A more reliable way to get enough investment returns

A WEEK ago, I was in Guangzhou to participate in a closed-door meeting with the Chinese investment advisory industry leaders and government officials. I also gave a keynote speech to investment advisers and then took some media interviews.

Throughout these sessions, the key concern was how investment advisers can help clients weather this volatile period in the Chinese market and help them get the needed returns.

This isn’t just a China problem. In the past five years, the world suffered the Covid-19 pandemic, witnessed the Russia-Ukraine and the Israel-Hamas wars, experienced a high inflationary and interest rate environment and now, tensions between Israel and Iran.

If investors cannot stay invested through short-term volatility, they will not be able to reap the long-term rewards. I have written and spoken much about the philosophy of sufficiency in wealth planning and investing since 2010, and I’ve seen how it has helped investors cope with uncertainties and get their required returns. I define sufficient returns as the returns investors need (not want) and can reliably achieve to enable their non-negotiable life goals.

Investors and their advisers should start by examining empirical evidence to determine the asset classes that can reliably give the long-term expected returns. As examples, global equities and bonds are reliable whereas cryptocurrency is not.

Next, scientifically and conservatively work out the expected returns from these asset classes. Once investors are clear on their non-negotiable life goals and the amount of money they need to achieve them, they would be able to work out the level of returns they require.

Their advisers can then put together a mix of asset classes (their asset allocation) with the estimated expected returns to match their clients’ needs. The volatility of a curated portfolio must of course be at a level where the investors are able and willing to stay invested for the long term. Investors’ willingness to take risk is largely influenced by their relationship with money, something I shared in the most recent WealthBT podcast.

But what kind of instruments should be used to execute the asset allocation to give investors returns in the most reliable manner?

Fund managers as well as financial advisers often sell funds to their clients based on their past performance. But as the saying goes, past performance is no indication of future results. In addition, fund performance and what investors actually achieve can be quite different.

Morningstar’s Mind the Gap study, which started its first edition in the US in 2005, looks into the “gap” between investor returns and fund returns. In the 2023 study, Morningstar looked at how investors in six key fund markets have fared in the last five years.

The study contrasts two types of returns to arrive at the “behaviour gap” between them. Total returns reflect the growth of a fund’s value between the start and end of a period. Investor returns show the effect of buying and selling of the fund during the same period.

In all six markets, investors suffered a negative returns gap – that is, they did worse than the actual fund performance. In terms of the returns gap, investors in funds domiciled in Ireland and Luxembourg did the worst.

Morningstar pointed out that it was because funds in the two domiciles serve a broad range of investors from Europe and Asia, where funds are sold to retail investors on a retrocession model under which distributors and financial advisers are paid trail commissions. This can lead to funds being sold for the commissions that intermediaries receive, rather than their value for investors.

In terms of the returns gap as a percentage of total returns, investors in Hong Kong (41 per cent) and Singapore (37 per cent) fared the worst. Investors in Australia and the United Kingdom had the smallest gaps. Morningstar said Australia and the UK are characterised by more holistic financial advice than the other markets included in the study, where funds are often sold as isolated products.

Our own experience is that with holistic advice, clients are better able and more willing to stay invested and thus the returns gap is reduced. Morningstar also noted that across asset classes, the most volatile categories and the most volatile funds within each category typically cause investors to underperform due to poor timing of buy and sell trades.

As an example, in 2020, investors were drawn into the popular energy transition space and funds flowed into the iShares Global Clean Energy ETF. This caused the fund to double through 2020 to over US$6 billion in January 2021. But after experiencing 140 per cent returns in 2020 (in US dollars), the ETF suffered two consecutive calendar years in the red and investors stopped investing.

As a result, while the fund returned 17 per cent per annum between 2018 and 2023, the estimated investor returns were minus 3 per cent a year. Most investors bought into the fund only after it generated strong returns for the fear of missing out, just in time to experience the decline.

This type of investor behaviour – investing into favoured sectors, regions and themes – can be seen in all markets. Morningstar observed that the largest and most pervasive return gaps are to be found in the most niche offerings, such as single-country and sector funds.

Morningstar also noted that active equity managers may change their investment style during different periods which makes them less interesting for a client. Or a fund may change portfolio managers, leaving investors unsure about whether to continue with the fund.

In this regard, indexed funds or ETFs are easier to hold on to and may help reduce investors’ temptation to overreact to short-term outperformance or underperformance. This means the returns gap may be narrower.

In addition, other studies showed that active managers have failed to beat their index, and those who do outperform don’t do it consistently. This suggests that the returns gap between an active fund investor and the index is likely even wider.

The writer is chief executive officer, Providend, South-east Asia’s first fee-only comprehensive wealth advisory firm