Mind the gap!

Investors spend a disproportionate amount of time trying to identify the ‘best’ fund manager or fund for each and every occasion. The rewards of identifying the better fund managers are clear; over the past 10 years the top quartile of South African equity fund managers outperformed the bottom quartile by 5% per annum[1] - and 5% per annum compounds dramatically over the longer term.

The challenge, of course, is that it is notoriously difficult to identify the fund managers that are going to do well in advance. Not only is fund selection difficult, but investors usually find it hard to stick with their choice once the fund they choose inevitably goes through a poor patch. Jeremy Grantham, head of GMO and one of the industry’s most respected investment thinkers puts it perfectly when he says: “…fund managers are harder to pick than stocks. Investors have to choose between facts (past-performance) and the conflicting marketing claims of several potential managers. As sensible businessmen, clients will usually feel that they have to go with the past facts. They therefore rotate into previously strong styles which regress, dooming most active investors to failure”.

This rotation between funds is likely to be more punitive than being invested in a bottom quartile as opposed to a top quartile performer. The Dalbar survey, which measures investor returns versus fund returns (the difference being the result of switching between funds), indicates that over a 20 year[2] period, US fund investors underperformed the average fund by nearly 8% per annum. The South African experience is likely to be similar. This 8% is the ‘investor behaviour’ penalty – the price investors pay for switching out of poor performing funds into better performing funds at an inappropriate time. Given that the average fund in the survey delivered 12% per annum versus the average investor experience of 4% p.a., this implies that 2/3rds of returns were eroded by investor behaviour.

Investors are likely to have a better experience if they expend their efforts on making an informed choice upfront and then teaching themselves the importance of staying the course and not falling prey to the next best thing. Such a focus presents a remarkable opportunity for investors to improve their odds of a successful outcome; there is up to 8% p.a. upside for teaching yourself to do nothing!

The investment industry itself has a huge responsibility to investors to guide them appropriately rather than aggressively marketing the current ‘hot’ fund. Investment firms ultimately need to act as stewards of their clients’ capital. The concept of stewardship is simple: those firms that take theirresponsibility to fund investors seriously andput investors’ interests above their own are good stewards.

Morningstar, the global provider of independent investment research, has recently taken to rating investment firms according to a number of stewardship criteria, as opposed to simply using performance criteria. Interestingly, there exists a strong positive correlation between the degree of stewardship and long term investment results. This happy outcome is compounded by the fact that the clients of firms with higher stewardship scores have also been more responsibly anchored, thereby reducing the investor behaviour penalty. Therefore, by investing in firms that act in your best interests, not only are you more likely to achieve better ‘fund returns’ but you are also less likely to make mistakes that can erode those returns.

I believe that investors may be best served by identifying those fund managers that will act as responsible stewards of their capital and stick with them through performance ups and downs. This simple factor may well be the single most important consideration in selecting your fund manager.