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Investment Strategy
Thursday, November 1, 2007
Aligning one’s interests

Picture the following scenario. You are an investor in ABC Fund, an equity unit trust fund managed by Manager X. After having invested in it for a year, one of the following three outcomes occur:

• Scenario 1 - ABC Alpha returns 43% over the year, while the average equity fund returns 32%
• Scenario 2 - ABC Fund delivers 12% for the year, while its average peer manages 17%
• Scenario 3 - The average equity fund returns –8% compared to Fund Alpha’s –3%.

Comments Rene Prinsloo of Glacier Research, “Given the choice, an investor and Manager X would choose scenario 1. The fund delivers a good performance, which is also better than most of the peers, and the investment added value to the investor’s capital. This would be the proverbial ‘no-brainer’ because it benefits both the investor and the asset manager.
Now remove scenario 1 from the list. The investor and Manager X are left with the option of scenarios 2 or 3. A rational investor would choose scenario 2 as it allows him to grow his capital and increase the likelihood of achieving his financial goals. Outcome 3 will have the opposite effect. Although it is never pleasant to get a return of 12% when your neighbour achieved 17%, surely this is preferable to losing capital?
There are, however, many equity managers who would choose scenario 3 instead. This is because scenario 2 costs the asset manager money while scenario 3 costs the investor money. Investment houses struggle to keep clients through long periods of under performance and it is often easier to retain clients while losing money but at the same time outperforming the average.
Manager X could defend its peer group-inclination by saying that ABC Fund has the peer group or All Share Index as a benchmark, and that over a one-year period the fund may not explicitly grow capital. He could go on to say that an investor who prefers scenario 2 to 3 should rather be invested in Manager X’s absolute return products.
“Although this logic may not be completely unreasonable, it is arguably not aligned with the investor’s interests. We are yet to meet an investor who invests his money purely for the purpose of beating the average peer group fund or the benchmark,” she says. “Clients invest their money in order to grow it over time and achieve their financial goals, whether they adopt an equity or absolute return approach.”
This does not mean that investors should only focus on conservative equity funds that are unlikely to lose money. “Potential capital growth is also an important consideration,” she adds. “However, it is key that the fund manager and the investor’s interests be aligned.
“One way of ensuring this is to look for managers that are heavily invested in their own products. These people typically manage clients’ money in the same way as their own, with little cognisance of what the peers were doing. They are unfortunately hard to come by.”

Copyright © Insurance Times and Investments® Vol:20.10 1st November, 2007
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