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John Rekenthaler: [Morningstar director of fund research] Russ Kinnel has written a series called Mind the Gap that’s available on Morningstar.com, and I would recommend that people take a look at the Mind the Gap series in which he looks at the investor experience or investor returns on funds. Basically that measures not just the standard total return of a fund but how much money was in a fund at a given time. So the idea being, are people buying funds at the right time? Or possibly are they buying high and selling low? So it looks at the amount of assets that are in a fund as well as the fund performance, and it looks at just how well people are using funds. The answer, unfortunately, is people are not using funds that well. They tend to trail what we see as the paper returns or the standard total returns of a fund. Bottom line is, they are getting in high and they are selling low.

Benz: And you really see this across asset classes. Are there any asset classes where that performance-chasing trend tends to be especially stark, where you see investors really undermine their results with some of their poor-timing strikes?

Rekenthaler: Generally the more volatile and unpredictable the performance of a fund type is or fund category, the more this problem occurs. [Some examples of these asset classes are] sector funds, volatile equity funds, and emerging-markets funds. And some of new alternative funds, as well--they may not as volatile but they are unpredictable, people don’t know what to expect of them.

The best success tends to be in what we call solution-based funds--so allocation funds, target-date funds in particular because the asset flows are so steady in the target-date funds. People tend to do pretty well in those. So one takeaway from Kinnel's work is unless you as an investor have kind of a special and strong personality or as an advisor you are working with somebody who is like that, you're probably better off in a broader solution-based fund than brick-by-brick assembling the individual bits because the temptation becomes too strong at the end of a year or at the end of a three-year period to look at the individual bits and get upset of the ones that performed the worst and clear them out. What you are doing is you tend to be clearing out of not your worst fund but your lowest-performing asset class which then is maybe your best-performing asset class next time around but you don’t have it any more.

Benz: I want to get back to that point later on, but first, you took a closer look at really where this disconnect is occurring where investors are undermining their own results, and you looked at the fund-selection levels. So you looked specifically within categories. Are investors selecting the crummy funds? What did you find there?

Rekenthaler: The reason I started there is, implicitly, we’re not the first ones, or the only ones to notice that investors don’t use funds as successfully as they might, that there is a so-called return gap. And a lot of people say, well, that’s because they are chasing performance like the number one [fund] in a category, a Morningstar Rating for funds of 5 stars, and so forth.

Well, generally when you look at these explanations they all have to do with how people invest within a category. They're all about measuring funds within the category--when I say category, I mean a narrow group. So the thesis is that people are buying poor funds of a given type. So when they are buying large-blend funds they are buying the bad large-blend funds. That's implicitly what’s going on with these comments and this criticism. But you look that’s not the case at all.

I went back and looked over the last 10 years and looked where the assets are, the asset-weighted performance of each category. So basically, the question is: Do the big funds underperform the small funds within a category? And consistently category by category, asset class by asset class, they do. Generally, it's about one third of a percentage point or so. It varies, but maybe 0.3 percentage points per year of performance, the big funds are underperforming the small funds. So people are putting their money into relatively successful funds within each category, the problem doesn’t lie there.

Benz: The problem lies as you found in your research with asset-class selection. So even though investors are finding their way to good funds, they do tend to underperform when they decide which asset classes to be in. Let’s talk about your research results in that area.

Rekenthaler: Yes. That’s a massive effect, that allocation effect. And the intuition is it doesn’t matter--what quality of commodity fund you bought three years ago, or oil fund when oil prices were much higher, or a gold fund two years ago--if you went in there and you bought that asset class. It certainly didn’t matter in the mid-2000s if you went into really any kind of equity fund. If you moved from fixed income to equity and got hit by the 2008 market crash, you were hurt by those results.

You might've well picked a good fund within that category and done all your research, but the asset-allocation decision didn’t work for you. And that’s really the effect; that’s what hurts people with their fund investing--moving between the asset classes at the wrong time. And clearly the challenge that we all face--when I say we all face, I mean anybody that’s in the position of trying to help investors reach better investment decisions, which is what it says on Morningstar’s website right and what financial advisors try to do and fund companies try to do and media tries to do and financial writers try to do.

I’d say let’s spend a little less time thinking about how to compare this fund versus this fund of this type. That’s a backbone of what we do at Morningstar; so it’s a little hard to give it up. But let’s try to find better ways of helping people form portfolios and stay on those portfolios that are successful.

Benz: It sounds like that would be your counsel to individual investors, too, if they have a set amount of time to dedicate to managing their finances that they want to think about perhaps putting fund selection or security selection a little further down in their list of tasks and put asset-class selection [toward the top of the list]?

Rekenthaler: Yeah, when we all [focus on security selection] we’ll spend 90%-95% of our time thinking about, "let’s compare this fund to that fund or that stock to that stock or maybe this bond to this bond" and relatively little time on allocation, which isn’t bad, if it’s a strategic allocation that you rebalance to and stick with. What you find is people spend relatively little time on allocation, but then they cheat on that allocation because of their security-selection work. And, again, they’re not satisfied with this fund's performance or that fund's performance, and they move it. But they’re not moving to a like type of fund, or a like type of stock. They're changing their asset allocation effectively from the bottom up when they’re doing that. That I think is really the key, these unconscious or subconscious asset-allocation changes that occur.

Benz: One thing that we have seen in a very pronounced way during the past three years has been this is very strong inflow into bond funds, and I’m wondering if you can kind of talk about that trend in the context of this research. I think that we’ve got a lot of investors moving into an asset class that arguably will not have particularly strong results in the decades ahead.

Rekenthaler: Yeah, I think this will fit in. I’m hesitant to use the word bond bubble that some people have said about this. I think bubbles are pretty difficult to identify ahead. It’s easy to go back and say this was a bubble, but we didn’t know that at the time. And there are many things where markets maybe got a little bit more highly valued or didn’t look as attractive. But they weren’t bubbles; you didn’t end up making a lot of money in them. I think it’s pretty clear when you look out over the next 10 years given where yields are in high-quality bonds, really across the board, that equities will make more money and will outperform bonds, as they have for the last three or four years pretty well.

And it’s pretty clear also, since there has been a movement out of equities and into fixed income a lot since 2008, that this is the kind of thing that's going to factor in and will continue to do so. The industry will continue to have the kind of numbers; the pattern that we’ve identified in our research will continue. There will be a return gap, and it will mostly be from allocation.

Now, I hesitate to point to this investor and that investor and say you have too much bonds, or you shouldn’t have made that trade. I mean there are legitimate financial reasons or psychological reasons or and as well as people buying fixed income who are doing so thoughtfully and knowledgably ...

Benz: A lot of baby boomers getting ready to retire.

Rekenthaler: Yes, we need to be careful and not just sit here and say "we’ve got this sorted out," [like] you're a lemming moving through the bubble. But if you step back and you look, yes, there has been a lot of movement out of equities into fixed income, and that most likely is going to end up hurting the performance of fund investors, the actual dollars in funds compared with the paper returns going forward, which has consistently been the pattern in the past.

So I think, if I’m somebody who’s done that, let’s just think about that a little bit. It doesn’t mean you have to reverse those trades. But just understand that’s the stark context and in a sense the odds are not in the favor of that trade.