Everyone knows that investors frequently mistime their stock fund purchases and sales. For example, the latest Morningstar Investor Returns report noted that the average dollar invested in diversified stock funds underperformed the annualized 10-year return of those funds by nearly one percentage point – 4.36% compared with 5.15%.
With interest rates rising and bond funds posting losses recently, it’s certainly timely to ask whether the same is true when it comes to bond fund purchases and sales?
As it turns out, it is. Like their counterparts in equities, the average bond fund investor trailed the average bond fund’s 10-year annualized return by nearly one percentage point – 2.99% compared with 3.72%.
This pattern holds true if you widen the data out too. If you run the data supplied by Morningstar Direct through the end of 2017, calculate returns over 15 years and compare them with an index instead of a category average, you will find that the average investor in funds in Morningstar’s intermediate-term bond fund category achieved an annualized return of 2.89% over the past 15 years. By contrast, the Bloomberg Barclays US Aggregate index produced a 4.15% annualized return over that period. In other words, investors gave up more than one full percentage point, or a quarter of their potential return.
Even short-term bond funds produce bad investor returns. These statistics are particularly interesting because they show that the volatility of stock funds isn’t the only thing that causes investors to trade their funds badly. Bond funds, after all, are much more stable than stock funds.
In fact, Morningstar’s short-term bond category – which includes funds that track an even more sedate part of the bond market – tells the same story. Morningstar wasn’t able to provide a 15-year number for the Bloomberg Barclays US 1-5 Year Gov/Credit index, but over that period to the end of 2017, the Vanguard Short-Term Bond index fund, which tracks the index, posted an annualized return of 2.7%. Meanwhile, the average investor return for bond funds in the category was a meager 1.51%.
It may be that investors expect lower volatility from bonds, but this expectation seems to make them behave the same way with their bond funds as they do with their equity funds. In other words, investors don’t expect to lose any money in bonds, or at least they expect to lose less money than they might in stocks, so the prospect of any loss due to interest rate rises, for example, makes investors trade their bond funds just as actively and just as badly as they do their stock funds.
It’s important to note that the math doesn’t tell us why investors are missing out on returns, as economist and author Michael Edesess has previously argued. It could be that automatic contribution and withdrawal plans somehow affect the numbers. After all, comparing fund returns and investor returns for a particular period assumes that the entire investment was made at the beginning, as Edesess rightly acknowledges.
The fact that investor returns are as poor for bond funds as they are for stock funds might support Edesess’s wider point, since the behavioral explanation often pins the blame for at least some of the bad behavior on volatility – or rather, investors’ inability to tolerate volatility.
Still, when observing the monotonic returns of the Vanguard Short-Term Bond index fund, its investor returns and the category’s investor returns, you’ve got to wonder why the category’s investor returns are so much worse than the fund’s investor returns. And it’s difficult to believe that a study done by Index Fund Advisors on its own clients’ bad trading is in some way unique or idiosyncratic.
These observations don’t provide the mathematical proof that Edesess seeks about investor behavior, but they do make it seem as though there’s something less random at work. Why should the Vanguard fund have significantly better investor returns than non-Vanguard funds if some bad behavior isn’t at work?
Even if there is no mathematical proof for what causes poor investor returns, their very existence should give investors pause for thought about their own trading habits. That means investors should think hard about whether they have the ability to forecast interest rate moves and trade their bond funds accordingly, just as much as they should question their ability to forecast every twist and turn of the stock market.