Return gap is the difference between a mutual fund’s actual return and what it would have earned by holding the most recently listed holdings. A study found that mutual funds with a constant positive return gap are more likely to perform well in the future. Benchmarking against its own unique performance is better than comparing it to an arbitrary market benchmark. Return gap should be considered when selecting mutual funds.
A yield gap is the difference between the return actually provided by a mutual fund and how much that fund would have earned if it had simply held on to the most recently listed holdings. Return gap information must be disclosed to the public at least twice a year, but nearly 50% of mutual funds report this information quarterly. A study published in the New York Times in January 2006 found that a mutual fund with a constant positive return gap is more likely to perform well in the future compared to one with a constant negative return gap.
This study took place over a 20-year period and examined return gap data from more than 2,500 domestically-owned mutual funds. The results of the return gap study were not affected by the number of times the portfolio information was disclosed. During the study, the researchers created two hypothetical portfolios based on return gap information. One contained the top 10% funds with the most consistent return gap over the past year. The other portfolio contained the 10% worst return gap performers.
From 1985 to 2003, the first portfolio beat the market by an average of 3.8% each year. The other portfolio performed 4.4% worse. This difference in performance is one that larger researchers have found by retesting different fund selection strategies over an extended period of time.
When a mutual fund is benchmarked against its performance gap, it is benchmarked against its own unique performance. This is a departure from the traditional method of measuring the success of a mutual fund, which was to compare it to an arbitrary market benchmark. Using this method above, a mutual fund could look better or worse than it actually is, because it can easily be compared to the wrong index.
While the return gap isn’t the only tool a person should use when determining which funds to include in a portfolio, it certainly should be a consideration. Furthermore, it can be the determining factor when deciding between funds that otherwise appear to be equal in their potential for success.
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