Disconnect between investor client and investment manager

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The investment business tracks investment managers based on their return on investment as measured against a particular index.
The investment business tracks investment managers based on their return on investment as measured against a particular index.

There is a conflict of interest between the two major participants in the financial services industry. I anticipate this conflict will continue.

Specifically, there is a disconnect between the investor client and investment managers responsible for managing mutual funds and other investment products.

On the surface, it would appear that both investor clients and those who manage mutual funds would want the highest possible return. That is true in theory but in practice there are problems.

The disconnect was in plain sight at the Evidence-Based Investing Conference held in New York City this month.

The conference was attended by financial advisors who work directly with clients and with those who manage mutual funds and other forms of managed products.

The investment business tracks investment managers based on their return on investment as measured against a particular index. For example, if a manager invests in U.S. stocks then that manager’s investment performance could be measured against the S&P 500, which is a collection of 500 stocks in the U.S.

An investment manager’s success at attracting new assets is primarily based on the returns they produce. A fund with good performance numbers one year usually experiences a significant inflow of new money the following year.

New money means increased fees and the mutual fund company, and all those employees who participate in sharing those fees, are happy. In an extremely competitive business, good investment performance numbers are essential to the mutual fund’s financial success.

New mutual funds are started on a regular basis and their average lifespan is about seven years. There is a strong correlation between the funds that cease to exist and poor performance numbers.

Managers will boast of their stellar performance but fail to acknowledge that many of their funds with poor performance were discontinued. Because poor performing funds can be eliminated from their track record, it makes business sense for the fund company to continue to start new funds. That way they can capitalize on some of the funds that will eventually have good performance results.

Achieving excellent performance results is the prime goal of most managers. This is the way to achieve all-star fund manager status, and all the fame and money that will generate.

At the other end of the spectrum is the individual investor.

Two things are of concern.

An investor who owns a poor performing fund cannot erase that poor performance from the reality that it will affect the value of their total investment portfolio.

An even greater risk of short-term under performance and normal market volatility is driving investors out of the market. Investors have a long consistent habit of selling after they have suffered poor performance and not participating when the market eventually regained lost value.

As stated above, there is a conflict of interest in the investment business and I don’t see that changing anytime soon.

It would be beneficial for the investment business if investment managers spent less time doing things within their power to hide bad returns and then over-exaggerate their true performance by just advertising their top performing funds.

More advertising dollars should be spent on educating clients about the value of being a long-term investor. Expectations should be clear about the volatility of stock markets.

Investors have a disastrous track record at underperforming the very markets they invest because of the strong human behaviour of buying high and selling low.

A much better way managers should be evaluated would be to measure the investor’s return not the manager’s return. There would be several improvements.

Managers would not be able to hide past inferior results and investors would be encouraged to remain invested during periods of normal market volatility.

It is time to align the goals of individual investors and the mutual fund managers that serve them.

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