Brent Sheather: To educate or legislate?

File Photo / NZ Herald

Today's story presents more evidence, not that any is needed, that all is not as it should be in retail investorland. Despite all the advertisements, the upward sloping graphs, projections of what could be and the best efforts of the Retirement Commissioner, Consumer Magazine and the Government Actuary many people find investing for retirement problematic with the effect that objectives are frequently not achieved.

A study, just published in the US, underlies the magnitude of the challenge facing regulators when it cites "mounting evidence that retail investors make predictable, costly investment mistakes, including underinvestment, naive diversification and the payment of excessive fund fees".

This column has certainly rehearsed the problems of poor diversification and fees neither of which, unfortunately, the fund management industry has much incentive to do anything about. Naive diversification frequently means more trading and more fees whilst the problem of "excessive fund" annual management charges obviously isn't going to be brought to the attention of Mum and Dad by the industry in a hurry either.

It is however somewhat comforting to know that these issues occur all over the world and, as the responsibility for saving for retirement is increasingly delegated to the individual rather than the state, it is becoming more important that everybody has a decent go at it thus there is intense interest amongst academics in improving things.

The "excessive fees" issue is arguably worse in NZ due to relatively poor disclosure and the fact that just about anything goes in terms of mis-specifying the benchmark so as to extract extortionate performance fees from unwitting investors in managed funds.

The paper, entitled "Why Do Retail Investors Make Costly Mistakes - An Experiment On Mutual Fund Choice", was written by two law professors at the University of Pennsylvania Law School and they have kindly emailed it to me.

This subject has been covered numerous times before by academics but where this latest effort differs is that it attempts to understand the retail investor's decision making process using an internet based experiment. It thus offers regulators some clues for better regulation and design of financial products.

So let's have a close look at the study. First off what are the costly mistakes retail investors make? The professors list the following:

* saving too little,
* trading too frequently,
* buying high and selling low,
* investing in complex/inappropriate/esoteric instruments they don't understand,
* paying excessive fees.

The million dollar question is why do retail investors keep making these mistakes when they are so well documented? The professors note that part of the problem is the fact that the managed fund sector is dominated by individuals with little participation from large investors and they note that because of this Mum and Dad don't benefit from the market disciplines imposed by the presence of more sophisticated institutions.

The professors doubt "the efficiency of the managed fund market" and specifically whether "it offers retail investors reasonable investment options". They cite the large number of fund choices, their inappropriate level of specialisation and the fact that high fee funds which underperform continue to attract money. In the US Congress, the Securities and Exchange Commission and the Department of Labour worry that market forces are not sufficient to protect retail investors from poor investment decisions. This revelation has huge implications for the way we regulate markets here.

What these US government institutions are effectively saying is that disclosure statements from advisers and investment statements from fund managers may be a complete waste of time. The authors of the study then pose the heretical question as to whether "effective investor education is even possible".

This is radical thinking but substantial credence to this view is provided by the fact that the finance industry seems to advocate education initiatives as their preferred alternative to more regulation. The industry obviously doesn't see higher levels of investor education as a threat to the status quo which, if they are in charge of the "education", it won't be.

Incidentally it has always bothered me that local institutions like the Retirement Commissioner who are on the same side as Mum and Dad would accept funding from the providers of high cost, managed funds. The very clear implication is that the Retirement Commissioner is not aware of the impact of fees and in particular the small size of the risk premium.

But I should get up to date - the Retirement Commission has been replaced by the Commission For Financial Literacy and Retirement Income, a rather grand title but dig a bit deeper and things don't look so grand. For a start we don't have a Retirement Commissioner yet - he or she hasn't been appointed and the National Strategy Advisory Group who are charged with educating the public on matters financial is comprised of two, arguably compromised, individuals from the finance sector, two other people whose knowledge of matters financial isn't obvious at first glance, with the interests of the public represented by the Chief Executive of the FMA and the Governor of the Reserve Bank, both of whom probably already have enough on their plates.

Other defenders of the interests of Mum and Dad are often also compromised. In the past we have had the ridiculous situation of Consumer Magazine needing to enlist the help of financial advisors to analyse the recommendations of other financial advisors. That makes sense, not.

But let's get back to the topic - what the law professors did was to put together a computer based, simulated investment task where the participants were told to invest across ten managed funds with an investment horizon of thirty years. The participants were advised of the expense ratios, the risks of the funds and their top ten holdings.

Some funds were closet indexers which just varied by the size of their expense ratio. The researchers were able to see how each person allocated their funds and the process they used so as to determine whether their mistakes were made on the basis of not understanding what they were doing or not being bothered to do the research.

They found that people who were told that fees were the biggest determinant of performance (good advice) opted for funds with lower fees but some individuals were unable to identify and avoid bad options.

This is important information for regulators as it means there is some hope of achieving sensible behaviour from retail investors providing they receive unambiguous and blunt good advice. On the downside some individuals thought diversification would be best achieved by spreading their money over all of the funds offered and others allocated significant funds to cash despite being told that they had a 30 year investment horizon and that the returns from cash would be much lower than that from shares.

That's all we have room for today. The actual report contains a huge amount of information and should be compulsory reading for anyone involved in the local savings industry. Especially relevant is a section which reviews the extensive literature on the retail investor decision making process and also provides a background on the regulatory environment for retail managed funds in the US.

Brent Sheather is an Authorised Financial Advisor.