume that you're going to earn a market rate of return. You might want to haircut that a little bit just knowing that we as investors, we might be given to trading at inopportune times and that might actually dampen the return of our average dollar notwithstanding, whatever market forecast we're using would suggest. And so maybe take a little bit off and it'll help you to in an even more clear eyed way than perhaps would otherwise be the case.
- [20:08]
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Robert Brokamp
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Jeff Patek
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Jeff Patek
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Robert Brokamp
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- [20:41]
Robert Brokamp
It's time to get it done, fools. And this week I encourage you to think about something that is on your bucket list, especially if it's something you're saving for retirement and see if there's a way you can do it sooner. And I say this in light of the passing of Jonathan Clements this past Sunday at the way too young age of 62. Jonathan was a longtime personal finance columnist for the Wall Street Journal, author of nine books and the founder of the Humble Dollar website. He was one of my favorite personal finance writers, especially earlier in my career. He was just a model for how to cover the topic with wit and wisdom. He wrote about retirement countless times, how much to save, how much a retiree can safely spend to ensure their money lasts for decades. His plan to delay Social Security to age 70 and even his plan to buy immediate annuities to mitigate the risk that he would outlive his money. Then in the summer of 2024, he found out he had a rare form of lung cancer caused by a defective gene and he had about a year to live. So he spent this past year writing and talking about how he was preparing for his passing, how he was setting up his financial estate plans for his wife, kids and grandkids, and how he was making efforts to enjoy life's small pleasures. Jonathan Clement spent his career teaching people how to plan for retirement, but he passed away before he was able to enjoy his own full retirement. He did consider himself partially retired for several years before his diagnosis, but also acknowledged that running the Humble Dollar website was basically the equivalent of a full time job. So fools continue to save for retirement and save enough for retirement that lasts a long time. But don't put off everything until retirement. Life and health are uncertain. If possible, enjoy some of your retirement goals now while you can. And that is the show. As always, people on the program may have interest in the investments they talk about, and the Motley fool may have formal recommendations for or against. So don't buy or sell investments based solely on what you hear. All personal finance content follows Motley fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for the informational purposes only. To see our full advertising disclosure, please check out our show Notes. I'm Robert Brokamp. Fool on everybody. It.