official statistics in the uk show that the average investor loses out not through poor fund management but bad 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 his fund.
Thanks to very detailed official statistics it is possible to do so in the UK. The results are shocking and teach some important lessons for retail investors and their advisers.
Calculating total returns
This is possible because the Office of National Statistics (ONS) provides both a balance sheet and a cash flow 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 these as an index of values per unit. On this basis between the end of 1986 and the top of the bull market at the Millennium, unit holders earned cumulative capital gains of 80%. However the worst bear global market in living memory 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 to interest of only 3.4% currently available on riskless investments such as Treasury Bills. However, at the beginning of the period interest rates were above 10% and on average T-Bills returned 4% through this period. Thus even the most favourable comparison was 2.9% a year worse than cash.
Because unit trusts have a wide variety of different mandates, this poor overall performance could be attributable to bad asset allocation decisions. However those bad decisions cannot be blamed on the fund managers because the vast majority of assets are invested in funds with specific mandates, chosen by the investors.
Indeed asset allocation is unlikely to be the explanation at all. 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 that unit trusts have always been seen primarily as a vehicle for investing in ordinary shares.
Fortunately ONS statistics make it possible to calculate the influence of market timing. Both the sector's balance sheet and cash flow statement contains separate data for UK ordinary shares alone.
Therefore 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 only 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 and UK Equity Income is 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 that they are shockingly bad at it. At the peak of the Millennium bubble investors may have congratulated themselves on doubling their money since 1986, but during the same period British share prices almost quadrupled.
a uk round trip
As the results are hardly credible, it is worth looking at a simple example, such as the UK market's round trip between 1995 and 2002. The starting balance is £59bn. invested in UK shares. During the period additional net purchases amounted to £33bn, making a total of £92bn. However, the closing balance is only an estimated £83bn. This means that there was capital destruction of £9bn, equivalent to 10% of the average amount invested, at a time when the index rose from 1,803 to 1,893, which should have generated a 5% capital gain.
The chart on the right using UK data confirms that unit trust net purchases of UK shares are as effective a reverse indicator as mutual sales in the US. The key turning points are clearly identifiable:
• 3Q 1987 ' Buying peaked before the Wall Street crash.
• 3Q 1992 ' Net selling developed for one quarter before the index broke out to new all time highs.
• 1Q 1994 ' Buying next peaked as a market correction was beginning.
• 3Q 1995 ' Buying slackened just as price rises were beginning to accelerate.
• 3Q 1998 ' Net selling took place again when the market was depressed by the LTCM crisis
• 3Q 1999 ' The peak rate of buying was in the quarter before the peak of the bull market.
• 4Q 2001 Net selling reappeared after markets were again shaken by the 9/11 terrorist attack
managers not to blame
It would be wrong to blame fund managers for the mistakes of their investors, because the data shows the average manager has not surprisingly had an average performance. After management expenses there was modest under-performance, but if these costs are added back, then the performance of the individuals who manage the funds was on average within a 1% tracking error for the FTSE index itself.
Therefore the blame for under-performance lies with investors themselves and the explanation of that lies in the information upon which they base their decisions. As rational data processors, investors will react not to individual impulses, many of which may be conflicting, but upon 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. Thus unit trust investors are reacting to precisely the same evidence that is most dominating market participants at that time. Investors relying on such free information should not be surprised to find that they react systematically the wrong way.
paying for quality
Turning to an adviser is often also no solution for unit trust investors because the culture of free advice permeates the investment industry. Typically an adviser relies upon the sales presentations provided to him free by the marketing departments of the fund management houses, and earns his living by commissions from those houses rather than fees from his client.
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 that they did not get advice to sell at the top of the bull market.
Discovery that the true cost of free advice is 4% pain 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 out-performing their peers and have little cause to criticise their advisers.
Secondly, so debilitating is this cancer 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 'stupidly' pay for what they can get 'free' in fact benefit twice over because:
• Fee-based investment advice is under-priced due to the competition from free advice.
• The quality advice that fees buy is not discounted in share prices, because only a minority use it.
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