The return gap, which compares an investor’s return to the return of the mutual funds they invest in, is greater for actively managed fund shareholders. A Morningstar analysis found a 10-year annualized negative return gap of 2.48% for actively managed funds. Put another way, the investors in those funds realized returns that were 2.48% less than returns realized by the very same mutual funds on an annualized basis.

The gap is smaller for passively managed (index) funds. Passive-fund investors, in aggregate, realized an annualized negative return gap of 1.84% over the past 10 years.

The return gap is based on the timing of when cash flows go into and out of a fund. An investor who buys a mutual fund and reinvests their shares will realize the same return as the fund over the holding period, excluding any taxes. An investor who buys and sells shares during the measured holding period will have a different return. While it is possible to realize a higher return depending on the timing of the inflows and outflows, investors in aggregate realize a negative return gap—meaning they underperform the very same mutual funds they invest in.

Morningstar’s Ben Johnson attributes the smaller negative return gap for index fund investors to two key factors. Index fund investors generally expect to simply match the return of the market rather than trying to beat it. As such, they are more content to think over the long term and leave their investments alone. Growth in usage of target date funds, particularly those that allocate to index funds, has brought in more longer-term dollars. Target date funds are often the default allocation in workplace retirement plans.

The return gap is not universally smaller for passive funds. Among emerging market funds, for instance, the return gap actually is larger for passive funds (–3.50%) than it is for active funds (–1.13%). The poor relative performance of emerging markets relative to the U.S. market may be a reason why.

Overall, the return gap has narrowed for all categories over the past one-, three- and five-year periods compared to the last 10 years. The extended bull market for U.S. stocks, global economic recovery and calm bond markets have all reduced volatility and made it psychologically easier for investors to stick with their chosen funds.

Source: “Mind the Gap: Active Versus Passive Edition 2018,” by Ben Johnson, CFA; Morningstar.com, May 2, 2018. Ben Johnson recently spoke at the 2018 AAII Investor Conference; if you weren’t able to attend, session audio and handouts are available for purchase at www.aaii.com/investoraudio.