How can a 401k participant have lower performance than the fund they invest in?

Posted on April 7, 2011. Filed under: Uncategorized |

By Chuck Jaffe, MarketWatch

BOSTON (MarketWatch) — Mutual fund shareholders will say they are investing for a long time — not timing the market.

But the typical fund tells a much different story.

It’s an issue worth exploring now, when both mutual fund flows and the stock market have seen wild swings over the past three months.

Studies show that investors actually don’t capture the full performance of their mutual funds. Boston-based research firm DALBAR Inc. has shown that investor portfolios have lagged market returns by roughly 5% per year over the last two decades.

Meanwhile, academic studies have shown that investors average a return of 2% less than the funds they own, simply because they plow more money into a fund after performance has been hot, and step away or slow deposits when times have been bad.

Investment researcher Morningstar Inc. calculates “investor returns,” tracking how investors do based on when their money flows into a fund. Morningstar research shows that investors earned about 1.5% annually less than their funds over the past decade.

Following the leader

The problem can be explained mostly by human nature.

One MarketWatch reader who believes market timing is a folly recently bragged about how successful he has been simply buying and holding funds over the last two decades. I asked if he had ever added to his initial holdings, or had added new funds to his portfolio. He said proudly that he lets his cash build up a bit and then invests more “every time I have enough to invest.”

“How do you pick your new fund or decide which existing account gets that deposit,” I asked.

“I look for the funds that have been doing the best for me, and I add to them.”

Much as he couldn’t see it, that action — picking what has been hot lately — is a form of market-timing. Call it “accidental timing” or “faux timing,” but it explains how money goes into a hot fund at just the wrong time.

When the fund cools, it still has the hot stretch to make the record look good, but the investor only gets the cooling off, which explains the difference between fund returns and investor returns.

Investors can avoid being an accidental timer or the kind of investor whose returns significantly lag those of their fund.

Strategy and planning have a lot to do with it. So, too, does buying a fund for what it can do, rather than for its performance numbers.

“If you have a plan for the role the fund is playing in your portfolio, that helps you invest in the fund that is best for you rather than the one that has looked good most recently,” said Russel Kinnel, director of mutual fund research at Morningstar. “The first thing planners always tell me is that their new clients come in without knowing why they own the funds or what the funds are supposed to do for them.

“If you have a plan for a fund — rather than ‘I need to invest this money, what looks good right now’ — you will tend to naturally put the money to places where it is right for your portfolio,” Kinnel added.

That means going to areas where your holdings may be below allocations. Rebalancing a portfolio — culling winners and setting the portfolio back to its allocation plan — is another way to fight the urge to buy the hot fund.

So, too, is dollar-cost averaging, making regular deposits that hit the fund whether it has been hot or cold. The DALBAR study historically has shown that investors who invest regularly in their funds wind up about 0.25% ahead — annually — of investors who make additions to their portfolio sporadically.

“You’re going to pick a fund because it has done well,” Kinnel said, “but the idea is not to find a fund that has done well lately, but one that you think will do well over three-, five- or 10 years, that will let you reach your goals. … If all you do is buy what looks good right now, you set yourself up to sell it when it doesn’t look so good.”

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