What is a Return Gap?

A return 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 to the holdings that were most recently listed. Return gap information must be disclosed to the public at least twice per year, but nearly 50% of mutual funds report this information on a quarterly basis. A study published in the New York Times in January 2006 found that a mutual fund with a consistent positive return gap is more likely to perform favorably in the future when compared to one with a consistent negative return gap.

This study took place over a 20 year period and examined the return gap information of more than 2,500 domestic equity 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, researchers created two hypothetical portfolios based on return gap information. One contained the top 10% funds with the most consistent return gap over the previous year. The other portfolio contained the 10% with the worse return gap performance.

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 the largest researchers have found when back-testing different fund selection strategies over an extended period of time.

When a mutual fund is compared against its return gap, it is being compared to its own unique performance. This is a change from the traditional method of gauging the success of a mutual fund, which was to compare it against an arbitrary market benchmark. With this older method, a mutual fund might look better or worse than it really is, because it can easily be compared against the wrong index.

While the return gap is not the only tool a person should use when determining which funds to include in a portfolio, it should certainly be a consideration. In addition, it can be the determining factor when deciding between funds that otherwise appear to be equal in their potential for success.