The fund return dilemma
Instead of offering more investment choices as their funds underperform, asset managers should measure outcomes from the client's perspective
In the pursuit of even a glimpse of certainty in uncertain markets, nothing demonstrates the misaligned interests and irrational investment behaviour among investors, asset managers, private bankers and regulators better than the fact that fund managers consistently underperform the market. Yet financial advisers and asset managers insist that investors keep buying.
A recent report by Aye Soe at S&P Dow Jones Indices said: "2013 was a stellar year for stocks as domestic equity markets posted double-digit returns."
It points out that the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indices posted record-breaking gains of 32.39 per cent, 33.5 per cent and 41.31 per cent, respectively.
Unfortunately, results were mixed for active domestic equity managers. The report said 55.8 per cent of large-cap and 68.09 per cent of small-cap stock managers underperformed their benchmarks in 2013.
And over the past three to five years, the majority of active managers across all domestic equity categories failed to deliver returns higher than their respective benchmarks.
In a related report, Soe said: "Very few funds can consistently stay at the top." Only 3.09 per cent of large-cap, 3.6 per cent of mid-cap and 5.48 per cent of small-cap funds maintained top-half performance over five consecutive 12-month periods.
The research suggests only 6.25 per cent can repeat their success. Worst of all, top-performing funds are less likely to maintain their status. Only a handful of fund managers consistently outperform their benchmark indices over the long term.
Despite this, financial advisers still insist the only way for investors to achieve superior, long-term, diversified returns is to invest in funds.
Investors could increase their portfolio performance by dumping their private bankers and financial advisers. Instead, consider using low-cost exchange-traded funds rather than traditional funds for equity index exposure. Access a world of securities through efficient online brokerage services that charge low commissions. Take your estate planning to a law firm. And use a concierge firm to support your luxurious lifestyle.
This financial blasphemy challenges the existence of the private wealth and fund management industries. But they need to redefine their business models.
Product transparency and clarity remains an intractable problem. It has become almost impossible to describe the inner workings of a typical fund that invests in over a hundred securities. I have not met a single investor that truly understands how their funds operate.
Unlike directly investing in individual securities, it is almost impossible to understand a fund manager's strategy. Asset managers rarely speak openly because they are usually shielded by their investor relations department. Information is limited to a website and a brochure.
Ironically, it is more sensible to buy listed stock in a big diversified company such as Walt Disney because so much more information and research is available about its operations and investments online compared with any mutual fund.
Greater transparency and a diversity of views and information are valuable advantages that large-cap stocks have over funds.
While advisers point out the benefits of portfolio diversification, no one can define how much is needed. Over-diversification almost guarantees a fund will underperform. The consistent underperformance of many funds can be explained by high management fees, which automatically subtract about 1 per cent each year, in addition to subscription and exit fees.
Fund marketers counter the return dilemma by offering more investment choices to create the hope of finding better returns. Yet the industry assaults and numbs investors with an ever-increasing and stunning sea of choices. According to ICI, 73,343 funds are sold through more than 810,000 banks. And in Europe, there are more than 3,100 asset managers.
Asset managers need to comprehend that retail investors do not necessarily seek to maximise total or risk-adjusted returns - this is a myth perpetuated by academics. Investors are oriented towards outcome, especially predictable outcomes. And when they cannot find them in one class, like equities since 2009, they irrationally migrated in herds to fixed income.
Investors are pulling away from benchmarking as a measure and moving towards seeking more aggressive and understandable absolute returns. The fund management industry needs to rediscover and embrace change - a new way of measuring and achieving returns from the client's perspective.
Peter Guy is a financial writer and former international banker