MarkHulbert

ANNANDALE, Va. (MarketWatch) — When I devoted my column one week ago to the virtues of patience and discipline in investing, I thought that I wouldn’t return to the topic for quite a while.

Let’s face it. Important as patience and discipline are, they are anything but exciting from a journalistic point of view.

But Thursday afternoon, I came across yet more evidence about why they are investment virtues. The new evidence is so compelling that I would be doing a disservice if I let journalistic imperatives stand in the way of bringing it to your attention.

The new evidence came in the form of a press release from Morningstar, Inc. MORN, -1.76% the Chicago-based security research firm. It announced that it was going to start reporting mutual funds’ returns in a new way, in addition to all the traditional ways for which Morningstar is already famous. The firm is referring to this new performance metric as the Morningstar Investor Return, and it directly measures the price investors have paid for failing to be patient and disciplined.

A fund’s Morningstar Investor Return is what statisticians refer to as a dollar-weighted return, to contrast it with what is normally reported as that fund’s performance, which is known as a time-weighted return. A fund’s time-weighted return simply reflects how much your money would have grown had you invested in that fund at the beginning of a time period and held it without interruption until the end of that period, reinvesting dividends along the way.

A fund’s dollar-weighted return, in contrast, measures the returns that investors actually achieved in that fund. Since the average fund investor does not buy-and-hold, and the assets under management at the fund fluctuate, a fund’s dollar weighted return sometimes will be significantly different than its time-weighted return.

Here’s an example. Let’s assume that a fund starts year 1 with $10 million in assets under management, and that during this year no new cash is invested in it and no shares are redeemed. Let’s further assume that the fund produces a 100% return in that year, turning that $10 million into $20 million.

Now let’s imagine that a huge amount of cash flows into that fund at the beginning of year 2. That’s an unobjectionable assumption, of course, given that the fund did so well in year 1. To keep the example simple, let’s assume that $180 million of new cash is invested in the fund at the beginning of year 2, so the fund begins that year with $200 million under management.

To complete the illustration, let’s finally assume that in year 2 the fund produces a 10% loss, turning the $200 million into $180 million.

The fund’s time-weighted return will be huge (80%, in fact, or 34.2% annualized), but the fund’s dollar weighted return will actually be negative, since investors collectively lost a total of $10 million in the fund.

What factors will cause a fund’s dollar-weighted return to diverge from its time-weighted return? The biggest one will be the timing of investors’ buy and sell decisions in that fund. If, as is typical, investors plow more money into a fund after it has performed well, and then sell shares after it has performed poorly, the fund’s dollar-weighted return will be a whole lot less than its time-weighted return.

If, in contrast, a fund’s investors do not try to chase returns, but tend more to the buy-and-hold end of the spectrum, then the fund’s dollar-weighted returns will diverge only slightly from its time-weighed returns. And if a fund’s investors are shrewd enough to invest more in a fund when its price is low than when it is high, its dollar-weighted returns can exceed its time-weighted return.

This last possibility is largely theoretical, however, as it is rare for the average investor to exhibit any market timing or fund-timing ability. Indeed, in an interview, Morningstar’s managing director Don Phillips, said that the average fund’s dollar-weighted returns are significantly less than its time-weighted return.

How much less? Phillips provided the following telling statistics, which were based on dividing all mutual funds in Morningstar’s database into four groups according to the volatilities of their returns relative to comparable funds. Consider first the quartile of funds with the greatest relative volatilities: On average, their dollar weighted returns were just 62% of their time-weighted returns.

In contrast, the quartile of funds with the lowest relative volatilities exhibited dollar-weighted returns that, on average, were 98% of their time-weighted returns.

The reason for the low percentage among high-volatility funds, according to Phillips, is that volatile funds are the very ones in which investors have the hardest time staying the course. These are the funds that on occasion produce huge short-term returns that all but the disciplined find irresistible. And, by the same token, these are the funds that on occasion also suffer huge short-term losses that only the few with iron stomachs can tolerate.

Should a fund be held responsible for dollar weighted returns that are a lot lower than its time-weighted returns? You might think that it would be unfair to do so, on the assumption that the fund has no control over what investors actually do in that fund.

But Phillips disagrees. Fund companies don’t have complete control over how investors use their funds, but that doesn’t mean they can’t exercise any control. Fund companies can influence investor behavior through fund design, the timing of launches and closings, marketing efforts, and shareholder communications.

In fact, Phillips indicated that Morningstar was planning on taking a fund’s dollar-weighted returns into account in calculating its stewardship grade. This grade, which Morningstar inaugurated two years ago, is based on several different dimensions of a fund’s governance and corporate culture. Phillips argues that a fund probably has serious governance and corporate culture problems if its dollar-weighted returns are a lot lower than its time-weighted returns.

Morningstar plans to begin rolling out its dollar-weighted returns in various of its products later this month.

In the meantime, the table below lists those funds, of the 25 with the most assets under management, whose dollar-weighted ten-year returns through September 30 diverged by more than one percentage point per year from their time-weighted returns. All data are courtesy of Morningstar, Inc.