An argument that’s often made is that indexing advocates like myself put too much emphasis on the cost advantage that passive investors have over active investors, when a bigger determinant of future returns is investor behaviour.
It’s certainly true that our behaviour as investors has a huge impact on the long-term returns we can expect to receive. A passive investor who knows all about the efficient market hypothesis, modern portfolio theory and Fama-French can scupper their entire strategy at a stroke by taking fright after a market crash. Similarly, an active investor who invests in funds that consistently lag the market after costs can still achieve half-decent results by sticking to their plan.
But what if I told you that, as well as having a significant advantage in terms of cost, passive investors also behave better than their active peers?
That is one of the findings of ongoing Mind the Gap analysis from Morningstar. Researchers there have been measuring what they call the “investor return gap” for nearly two decades. The study compares the returns that funds deliver with the returns that investors in those funds actually receive. It consistently shows that total fund returns are, on average, significantly higher than investor returns.
This is because, instead of simply buying and holding, investors tend to act on their emotions, trade too often, and, inevitably, buy and sell at the wrong times.
The latest Mind the Gap report for the United States has recently been published. Over the ten-year period to the end of December 2023, fund holdings earned an aggregate average total return of about 7.3% per year. But the average return that investors in those funds experienced was 6.3% a year — about 15% less than the fund return. Compounded over many years of investing, losing 15% of your potential return each year makes a huge difference.
What does the latest Mind the Gap report tell us specifically about the investor return gap between passive and active investors? Well, over the study period, the average dollar invested in index funds earned a 7.6% annual return. That compares with 5.5% average return per year in active funds. The return gap for index investors was -0.8% for passive investors, and -1.2% for active investors.
In other words, the returns that index fund investors actually received were around 38% higher than those received by active investors.
As you can see from the next chart, the results varied from category to category, but, overall, the data clearly show that, at least for this ten-year period, passive investors behaved much better than active investors did.
Interestingly, Morningstar’s analysis also highlights a substantial difference in return gaps between index mutual funds and index ETFs. There was a very small return gap, of -0.2% a year, for investors in index mutual funds over the ten-year period, but a very much bigger gap of -1.1% between the return of the average dollar invested in index ETFs and the buy-and-hold return.
“It does raise the question,” says Morningstar’s head of research Jeffrey Ptak, “of whether the convenience ETFs afford — that is, the ease with which they can be bought and sold — comes at a cost.”
Here’s a summary of some other key findings from the Mind the Gap study:
- Encouragingly, investors earned high dollar-weighted returns in popular fund types like US equity funds (10% investor return per year) and asset allocation, or balanced, funds (5.9% annually)
- On the flip side, alternative funds were the only fund type that failed to generate a positive investor return over the ten-year period
- Asset allocation funds had the narrowest return gap — just -0.4%, which is less than half the gap for funds as a whole
- Conversely, investors in sector equity funds had the widest gap, lagging fund returns by 2.6% a year in average
- The more volatile a fund’s returns were, the larger the gaps tended to be. The average dollar invested in the most volatile sector equity funds lagged the buy-and-hold return by more than 7% a year
Lessons to learn
This latest Morningstar study is yet another reminder that investors who are patient and disciplined receive much higher returns in the long run than investors who aren’t. Keeping things as simple and as light-touch as possible is generally the way to go.
“Investors could capture more of their funds’ total returns,” says Jeffrey Ptak, “by holding the line on transactions, perhaps by opting for widely diversified, all-in-one options like allocation funds that automate certain tasks while avoiding narrower, volatile strategies that are harder to handle.”
Passive investors are generally better at these things than their active peers. Of course, they’re not immune to poor discipline. But they are significantly more likely to capture a higher proportion of the total returns their funds generate over time.
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