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COLUMN-SAFT ON WEALTH: A world of lagging investors

(The opinions expressed here are those of the author, a columnist for Reuters.)

July 26 (Reuters) - If you invest in mutual funds, no matter where you live in the world, you are probably doing it wrong.

Thats the upshot of the first-ever Morningstar study looking globally at how investors in open-ended mutual funds actually perform, taking into account when they enter and exit a fund. http://corporate1.morningstar.com/ResearchLibrary/article/810671/mind-the-gap-20 1 7 /

There is hope, however, and it comes from plans that limit the amount of unwise market timing by mutual fund investors.

In most places, and in most types of funds, savers are suffering an investor returns gap. Over 10 years the average investor in a U.S. fund earned 3.96 percent annualized, below the 4.33 percent of the average fund or the 5.0 percent they would have earned had they simply left their portfolios untouched throughout the period.

For Luxembourg-based funds, a proxy for European investors, the average saver made just 2.24 percent annually over 10 years, well below the 2.98 percent of the average fund. Five-year average investor returns lagged in Singapore, Taiwan, Hong Kong and Canada as well, though UK investors just about kept pace with the returns generated by the underlying investment vehicles.

The study measures money-weighted returns, rather than the more typical time-weighted. The former illustrates the flow of money in and out of funds, measuring how and when investors actually put their money to work or take it off the table. This gives a read not, as a time-weighted return, of how the fund is doing compared with the market, but how typical investors' money will actually compound based on their own behavior and the performance of the fund.

As investors try to time the market, or to ride the hot hand of a given fund manager, they tend to shoot themselves in the foot, missing out on periods of better returns and piling on at times just before returns turn sub-par.

The results showed a general trend toward an investor gap in most markets and most fund types around the world. The data also suggest that fees matter, and not just in the traditional way of limiting costs.

"When sorted on fees, investor returns declined as funds rose in cost, often by more than the difference in costs, suggesting that behavior of investor and manager alike in high-cost funds was poor, while low cost-funds represented a meeting of smarter investors and managers, Russel Kinnel of Morningstar wrote in the report.

It also seems likely that higher-cost mutual funds take on bigger risks in an effort to justify their fees.

A DISCIPLINED APPROACH

Earlier research has also shown that funds with lower inflow tend to generate better returns in the following month. A Research Affiliates study showed funds in the top quintile of flows generate next month returns of less than a third of those in the bottom quintile. Chasing alpha, or outperformance, is a losing game.

Ironically, the pursuit of positive alpha, which leads to the regular switching of investment strategies and managers, is the very reason why mutual fund investors and pensions have earned negative alpha. Investors should realize that the widely followed selection practice is technically an attempt to time manager alpha, Jason Hsu of Research Affiliates wrote in 2015. https://www.researchaffiliates.com/entus/publications/articles/488tiftfactortret u r n s t a r e t p r e d i c t a b l e t w h y t i s t t h e r e t a n t i n v e s t o r t r e t u r n t g a p . h t m l

As manager styles come in and out of favor, the hiring and firing of managers is akin to timing the returns of style factors. That pro-cyclical timers, such as mutual fund investors and pensions, do poorly is the very reason why countercyclical factor returns persist.

The Morningstar study showed very encouraging data for automated investment plans, under which asset allocation decisions are not based on a hunch or research by the asset owner but according to a pre-set plan. Australian superannuation plans actually show positive investor gaps. U.S. target-date funds have also consistently generated positive investor gaps, while South Korean general savings plans guard against market timing by featuring automatic monthly investment.

These relatively simple plans work wonders at keeping investors on track and preventing them from unwise market-timing moves. Seeing this work in three different investment cultures is a strong endorsement for the practice worldwide. The evidence suggests the idea has merit for its ability to help investors realize the potential of retirement plans. In a sense, it combines some of the strengths of defined-benefit plans and defined-contribution plans by making low-cost diversified investments the default option, according to the study.

A bit of outside discipline is exactly what the average investor needs to avoid the eternal errors created by greed and fear.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaftzjamessaft.com and find more columns at http://blogs.reuters.com/james-saft) (Editing by Dan Grebler)