Fund managers need to do a better job of explaining risk levels to their retail clients, suggests Martyn Ingram of The Investors Partnership
Retail investors usually have simple investment objectives - for example, some will want to target a rate of growth that exceeds the return they would receive from just investing in a high-interest building society account, whereas others will require a high level of income but would also like to preserve the buying value of their remaining capital, after taking account of the effects of inflation.
Providing solutions to these simple requirements is far more challenging than most investors realise yet, as an industry, we rarely tell investors this. Indeed, many private investors might think they could buy almost any retail investment fund and make money if they remained invested for long enough.
Retail investors are encouraged to reveal their attitude to risk (whatever that means) and they are then encouraged to buy investment funds that are categorised as high-risk, balanced, cautious and so on. It will be assumed the high-risk investments are likely to produce the highest returns over the longer term and that the cautious investments are almost risk-free.
The investors will be warned that past performance is not a guide to the future. But they won't necessarily be told the manager who runs the fund they are advised to buy could simply be looking to achieve performance returns that are equal to or slightly better than a selected performance benchmark, irrespective of whether the benchmark return would result in a profit or a loss for the fund's investors.
Most retail investors would not know whether now is a good time or not to invest in a fund that is targeted to outperform the FTSE 100 index. They are even more unlikely to know about the short-term prospects for the FTSE 100 or the UK equity market if they are ready to make an investment now.
Yet it will be assumed by their advisers that, because of their attitude to risk, their investment time horizon and because they live in the UK, they should have exposure to UK equities now, irrespective of the UK equity market's short-term direction.
Retail investors who are already invested in UK equities - or who have been so before - will know the FTSE 100 is an important UK index. They will know some of the big names in the index, such as BP, and the names of companies that were popular privatisation issues, such as BT.
They may also know the names of some companies that have recently joined the index (such as Standard Life), as well as the names of some that have moved out (such as Schroders, just recently). Knowing all this, however, doesn't mean they should be buying UK equities today.
Most retail investors are persuaded to buy equities on the basis that equities produce the best longer-term returns, and they are encouraged to hold fixed-income investments because fixed-income investments often produce better returns than cash deposits.
Inexperienced retail investors will be shown performance charts that show this has been true in the past, and they will be encouraged to make investments on the basis that the same is likely to be true in the future. They will also be told not to worry if their investments fall in value in the shorter term.
Giving it straight
There are a few observations I wish to make about this. First, retail investors need to be told if the investment return they expect is realistic or not. The market rate for money is the same for everyone, and investors who want more than the market rate at any given time will need to accept the fact there is a reasonable probability they will not be successful in achieving their investment objective - especially in the shorter term.
Personally, I prefer to target returns that meet specific requirements using an asset/liability model over a pre-agreed time horizon. This way, there is a clear goal in mind, and the approach can help investors avoid losing money unnecessarily.
Second, retail investors need to be told fund managers usually target returns relative to a benchmark, and that managers manage their own risk rather than the risk of the investors in theirfunds. Fund managers set the bench-marks they want their funds to be measured against. It is important to be aware of the fact that some benchmarks will be more difficult to beat than others - some all the time and some at different times.
A number of fund managers choose not to use benchmarks as risk and performance reference points - they prefer a peer group to be used as their performance measure. But peer groups change and funds come in and out of peer groups, so investors also need to take account of this when selecting funds.
Putting the client first
From the fund manager's viewpoint, most managers will think they have done a good job for investors if their funds outperform within their respective peer groups. But good results, as well as risk and return, need to be measured from a client perspective, not from the perspective of the retail fund management industry.
Finally, the risk level of benchmarks changes over time. For example, in January 2000 there was a high risk the FTSE 100 index would fall, whereas in March 2003 it was likely the index would rise. It is not necessary for most retail investors to be heavily invested in the market all of the time, especially on occasions when markets are likely to fall.
As a general rule, the risk of making money should be exploited, whereas the risk of losing money should be avoided. Unfortunately, as we all know, most retail investors tend to make such decisions the other way around.
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