Battles to win your savings

By BRENT SHEATHER*

Events such as September 11 inevitably lead some people to reassess their investment portfolios.

At such times the media regularly seek "expert" comments from fund managers. But the fund management business, too, is fighting a war, in this case a war to get our savings.

In times of war the combatants produce a fair amount of propaganda. One favourite example in the funds management business is to describe plunging stockmarkets as exhibiting "high volatility" - much less unpalatable than saying "crashed".

Directly after September 11 the Herald reported a local fund manager as saying that one implication of these terrible events was that "the case for active managers has improved quite considerably". Another added that the crisis could be a "great buying opportunity".

Apparently, fund managers would have us believe that, in a crisis, private share investors panic and sell out to professional investors. Then the crisis eases and - wouldn't you know it - the professional investors make huge profits.

Similarly, intermediaries such as financial planners tell us that one of their most useful roles is to hold the hands of retail investors and reassure them that things will get better.

These sound like extremely noble pursuits but according to a recent study in the Journal of Finance (Who Blinks in Volatile Markets, by P. Dennis and Dean Stickfield, October 2002) reality is a bit different - the exact opposite, in fact.

First, though, some commonsense analysis: during the crash that follows a crisis, just where does the professional manager get the money to buy the extra shares that the silly individual investor sells? One imagines, for example, that funds were not flooding in to unit trusts in the aftermath of the attacks in the US.

Nor is the money coming from managers shifting money from bonds to shares; earlier in the same article various fund managers are quoted as saying that they have not and will not alter their "strategic asset allocation models".

Indeed one fund manager was reported as having "increased liquidity within its portfolios".

I'm not privy to all the secrets of professional fund managers but I always thought that "increasing liquidity" meant selling things (such as shares) for cash. Whether you label it "increasing liquidity" or "panic selling", the effect is the same.

Indeed, various professional investors may well have been "increasing liquidity" after September 11 because a lot of the money invested in shares is done through open-ended funds from which the investor can, theoretically anyway, demand his or her cash back at short notice.

Given the heightened nervousness it would not be surprising for managers of such open-ended funds (unit trusts and so on) to raise liquidity in expectation of higher-than-normal withdrawals.

The Journal of Finance article tries to answer the question of who sells when there is a large drop in the market.

The authors suggest that one could argue that individual investors are less sophisticated and more risk-averse than institutions, so the individual investor is likely to be the one who reacts and sells during a sharp market drop.

Alternatively, one might believe that institutional investors, although they are more sophisticated, have narrow horizons. Because of this, they herd together with their peers and sell during a market decline, since "an unprofitable decision is not as bad for reputation when others make the same mistake".

The answer to the question of who sells during large market swings is important because it helps us to understand the dynamics associated with big changes in stock prices and the sources of market volatility.

The authors, from the University of Virginia and the US Securities and Exchange Commission respectively, conclude that "institutions react more strongly than individuals when the absolute value of the return in the market is large on any given day. This evidence is consistent with our conjecture that since fund managers are evaluated more frequently than other types of managers and the focus is on short-term performance, they have a larger incentive to 'run with the herd' than do other types of institutional managers.

"Finally, we find that on event-days when the markets' return is negative, subsequent abnormal returns for portfolios with high institutional ownership are positive, which suggests that event-day selling by institutions drives prices below their true values."

This means that, contrary to the marketing brochures, when stock markets slump fund managers are inclined to become "momentum" players, reducing their share holdings rather than searching for bargains.

This "momentum" behaviour was apparently more frequently displayed by mutual funds (unit trusts in the US) and pension funds.

Retail investors, faced with large unrealised losses, are more likely to respond by not looking at their portfolios so often and hoping for the best.

Furthermore, the authors show that, by selling on the big down days and buying on the big up days, institutions push share prices below and above fair value, which can't be great for longer-term performance.

Another popular piece of propaganda is to suggest that falling markets potentially give active managers the opportunity to outperform passive or index funds. Again the argument assumes that the active manager is prescient enough to hold lots of cash before the crisis then buy in at the lows.

This fancy footwork is known as market timing and in the entire history of the world no one has been able to demonstrate a consistent aptitude for the task.

Numerous studies in the US and Britain have determined, time and again, that over the long term active managers underperform passive managers and at best just earn their management fees. The long term presumably includes a few crises.

Indeed, the Herald article mentioned earlier alludes to this inability to pick winners when it tells us "what is hot and what is not has changed significantly. At the start of the week insurance, financial services and airports were in vogue. Now they have fallen from favour and defence and building stocks are more favourable".

The "in vogue" comment is critical: in vogue with who? In vogue with professional investors, those dedicated followers of fashion, would seem to be the answer, suggesting that it is actually the professionals who might have been wrong-footed by recent events.

And, do I hear someone ask who would have been buying the defence and building stocks before the disaster when they were "out of favour"? The answer is clear: index funds of course, by definition.

The Journal of Finance study rejects the suggestion that private share investors are more inclined to panic-sell than institutional investors.

Undeniably some people do panic and jump ship, but that trait seems to have more to do with the time over which people measure performance and the individual's character rather than a generally poor understanding of market dynamics among private retail investors.

Indeed some people have been panicking and selling out of managed funds in response to weakening markets for as long as managed funds have been around.

Financial adviser Spicers produced a report some years back documenting the tendency of some unit trust investors to become despondent in a bear market and sell out at the worst time.

The industry's current strategy to cope with this sort of behaviour - repeating ad nauseam that "things will get better" - will not do. We need to understand why people abandon ship.

The mismatching of investments and risk profiles seems to be about the biggest culprit.

In other words, many portfolios are too risky for the individuals concerned. And a fundamental factor causing this could well be high annual fees, which force advisers to push client portfolios to take more risk in the hope of producing an after-fee return which "beats the bank".

What events like September 11 tell us is that for quite a period of history investors have diversified over risky and non-risky assets.

While the risky assets certainly do better over the long run, and a computer would say we should invest 100 per cent of our money in shares, we are not machines.

We experience greed and fear and thus the non-risky asset classes earn their keep in times of market stress.

* Brent Sheather is a Whakatane investment adviser.