Official statistics in the UK show the average investor loses out not through poor fund management but through poor asset allocation
As mutual fund sales are a well-known reverse indicator in the industry, it would be useful to see if it would be possible to calculate performance for the average fund holder, as distinct from the unit price of their fund.
This is possible because the Office of National Statistics (ONS) provides both a balance sheet and a cashflow statement for the unit trust sector. Capital gains and losses can be calculated for consecutive years by comparing the closing balance at market values with the opening balance plus net purchases.
That makes it possible to calculate total returns and express them as an index of values per unit. On this basis, from the end of 1986 to the top of the bull market in 2000, unitholders earned cumulative capital gains of 80%. But the worst global bear market in years subsequently reduced these to only an estimated 12% by the end of last year. These figures translate to average annual returns of 5.5% and 1.7% respectively. Neither peak nor trough comparisons are entirely fair.
At first glance, the peak comparison may seem to be a worthwhile reward for investment in unit trusts, compared with interest of only 3.4% currently available on riskless investments such as Treasury Bills. However, at the beginning of the period, interest rates were more than 10% and, on average, Treasury Bills returned 8.4% through this period. Therefore, even the most favourable comparison was 2.9% a year worse than cash.
Because unit trusts have a wide variety of mandates, this poor overall performance could be attributable to bad asset allocation decisions. However, these bad decisions can not be blamed on the fund managers because the vast majority of assets are invested in funds with specific mandates, chosen by the investors.
Asset allocation is unlikely to be the explanation. Even at the bottom of this bear market, the various equity sectors represented more than 80% of the total. Similarly, even at the bottom of the last great bear market in 1974, equities accounted for 68% of all unit trust assets, according to Bank of England statistics.
There is, therefore, little doubt unit trusts have always been primarily a vehicle for investing in ordinary shares. Fortunately, ONS statistics make it possible to calculate the influence of market timing. The sector's balance sheet and cashflow statement both contain separate data for UK ordinary shares alone.
So similar calculations can be made for capital gains on UK shares and these can be compared against a relevant benchmark, the FTSE All-Share Index, to calculate how well or badly unit trust holders performed.
Domestic shares have consistently been the most important investment to unit trust holders. With the exception of the 1974 bear market, UK shares have fluctuated between 41% and 61% of total assets. IMA statistics confirm this.
The UK All Companies sector is by far the largest sector and UK Equity Income the second largest. Together, with UK equities held as part of other mandates, domestic shares represented an estimated 46% of all unit trust assets at the end of last year.
That makes UK stock market timing the single biggest decision for unit trust holders and these calculations suggest they are shockingly bad at it. At the peak of the tech bubble, investors may have congratulated themselves on doubling their money since 1986, but during the same period UK share prices almost quadrupled.
The table confirms that unit trust net purchases of UK shares are as effective a reverse indicator as are mutual sales in the US. The key turning points are clearly identifiable. It would be wrong to blame fund managers for the mistakes of their investors, because the data shows that the average manager has, unsurprisingly, performed averagely.
After management expenses, there was modest underperformance but if these costs are added back, the performance of the individuals who manage the funds was within a 1% tracking error for the FTSE index itself on average. The blame for underperformance lies with investors, and the explanation for that underperformance lies in the information upon which they based their decisions. As rational data processors, investors will react not to individual impulses but to the weight of evidence available to them. Primarily that means news services and newspapers because the former are unavoidable when watching television and investment information in the latter is free.
Therefore, investors are reacting to precisely the same evidence that is most dominating market participants at that time. Those relying on such free information should not be surprised to find they react systematically the wrong way.
Turning to an adviser is often no solution for investors as the culture of free advice permeates the investment industry. Typically, an adviser relies on the presentations provided to them free by fund managers and earn their living by commissions from those houses, rather than fees from clients.
That is what distinguishes professionals in the investment industry from those working in professions where clients pay fees. Since commissions are only paid on the purchase of units and not their sale, investors relying on advisers should not be surprised to find they did not get advice to sell at the top of the bull market.
Discovery that the true cost of free advice is 4% a year in terms of opportunity cost or capital destruction is a wake-up call to investors and their advisers. First, clients whose portfolio of funds performs in line with the indices are massively outperforming their peers and have little cause to criticise their advisers. Second, so debilitating is this in the industry that only the highest quality fee-based providers can make a living at present.
This may change as regulators on both sides of the Atlantic modify their rules, but until new business practices become well-established, the few who pay for what they can get free will benefit twice over. Fee-based advice is under-priced because of competition from free advice, and the quality advice that fees buy is not discounted in share prices,s as only a minority use it.
Nick Dewhirst is CEO of www.investors-routemap.co.uk
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