The paper, ‘The biggest failure in investment manager: How smart beta can make it better or worse’ was written by John West and Jason Hsu of Research Affiliates.
In the paper, the duo looked looked at the gap between the returns realized by the investor and the returns earned by the strategy or fund the investor owns is overshadowed by the alpha spotlight.
The team concluded that the negative gap between investor and fund returns is the biggest failure in the industry with Alpha being only a sideshow.
“The investor returns gap means that even for asset managers skilled enough to produce alpha, chances are their clients won’t be able to fully capture it in their own portfolios because of the clients’ investment timing decisions.
“For this reason, we call the investor returns gap the biggest failure in the investment industry.”
Even smart beta strategies were affected as poor client timing often completely negated the potential for positive excess returns found the paper.
“Many high-tracking-error smart beta strategies may actually exacerbate the investor returns gap, especially if noisy short-term performance is sold to trend-chasing clients. The investor returns gap of nearly 2 per cent will wipe out the majority of smart beta strategies’ long-term returns,” it said.
The team said that the industry needed to change the conversation and adjust the mindset of offering advice.
“A new mindset is called on for both professionals in how they frame their advice and for clients as they learn to adjust their expectations and adopt longer horizons for assessing performance,” the paper said.
The paper offer two straightforward steps to facilitate the change in conversation, one being to believe in the ability of the style to deliver return in the long run before investing in it.
“The easiest way to eliminate performance chasing is not to engage in a conversation about performance. Instead, focus on the style,” it said.
Secondly, the paper said that clients had to understand that the investment journey may be rocky but staying the course will get them what they want.
“Underperformance will happen. Investors need to be prepared ahead of time. A better-outcome client review will spend just as much time on the range of returns as the expected,” it said.
The paper said that the investor return gap cycle could be broken but it required the industry to embrace a different way of thinking.
“Robust, academic-quality research and efficiently designed products are important, but no longer enough. To avoid the biggest failure in investment management, we must embrace a new conversation,” it said.
