As an industry we are fixated with the returns that our unit trusts managers deliver. But how much of the gains made by unit trusts actually end up in investors’ pockets? A lot less than you may expect.

This is true across regions and time periods. A comprehensive study done by the University of Michigan concluded that dollar-weighted returns (the experience of the client) was consistently lower than the time-weighted returns (actual performance of the fund) over a range of markets and periods.

Over an 80-year period in the US, investors received 1.3 percent less per annum because they went in and out of funds at the wrong time. The experience with higher risk markets (such as the Nasdaq) is significantly worse, at 5.3 percent per annum. The study also shows that as the investor holding period has reduced over time, so the deficit has increased.

Lost performance

So where is the performance lost, what are the reasons for the loss, and what can you do to avoid a similar fate? These are critical questions. For many investors this could mean the difference between retiring comfortably and struggling to make ends meet.

At first glance, many would think the reason was excessive fees, strange performance reporting or some other shenanigans of investment companies. While this may play a role, a large part of the answer lies in the enormous influence that emotion has on how we invest (the timing of when we buy and sell). The stock market can, and does, easily bring out the worst in people.

There are three main reasons that drive the shortfall, and they are all based on our behaviour:

• Fear and envy;
  
• Noise;
  
• The agency affect.

But how is it that some investors, having achieved splendid returns, are pre-occupied with envy because their neighbour did better (Charlie Munger remarked at this year’s Berkshire Hathaway AGM in Omaha that envy is the most stupid of the seven deadly sins as you derive no pleasure from it, unlike lust or gluttony).

Countering the emotions

How does one counter these destructive emotions?

The key is to be aware of the damage they cause (education) and to develop a sensible framework with realistic expectations before investing. It is an unfortunate reality that returns in excess of cash go hand in hand with the risk of losing money.

Most investors would be better off investing in appropriate assets, forgetting about it and only re-visiting their position in ten or twenty years. The longer one’s time horizon (most people tend to under-estimate their time horizons), the less the short-term gyrations of the market are of concern.

The second reason is noise — principally generated by the marketing machines of the investment companies and the headlines in the financial press. Their respective jobs are to gather assets and sell newspapers — and nothing sells better than superlative recent performance (remember those global technology funds that were launched to great fanfare in 2000, after technology companies had delivered stellar returns). In fact, specific fund advertising and newspaper headlines are often an excellent contrary indicator.

The agent's role

The final reason, and one less covered, relates to the ‘agency’ effect. This refers to the pressure an intermediary (such as a financial adviser, multi-manager or trustee) faces from their clients in their role as investment expert.

These agents are regularly responsible for selecting and monitoring investment managers, and making asset allocation decisions. In the ideal world, they would consistently select the top-performing managers (and asset classes) and everyone would live happily ever after.

Unfortunately, the real world is not that simple: superior managers over the long-term regularly perform poorly (on a relative basis) over shorter periods. It is their willingness to act differently from the crowd and endure those periods of under-performance that actually creates the opportunity for them to outperform over longer periods.

Agent challenges

Let’s look more closely at the challenge the agent faces. They are normally relatively well-informed, have access to vast amounts of information, are bombarded with noise and are broadly aware of the pitfalls of trying to time markets and manager selection (probably because they have been burnt a few times). But clients may perceive their job (and often that is how they have marketed themselves) as being able to consistently pick the top manager or asset class.

At the start, the agent may be able to explain the ‘need to stick the course’ and that ‘past performance is not a good indicator of future performance’; but the longer this relative under-performance persists (irrespective of the reason), the greater the client pressure and the more stress the agent feels.

Doing nothing, which is often the appropriate action, is excruciatingly difficult and requires a steely resolve. At a certain stage, the agent faces the business risk of losing clients and the pressure reaches boiling point (the ‘uninformed’ client has been telling you, the ‘expert’, for some time that you were wrong). The agent then capitulates and almost always selects a new manager/asset class that has recently performed well. And so the cycle continues.

No easy dilemma

This is not an easy dilemma to resolve. Undoubtedly education plays a major role, particularly at the time of investment. Equally, how the agent positions their role is vital. Often, the most important role is to be an honest and trustworthy adviser, to create a sensible and realistic plan and then encourage and coach the client to stick to it.

If we can avoid the fear and envy, ignore the noise and be aware of the challenges the role of agent involves, hopefully we (as investors) have a better chance of not being yet another disappointed average investor.

This article is published courtesy of Nedgroup Investments.