Charles D Ellis, author of Winning the Loser's Game and a former Yale lecturer and chairperson of the Yale investment committee, argues that the time and money spent by fund managers on trying to beat the market and chasing competitors' returns would be better spent on educating clients about how to make appropriate investment decisions.
"Very few investors have been able to outsmart and outmanoeuvre other investors often enough and regularly enough to beat the market consistently over the long term, particularly after covering all the costs," Ellis writes. But investors can improve their returns significantly by adjusting their behaviour.
A famous study by Dalbar, a company that studies investor behaviour, showed that, over 20 years, the average American investor underperformed the market by 4% a year because of emotional responses to market movements, buying at the peak and selling in panic when the market falls.
Allan Gray analysed its own fund performance and found that the average investor in the Allan Gray balanced fund, designed to limit the volatility of the markets, received a 14.3% annual return over the past 10 years compared with the 16.6% return delivered by the fund over the same period. The difference is directly related to losses incurred by investors moving in and out of the fund in an attempt to "protect" their capital.
Over 10 years, that 2.3% a year difference between the fund and the investor on a R100 000 investment meant the difference between R520 000 and R414 000.
Any fund manager who consistently outperformed the benchmark by 2.3% a year would have very satisfied investors, which makes Ellis's argument compelling: rather than paying for expensive skills to pick shares, which may or may not result in outperformance, the investment business should ensure that clients are invested in the fund corresponding to their risk appetite and financial goals and fully understand the nature of the investment.
Ellis refers to performance investing as "the loser's game". "There are people all over the world trying to find ways to beat the competition. We have reached a point where our mission is to beat the competition, not to deliver returns," Ellis said at the African Cup of Investment Management conference last week. During a presentation, he said the increased competition not only made it harder to achieve outperformance, but investment fees had also increased over the past 50 years. As a result, the investment industry had reached a point where the additional cost of expertise could not deliver the additional returns.
Fund rating agency Morningstar found that the single largest variable for outperformance was fees. "The line between rising fees and fading performance has already been crossed. Fees exceed the ability to deliver superior returns. At some stage clients will figure it out and there will be hell to pay," Ellis said.
Despite the logic of this, most investors do not like passive investments, which means the active management industry is unlikely to come under threat any time soon. In his book What Investors Really Want, Meir Statman, the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University in California, writes that status is as important as returns.
Statman, who also addressed the African Cup conference, asked why a person would spend $10 000 on a watch to tell the time when a $100 watch did exactly the same thing? "A watch manufacturer knows they sell prestige and style; they don't try and compete on whose watch is more accurate. The financial industry thinks it is about who has the higher alpha, but we don't understand our industry."
In his book, Statman uses United States hedge funds as an example of investors seeking status rather than returns: "High returns bring wealth and wealth elevates status. But hedge funds elevate status even when they detract from wealth."
Despite research showing that high-cost hedge funds make more money for the investment company's partners than for the investors, they remain popular because of their status. "Hedge funds open their doors only to the rich, making it easy for investors to brag about their riches without appearing to brag." Statman illustrates this with an anecdote: "An employee at a British hedge fund told me about a group of investors who protested when the fund lowered its minimum investment from a million pounds to half a million. 'Now they'll have to consort with the working class, they said.'"
Passive investments such as index trackers need to overcome this hurdle. Research has shown that only a few active fund managers outperform over a sustained period, but passive funds still fail to attract widespread inflows, possibly because they do not offer the same ring as references to "my fund manager" or "my stockbroker". Index funds can also be seen as a "less intelligent" investment or a "cheaper" option.
But this may change if investors understand the real cost of investing and how disingenuous fees on assets under management are.
"You already accumulated the assets; why are you paying fees on those? The fund manager should make fees only on the returns it generates on those assets," Statman said. A fund with a 7% return and a 1% annual fee on assets under management is equivalent to a 15% fee on the growth, which, when calculated like that, is very expensive. In bear markets, fund managers also make money, irrespective of performance.
Statman agrees with Ellis that the industry needs to stop emphasising performance investing and should rather focus on helping clients to understand what they want to achieve and how to achieve it. Statman recommends understanding the science of financial markets, understanding what looks true and what is actually true, and learning how human behaviour affects our decisions.
"Stocks go up and down, not because you are stupid or clever. We look for evidence that confirms our claims and beliefs and we overlook evidence that disconfirms them."
More often than not, poor choices or emotional decisions lead to negative returns. If investors understand what they are investing in, why they are investing and make more optimal investment decisions, we would have better outcomes than simply chasing returns.
"Investors want it all. We want good financial education, advice and protection, yet we are reluctant to pay for it, or to devote the effort necessary to acquire it. Our desire for good free advice joins our other investment desires, from the desire to stay true to our values to the desire for status," Statman writes.
Perhaps it is time to take another look at the entire investment industry model and place more emphasis and value on sound advice on long-term investment decisions than on a fund manager's performance.
Charles D Ellis and Meir Statman were guest speakers at the African Cup of Investment Management conference hosted by IMN. The lead sponsor was Sanlam Investment Management