Why Investors Earn Less Than Their Funds, and the Small-Cap Surge

Core Insights - Fund investors typically earn lower returns than the funds themselves, with a gap of approximately 1.2%, equating to a 15% reduction in total returns over a decade [6][7][8] - Small-cap stocks have recently outperformed larger stocks, with the Vanguard Russell 2000 ETF returning 11.3% and the iShares Micro-Cap ETF returning 15.7% since August 1st [1] - The forward P/E ratio for small caps is significantly lower at 15.7 compared to 22.6 for the S&P 500 and 30.3 for the "magnificent seven," indicating better valuations for smaller companies [1] Small-Cap Performance - The Russell 2000 index reached a new high on September 18th, 2023, marking a resurgence in small-cap stocks after a period of underperformance [1] - The outperformance of small-cap stocks is attributed to their lower valuations and the anticipated benefits from potential rate cuts by the Federal Reserve [1] Fund Investor Behavior - The Morningstar study highlights that the timing and magnitude of cash flows significantly impact investor returns, with many investors buying high and selling low [6][10] - Investors with more volatile cash flows tend to capture less of their funds' total returns, suggesting that lower trading activity may lead to better outcomes [10][11] Volatility and Returns - Funds with higher return volatility correlate with larger gaps between dollar-weighted returns and total returns, indicating that investors may react impulsively to market fluctuations [13][14] - Allocation funds, such as target date funds, show better performance in capturing total returns due to their automated nature, reducing the need for active management [19] Fees and Costs - The relationship between fund fees and the gap in returns is less clear, with low-cost funds generally performing better, but investor behavior in trading can offset these advantages [16][17] - Lower-cost funds consistently demonstrate better performance, reinforcing the importance of keeping fees low for better investment outcomes [17][18]