Investors conquered fees, now for a new battle
Investors have beaten the money managers. Their next adversary will be even more difficult: themselves.
Itís impossible to overstate the magnitude of the changes that have swept through the investment industry over the last decade. Until recently, investors looking to grow their money encountered high fees everywhere, from brokerage commissions to fund and advisory fees. The combined tolls routinely amounted to more than 2 per cent of their savings every year and much more in some cases. There were few avenues of escape despite mounting evidence that higher fees lead to lower returns, the industryís emphatic denials notwithstanding.
After the 2008 financial crisis, however, a wave of investors decided they had enough. Aided by a burgeoning line of low-cost exchange-traded funds and robo-advisers offering online money management for a fraction of the cost of traditional advice, investors fled to cheaper options. They ploughed roughly $3.8 trillion into index mutual funds and ETFs from 2010 through October while yanking $250 billion from traditional actively managed mutual funds, according to Morningstar. Investors have also handed an estimated $250 billion to robo-advisers, much of it invested in index funds.
Granted, more money is still managed the expensive way, but the gap is closing. Roughly $1.6 trillion was invested in index mutual funds and ETFs at the end of 2009, compared with $6.2 trillion in actively managed mutual funds. Now those numbers are closer to $8.1 trillion and $11.8 trillion, respectively. And sure, robo-advisers still manage a pittance compared with the money invested elsewhere, but no one doubts that online investing will continue to gather adherents, which is why Wall Street firms are rolling out robo-advisers of their own.
In any event, arguments about the significance of the flows to low-cost options miss the essence of the decadeís revolution, which is that investors now have myriad options to invest cheaply and thereby bolster their savings. And enough of them are focused on cost that financial firms are warring over who can offer the cheapest investments. There are now zero-fee funds and zero commissions, both unthinkable a decade ago. Even the once inviolable 1 per cent asset management fee is on the chopping block.
Still, declaring victory would be premature because there are other ó arguably even more stubborn ó costs to cut: the ones investors impose on themselves. They sit on cash too long, chase investment fads during booms and panic-sell during busts, to name just a few common cognitive and emotional lapses. But too little attention is paid to those mistakes, and for obvious reasons. Itís easier for investors to blame the financial industry for their sagging portfolios than confront their own poor choices. Itís also easier ó and more lucrative ó for financial firms to pander to investorsí worst instincts than help subdue them.
How costly are those mistakes? Itís hard to know exactly, which is yet another enabler. Itís far easier to quantify the cost of fees on portfolios than the impact of behaviour, which gives investors a convenient excuse to avoid introspection. But there are some reasonable attempts to estimate the so-called behaviour gap, or the difference between the return of an investment and how much of that return investors manage to capture.
One of them is Morningstarís recently released Mind the Gap study. The study estimates the behaviour gap for US mutual funds and ETFs over ten-year periods ended each year between 2014 and 2018, and the same number of five-year periods for a handful of other countries.
First, the bad news. The average behaviour gap in the US was -0.45 per cent a year across all investment categories, including stock, bond, alternative and asset-allocation funds. Thatís roughly the difference between the average expense ratio for traditional actively managed funds and index funds. The behaviour gap was only worse in Europe (-0.53 per cent) and Singapore (-1.19 per cent).
The good news is that the details behind the headline numbers offer hints about how investors might close the gap. One clue is that the gap varies drastically depending on investment type. In the US, for example, stock and bond investors gave up 0.56 per cent and 0.55 per cent, respectively, while the gap for asset-allocation funds was a positive 0.22 per cent.
Why did investors in allocation funds fare so much better? As the study notes, allocation includes target-date funds held almost exclusively in 401(k)s, where savers tend to invest regularly and pay little attention. That combination of disciplined investing and benign neglect also appears to have contributed to the success of investors in Australia and South Korea, which boast a positive behaviour gap of 0.65 per cent and 0.26 per cent, respectively, due in part to broad adoption of systematic investing that keeps savings flowing to markets regularly.
Another clue is that the gap appears to be related to the volatility of the investment. Morningstar sorted stock, bond and allocation funds into quintiles based on standard deviation, a common measure of risk. In the US, the behaviour gap worsened across all three categories as volatility rose. For the most volatile quintile of stock funds, the gap was a whopping -1.86 per cent. The results were generally similar around the world. The key insight is that just because an investment promises a higher return in exchange for more risk doesnít mean investors will capture it; when humans are involved, sometimes less risk translates into a higher return.
There are some caveats around all this. One is that investors donít always control the timing of their investments, so some of the behaviour gap may be attributed to luck rather than behaviour. Also, more data is needed. The numbers in the US stretch back to 2005, so they include just the one bear market around the 2008 financial crisis. And outside the US, the numbers begin in 2010. Given the apparent link between volatility and behaviour, the gaps are likely to widen during the next downturn.
The last decade will be known for the low-fee revolution. Letís hope the next one is equally revolutionary when it comes to changing investorsí behaviour.
ē Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan&Cromwell and a consultant at Ernst&Young
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