I was attracted to a recent article in a Sydney paper with a headline screaming about how lazy financial planners are charging for nothing.
Given that the information coming out of the Royal Commission focused on issues such as fees for no advice, or trailing commissions, I wondered what issue this author would be writing about.
It turns out that the article was largely focussed on investment philosophy.
The author recognised that good financial advisers deliver significant benefits through their strategic and structural advice in areas including tax, super, estate planning and many others.
However, the key proposition of the article was that investors are being dudded unless they are achieving better than average performance on their investments.
When you’ve got money to invest, particularly if it’s a sizeable amount, you’ve likely achieved that because you are above average. Perhaps you are of above average intelligence, harder working and more determined, more resourceful or a better sales person.
Of course, in the occasional quiet moment some of us might also consider that we’ve been assisted at least to some degree by luck.
Leaving luck aside though, whatever superior talent you have, you’ve taken (calculated) risks and used your talent to build a high degree of financial security.
Quite reasonably you want to take those financial resources and grow them further in the most effective way possible.
When you are wanting to beat the return of the average investor, it’s important firstly to determine what return the average investor actually receives.
We can start by looking to the indices of which investment managers compare themselves. . This might include the S&P/ASX200 if you are investing in Australian shares, or the MSCI World ex Australia for international shares.
But these indices only tell you what the market return was – they don’t tell you what return an investment in the market received. This might seem like a pedantic difference but it’s an important one, because while you can invest in a way that replicates a particular market index there are costs associated with doing so. These include transactions costs (the costs of buying and selling investments) and investment management costs (and in this article we won’t even consider the implications of taxation). These costs reduce the net return you will receive on your investments.
So before you even start to invest you are handicapped.
Surely then it makes sense to adopt a strategy that seeks to overcome this, to try and beat the market so that at the very minimum you can overcome this handicap and get back to the market return.
For the last 15 years, S&P have examined the returns of managed funds in Australia and published an annual scorecard[1]. They have looked at managed funds available to Australian investors which invest in Australian and International shares, A-REITS and Fixed Income securities. In 2017 they reported that 59% of Australian share funds (general) performed worse than the index, while for mid and small company managers this was true in 74.04% of cases.
Of course one year is hardly a long enough time frame to provide statistically significant results, so we can look at the 15 year report card. This shows that 77% of Australian share funds (general) performed worse than the index, while 54.72% of mid and small company funds were outperformed by their index.
There were similar 15 years results for International share funds and those investing in A-REITS, with the index beating 87.1% and 78.08% of funds respectively over this time frame. No Australian Bond fund survived for 15 years, but over 10 years the index won out on a risk adjusted basis in 70% of cases.
So from this study it appears that an investor needs to be in the top quartile of funds just to avoid being outperformed by the market index.
But surely a good financial planner can identify and recommend quality investment managers to ensure your investments are top performers?
This sounds good in theory. Over an extended period one would expect quality managers to become more and more obvious and hence easier to pick, a clear case of the cream rising to the top.
To examine this, Vanguard studied actively managed Australian share funds over a ten-year period to 2015[2]. They were looking to understand how persistent good performance among managers was, so they divided the ten years into two periods of five years and looked at the consistency of performance across both.
They found that if you looked at of those funds that were in the top 20% of performers for the first five years, only 30% were able to remain there for the second period. What’s even more alarming is that 22% of this group fell to the bottom quintile and 16% ceased to exist (they were closed or merged with another fund).
Let’s work through these numbers so they are clear.
If we start the ten years with 100 funds we would select the 20 top performers at the end of the first five years. We would then monitor their performance over the next five years. Based on the results:
- Only six of these would appear in the top 20 at the end of the second five year period,
- four would be in the bottom 20 and
- three would no longer exist.
This result is illustrative of the phrase known to all investors: past performance is no guarantee of future results.
But financial planners also have access to highly regarded research houses. These are companies whose sole business is to help with the selection of quality investment managers. They also have the inside track to spot new managers early, and surely this will assist in the selection of investments that are better than average?
Further research has been conducted by Vanguard to examine this premise[3].
While the research only looked at results for US equity investment funds, they found that in the three years after a fund received a star rating from Morningstar (1-star to 5-star with a 5-star rating being the best):
- only 39% of funds which had received a 5-star rating outperformed their (style) benchmark
- funds which received a 4, 3 or 2-star rating outperformed in 37%, 38% and 39% of cases respectively
- funds which received a 1-star rating outperformed in 46% of cases – significantly more than any of the other ratings had
What this shows is that a positive research rating in this example would appear to offer about a 2 in 3 chance of leading to investments that will deliver below average returns.
As an investor you may be wondering why you wouldn’t just have a stab in the dark yourself. After all, it would appear you’re just as likely as a professional to be able to pick an investment that is going to perform well.
There are two studies that have examined the returns investors receive over an extended period of time. A report by Dalbar looks at the return US investors receive compared to the return delivered by the market they are investing in[4]. The second report by Vanguard examines the return Australian investors receive compared to the managed funds they have invested in[5].
The Dalbar report shows that over the 20 years to December 2017 the average equity fund investor underperformed the S&P 500 index by almost 2% p.a. (5.29% vs 7.2%), while the average fixed income fund investor underperformed the index by over 4% p.a. (0.44% vs 4.6%).
The Vanguard report looks at Australian investors over the 10 years to December 2015 and the results are similar: investors in general Australian share funds underperformed their investments by 1.84% p.a. and in international fixed income funds they lagged by 0.85% p.a.
Both reports examine the movement of money into and out of the investment funds to determine when investors are in aggregate, buying or selling their investments. This shows the impact of the timing of investments, and accounts for the common practice of people investing more money when markets are going up in value, and withdrawing money when they are going down.
The results also account for the difficulty in predicting when markets are going to go up and down, and then acting on it appropriately. While the Dalbar report identified that investors have guessed right on the direction of the market 50% or more for 14 out of the last 20 years, unfortunately this did not produce superior results for them. This is because ‘the dollar volume of bad guesses exceeds the volume of right guesses…[and] even one month of wrong guesses can wipe out several months of right ones’ (page 21).
According to the Dalbar report:
The data shows that the average mutual fund investor has not stayed invested for a long enough period to time to execute a long term strategy. In fact, they typically stay invested for just a fraction of a market cycle. [our report] has also shown numerous instances in which market conditions create a shift in cash flows which run counter to the eventual direction of the market. (page 18)
So, where to from here?
Firstly, let’s acknowledge how difficult investment management is.
There are hundreds of thousands of market participants around the world, all of whom are trying to beat the other. The market is the essentially the result of all their transactions, and the market return is the average of them.
For every trade there is going to be a winner, and a loser – it is a zero sum game. Any investor is going to find themselves on both sides of that equation at different times. It is simply not possible for a high performing investment manager to exist in the absence of one with low performance.
Given all the money in the world, and all of the investors who are looking for an advantage or a better way of doing things, there is a huge incentive for identifying strategies leading to better returns. It is essentially an arms race though, and each new development is matched or improved on by competitors as soon as it is identified – which nullifies the benefits.
This is why it is extremely difficult to consistently deliver above average returns.
But as an adviser who is responsible for helping clients grow their pot of money so they can do the things that are important to them, my first duty is ensuring you at least achieve the returns of the market in which you are invested. For example, if you are investing into Australian shares then you are taking on significantly more risk than keeping your money in a savings account in the bank. As a result, you need to be compensated for taking on that risk – you need to receive at least the market return.
But the research quoted demonstrates that it is only a small minority of funds that can deliver a return exceeding the market. The research also demonstrates how difficult it is to predict which managers are going to outperform the market, and for those who don’t outperform, their costs mean they cannot even match the market.
In many cases, excess returns are simply the result of taking on more risk – not manager skill. If you take on more risk you should achieve higher returns – otherwise why would anyone do it? For instance, investing a greater share of your portfolio into smaller companies increases the level of risk and so should increase the level of returns. If the portfolio delivers these higher returns it is simply achieving the market returns that are owed to it – it’s not the result of superior skill.
It is important to understand what is driving the headline returns, and it’s equally important not to pay high active management fees for a fund that is simply delivering market returns.
Given all of this, doesn’t it appear that the sensible course of action is to aim to simply capture market performance – precisely because it is so uncommon for investors to consistently achieve this? Isn’t this the obvious conclusion to be drawn from this research, and hence the smart thing to do?
But this is a completely different paradigm for advice from what many investors expect. If an adviser isn’t recommending superior investments and generating above market returns, what are they doing?
The answer is that they are helping clients to achieve their goals and do the things that are important to them, rather than focusing on trying to beat the market.
This might sound trite, but for most people money and investment performance are not the things they really want – they want what money can buy.
You might want the ability to send your children to private school, to live in a particular house or neighbourhood, to be able to travel to the four corners of the earth (and run marathons in them hopefully!) or to be able to stop working at some point and maintain your lifestyle.
It is these things and more that people really want – and the amount of money you need is what will deliver this for you.
By learning what is really important to you, an adviser can work out how much money you need to be able to fund this. Taking into account how much risk you are comfortable taking, they can then reverse engineer your goals and develop a strategy to achieve them. There might be a disconnect between your objectives and the level of risk you are comfortable taking. In this case you will learn that you need to adjust your goals or adjust the level of risk you want to take, but you can make an informed decision about this.
To maximise the probability that your outcomes can match the modelling, conservative assumptions are used. No client I’ve ever done this for has asked me to assume that every year their investments shoot the lights out.
Then, if the modelling shows that what you want is possible it’s simply a matter of implementing the strategy in a manner that maximises the probability of success. It’s about focusing on achieving small gains consistently, guarding against significant losses, and not relying on a ‘Hail Mary’ shot to win.
It’s then about managing that process.
If you want to achieve results different to those of most people, you need to do things differently to most people.
The research shows that most investors don’t achieve a market return, in spite of their attempts to do better than it. So the starting point is to ensure you capture the market return most efficiently.
As the Dalbar research also points out, most investors cost themselves returns because they don’t stay invested throughout the market cycle. What this means is that they buy and sell their investments at the wrong time – a sure fire way to lose money.
By staying invested in your portfolio throughout the ups and downs, you are significantly improving your chances of success. This process should be made easier because you have seen through the modelling that your goals are achievable based on conservative assumptions. It should also be easier if you are not having to second guess an investment manager to determine whether they have lost their skill or whether they can recover. If what you are aiming for is to achieve the market return and the market drops, you just need to hold tight until the market recovers. Of course I recognise that it’s far easier to contemplate this situation in the abstract than when sharemarkets are down by 50% as they were in the GFC.
The other benefit an adviser can bring is discipline.
We all know the way to make money is to Buy Low and Sell High. We all do this intuitively in most aspects of our life – we love a bargain.
Yet it’s one of the hardest things to do with our investments.
When the price of an investment has gone done we worry that there is something wrong with it so we sell it, but when it’s gone up we figure we are geniuses and the investment is great, and we should buy more.
The hardest thing to do is to take profits on investments that have done well, and reinvest the money into areas that have underperformed. But what a disciplined rebalancing program does is it reduces the degree of risk in your portfolio, it reduces the degree of volatility in it, and it improves the long term returns.
It does all of this without taking on additional risk, and without needing to outguess the market.
As an investor, you have a clear choice.
You can choose to employ a macho, seat of their pants kind of adviser who appeals to your ego and your emotions. They will do lots of things, make lots of recommendations, but according to the research are ultimately promising you something they will struggle to deliver on.
Or you can opt for one who has done their research and looked beyond the promises, the hyperbole and the marketing spin of big talking fund managers. In taking the ‘lazy option’ of seeking to generate a market return for you they will help you actually outperform the majority of investors – relative to the risk you have taken.
More importantly though, they will actually help you to achieve what is really important to you.
What advice would you rather pay for?
[1] S&P Dow Jones SPIVA Australia Scorecard https://au.spindices.com/documents/spiva/spiva-australia-year-end-2017.pdf
[2] Vanguard’s Principles for Investing Success (page 31) https://static.vgcontent.info/crp/intl/auw/docs/corporate/principles-for-investing-success.pdf
[3] “Mutual fund ratings and future performance” (June 2010) – Christopher B. Philips & Francis M Kinniry Jr, https://www.vanguard.com/pdf/icrwmf.pdf
[4] Dalbar: Quantitative Analysis of Investor Behaviour – 2018 QAIB Report (for the period ending 31/12/2017). https://2wmko64dug4x3dv4oh97ijl9-wpengine.netdna-ssl.com/wp-content/uploads/2018/04/2018-QAIB-Report_FINAL.pdf
[5] Vanguard Investment Principles – “Why Returns Lag” https://www.vanguardinvestments.com.au/retail/ret/articles/insights/research-commentary/investment-principles/why-returns-lag.jsp?lang=en
