Why are investors settling for less?

Instead of settling for safe but sub-average returns, investors should seek out good investment managers, Johan de Lange argues.

The investment industry must be one of the only disciplines where buyers pay a significant price for a product that adds no value. Index investing is such a product yet their popularity with investors would indicate otherwise. 

A recent media report stated that: “Indexed funds under management have enjoyed enormous popularity since the GFC, with assets outgrowing non-indexed funds under management by a factor of seven to one.” 

It has been argued many times that using exchange-traded funds or indexed funds in the creation of an investment strategy is an accepted and sensible approach offering a number of benefits.

At its core, the investor will not be exposed to an underperforming manager for a management fee north of 1 per cent in the retail market.

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In the investment world value is often assessed by historic returns.

While the quality of the team, the research process, the approach and the like are all-important, ultimately the result is performance which is there for everyone to see. It is the most tangible thing the industry has to offer.

Most investors buy the expectation of future returns, a difficult decision made even trickier by the fact that an active manager’s expectation to outperform has only a 25 per cent chance of delivering (based on research by Julie Agnew and Lisa Szykman in 2004 entitled: Asset Allocation and Information Overload).

For investors who want exposure to the market and who want to beat the 7 per cent real return Australian shares have offered over the last century it seems logical to choose an indexed fund.

After all they come with the guarantee of the market return less fees paid.

The big problem is timing - none of us have the luxury of 100 years exposure to the market. 

This leaves the investor with a simple choice of taking a one in four chance of finding an active manager that can add value to their portfolio or choosing the index with a return of the market less fees of between 18-75 basis points.

This is reflected over 10 years assuming an investment of $50,000 and a market return of 10 per cent per annum (see Table 1).

The value lost by the passive investor could total as much as $23,811.

Over the past 10 years 33 per cent of the all Australia Equity Large Cap Funds outperformed the ASX 300 Index, but only 13 per cent outperformed by more than 1 per cent.

Importantly though, the downside would have been limited, with more than 55 per cent of the funds outperforming the index minus 0.50 per cent.

If the potential for active managers to get it wrong is not nearly as big as we thought, why are investors still settling for a return of less than 0.50 per cent?

One of the main reasons is that it allows them to “sleep easy”. After all they don’t have to wait anxiously to see the returns their manager has delivered against the benchmark.

Managers can address these concerns by doing a few things and doing them well.

Unfortunately the investment industry has favoured short-term product proliferation to accelerate their distribution efforts, resulting in an ever-growing array of funds.

This has made it even more difficult for investors to decide.

In an experiment conducted by Agnew and Szykman for their report in 2004, participants were asked to choose from a possible list of investment funds and were then randomly assigned a list of 6 or 60 funds.

Those with the shorter list reported higher satisfaction levels with their decision compared to those who had to choose from the longer list. 

While this may indicate that the excessive choice of funds on the Australian market may be a problem, it shouldn’t be the reason investors don’t seek out good managers at the expense of settling for safe but sub-average returns.

Instead, investors should be spending more time researching managers who actively pursue the investors’ best interests by delivering returns over long periods and who stay true to their investment principles.

Johan de Lange is the head of retail at Allan Gray Australia.