Why ETF Investors Persistently Miss 1%-2% of Potential Returns 

“Mind the gap” isn’t just a safety warning for London tube travelers.

Morningstar’s latest annual report of the same name, which analyzes the gap between aggregate returns for mutual and exchange-trade funds and the returns on the average dollar invested in them, found an average shortfall of 1.2% over the decade ending in December 2024. That’s equivalent to about 15% of the funds’ total aggregate returns over 10 years, and slightly higher than the gap in the decade through December 2023, according to the report, which was released this month. While overall gaps in studies over the past five years have consistently been larger than 1%, the performance of individual funds varies based on characteristics like cash flow volatility, which was tracked for the first time this year as a measure of trading activity. “The more often investors traded, the wider the gap was between the return of the average dollar and the return of the fund they were investing in,” said Jeff Ptak, the report’s author. “[Volatility] doesn’t make a bad fund, but investors in those funds have less returns.”

Filling in the Gaps

ETFs had wider gaps than mutual funds, especially international equity and sector equity funds, according to the report. Sector equity funds saw the greatest gap between the average dollar invested and aggregate fund returns, while investors in allocation funds captured the most returns, with a gap of just 0.2%. The data also showed that the more a fund diverged from its index, the bigger the returns gap became, although it’s not immediately clear why, Ptak said. “The challenge of measuring a fund that goes its own way is that it doesn’t follow the herd,” he added. “Other funds can stick out in a good way. Their returns can appear above the benchmark’s return, but [investors] might be purchasing it with hindsight at an inopportune time.” The findings also point to all-in-one funds having the advantage over narrower, standalone or building-block style strategies, he said.

Other notable gap findings in the report include:

• The average dollar invested in taxable bonds earned a 1.2% return, a percentage point less than the funds’ aggregate return of 2.2%.
• Investors in muni bonds earned 1.0% on the average dollar, less than half of the funds’ total returns of 2.1%.

Context Clues. The gap can also be a matter of context and circumstances. Retirement plans, for example, are conducive to capturing more returns because investors aren’t making opportunistic changes but simply adding money on a regular basis. And allocation funds — which captured the most returns — are often found in retirement plans. “Our understanding of what causes gaps has evolved over time. Previously, we had referred to this as a behavior gap, but as we collected more data, it became clear that the story is nuanced,” Ptak said. “Behavior is a factor, but there’s more to it than that.”