What about the investor's interests?

Picture the following scenario.  You are an investor in Fund Alpha, an equity unit trust fund managed by Manager X.  After having invested in the fund for a year, one of the following 3 outcomes occur:

1) Fund Alpha returns 43% over the year, while the average equity fund returns 32%

2) Fund Alpha delivers 12% for the year, while its average peer manages 17%

3) The average equity fund returns 8% compared to Fund Alpha's 3%.

Given the choice, an investor and Manager X would choose scenario 1.  The fund delivers a good performance, the performance is also better than most of the peers, and the investment added value to the investor's capital.  Scenario 1 is the proverbial "no-brainer" because it benefits both the investor and the asset manager.

Now remove scenario 1 from the list.  The investor and Manager X are left with the option of scenarios 2 and 3.  A rational investor would choose scenario 2 over 3, as scenario 2 allows him to grow his capital and increase the likelihood of achieving his financial goals.  Outcome 3 will have the opposite effect.  Although it is never pleasant to get a return of 12% when your neighbour achieved 17%, surely this is preferable to losing capital.

There are, however, many equity managers that would, when presented with Manger Xs options, choose scenario 3 over 2.  This is because scenario 2 costs the asset manager money while 3 costs the investor money.  Investment houses struggle to keep clients through long periods of under performance, and it is often easier to retain clients while losing money but at the same time outperforming the average.
 
Manager X could defend its peer group-inclination by saying that Fund Alpha has the peer group or All Share Index as benchmark, and that over a one-year period the fund may not explicitly grow capital.  He could go on to say that an investor who prefers scenario 2 to 3 should rather be invested in Manager Xs absolute return products.

Although this logic may not be completely unreasonable, it is arguably not aligned with the investor's interests.  We are yet to meet an investor who invests his money purely for the purpose of beating the average peer group fund or the benchmark.  Investors invest their money in order to grow it over time and achieve their financial goals, whether they adopt an equity or absolute return approach.

This does not mean that investors should only focus on conservative equity funds that are unlikely to lose money.  Potential capital growth is also an important consideration.  However, it is key that the fund manager and the investors interest be aligned.  One way of ensuring this is to look for managers that are heavily invested in their own products.  These managers typically manage clients money in the same way as they would their own - with very little cognisance of what the peers are doing.  They are unfortunately hard to come by.