Originally published: October, 2003 (Phillips, Hager & North Investment Funds Quarterly Report)
Context of the article: There are rules of thumb in the investment industry that get established despite the fact that they aren't necessarily correct. This article discusses four of these "truths" and calls them the "just plain wrong." The four are: (1) fees don't matter as much on equity funds, (2) it's a particularly tough time to invest right now, (3) three month performance numbers matter and (4) bond funds don't make any sense.
The problem with "noise" - the noise I try to cut through in this column - is that it obscures what investors should really be focusing on. It can be harmless, and even entertaining, as long as it doesn't unduly influence the way we think and act.
The noise discussed below, however, is not so harmless. That's because these widely held beliefs are dictating investment decisions - and they are just plain wrong.
"Sure, fees matter - but less so for equity funds." When investors say this, they are confusing issues. What they mean to say is: For less volatile, lower-return asset classes like bonds and money market, fees have a large and predictable impact in determining the winners and losers. For example, PH&N is consistently at the top of the rankings for fixed income management because our fees are significantly lower than the industry average (and, I might add, because we're good at managing bond portfolios).
When it comes to stocks, some investors say that fees aren't as important because the long-term returns are higher and the short-term volatility is much greater. With all kinds of other factors coming into play (e.g., fund manager, investment style, bull or bear market), the fee/performance relationship is less tight (or at least less obvious). As a result, the fee may appear to be less important, even if it isn't. Remember, the management expense ratio (MER) that investors pay is calculated simply on the amount invested. So a 1% fee savings on an equity fund is equivalent to a 1% fee savings on a bond fund - either way, the investor pockets the savings. In the short term, other factors obscure the impact of fees on equity funds, but as the timeframe gets longer, the impact becomes more evident.
"It's a tough time to be an investor right now ... it's just so hard to figure out where things are going." Sure, this is just noise, but is there really anything wrong with this statement? I think there is. It's wrong because the future is always uncertain. The future is always unpredictable. Whether markets have been in a defined pattern for a while, or are going up and down like a yo-yo, it doesn't matter. Whether the newspaper headlines are being alarmist about the market situation or fairly ambivalent, the future isn't any more or less certain. Investors should always be thinking that the future is unknown. Uncertainty is at the heart of investing. Not recognizing that fact will lead to poor decisions.
"Just look at that three-month performance!" When I hear this, alarm bells go off in my head. We're all looking for information that will let us determine if something, or someone, is successful or not. When we get a bit of feedback or news, we can't resist making a judgment based on it. A new coach is deemed to have made a difference if his team wins four out of their next five games. A new CEO is credited with turning a company around if next quarter's earnings show improvement. A new fund manager is lauded for her success if her fund has a good six months after she takes over.
The problem with this kind of noise is that it elevates short-term information to a status it doesn't deserve. What might have been luck, is interpreted as skill. Coincidence becomes a trend. And volatility (the short-term ups and downs of the market) is equated to investment returns. Short-term information is most often irrelevant, and most likely random. It is dangerous for investors to treat it as anything else.
"You can't get good value from a bond fund." This is a general view that leads some investment advisors to steer their clients away from bond funds. As with a lot of noise, there's an element of truth to this statement. Here's the argument in a nutshell: most bond funds don't make sense because the MER is too high (the average bond fund in Canada has an MER of 1.76%). No matter how good the fund manager is, he or she can't possibly be good enough to offset the high fee. Therefore, the investor is better off buying bonds directly.
This adage doesn't quite hold up, however, because there are bond funds that make a lot of sense. I'm referring to bond funds that have no commissions attached, have a reasonable MER, and are managed by a firm that takes bonds seriously - i.e., one that treats bonds as an important asset class and has significant research resources dedicated to the area.
A bond fund that meets those qualifications has some significant advantages compared to investing in bonds directly. It is well diversified. Its managers can buy and sell bonds much more cheaply than individual investors can (the commission an individual pays for buying a bond is factored into the yield, which makes the cost less visible, but no less real). The professional fund manager can access a wide variety of securities to enhance the yield of the fund (real return bonds, asset-backed notes, high-yield corporate bonds, mortgages, etc.). With interest rates as low as they are, these yield enhancements are important. But this stuff isn't for amateurs. The bond market has become a very complex place, and investors shouldn't wade into it if they don't know what they're doing. Just ask the holders of Air Canada or Microcell debentures how easy bond investing is!
One of the biggest challenges facing the money management industry in the period ahead is dealing with single-digit investment returns. We can't expect the next twenty years to look like the last twenty. At the same time, the industry has another major challenge. It has to help its clients become better investors. The industry has always focused on fund returns as opposed to investor returns, and the results reflect that. Study after study confirms that mutual fund investors do worse, on average, than the funds they invest in. I hope that by exposing the truth behind some widely-held misconceptions, we are taking a small step in the right direction.Technorati tags: steadyhand