Investors pour money into equity funds on market upswings and are far too quick to sell on downturns, reports a recent Morningstar Inc. study in the U.S. As a result, many investors are left with equity fund returns that are significantly lower than the advertised results for those funds. The difference had to do with the length of time shareholders held onto their fund shares and the timing of their purchases and sales, the study reports.

While this will not be a revelation to most advisors, information such as this can prove useful when dealing with disgruntled or disillusioned clients, either yours or new prospects. First off, though, it’s important to realize that these findings are not all that new.

Dalbar Inc. , a Boston-based financial services market research firm, conducted the first study of this kind in 1993 and has repeated it several times looking at: monthly cash flows in and out of both stock and bond funds; average length of time shareholders remain invested in a fund; and volume of sales and redemptions.

Dalbar’s research repeatedly shows that investors actively buying and selling mutual funds in the real world have a knack for not getting it right. Using exquisitely poor timing over the 20 years through 2004, the average stock mutual fund investor earned a skimpy 3.5%, annualized, compared with an annualized gain of close to 13% for the
S&P 500. Moreover, over other periods, investor returns from equity funds barely beat inflation — other than last year where, for the first time in at least 21 years, average fund investors did beat the index. But this is probably an anomaly, Dalbar says.

In fact, using what it calls the “guess right ratio,” it found investors were more than 75% more likely to correctly guess the direction of the market during rising markets but less than 50% during falling markets. But being right in up markets does not make up for being wrong more than 50% of the time in down markets, the study says. This guess-work in the form of market timing has resulted in a substantial drop in investors’
relative performance.

More recently, Chicago-based Morningstar analysed the returns for all U.S. stock funds with 10-year records, highlighting the gap between the funds’ published results — that is, the returns investors would have made had they stayed in that fund for the entire period — and their dollar-weighted returns over the same period. As dollar-weighted returns take into account how the fund performed based on its level of assets, they are a more accurate reflection of investors’ actual returns.

Among diversified categories, the gaps were largest among growth funds, the study showed. For instance, the 10-year annualized dollar-weighted return for the average large-growth fund was 3.4 percentage points lower than the stated return. For mid-growth funds, the gap was 2.5 percentage points and, for small growth funds, it was three percentage points.

Sector funds saw the widest gaps. For example, the dollar-weighted returns of technology funds lagged official returns by an average of 14 percentage points. The sizable gap is the result of shareholders scrambling to pour money into growth and technology funds in late 1999 and 2000, then cashing out their shares when the tech market collapsed a few years later.

Large value funds reflected the smallest gaps at 0.4 percentage points. That’s because those funds were less volatile and posted more steady returns, reports Russel Kinnel, the study’s author. It seems shareholders are more apt to stick with a fund that posts stable returns than one that bounces all over the place — regardless of overall results.

For instance, the average large-growth fund had a standard deviation of 19.3, which is much higher than the 14.6 of the S&P 500. The more volatile a fund, the more probable it is that investors will be motivated by fear or greed, Kinnel concludes. IE