The investment objectives of most investors are best served by a long-term approach; and yet the asset management industry often has a much more short-term focus. In this video, behavioural finance expert JOE WIGGINS outlines the incentive problem within the industry, and what investors can do about it.
TRANSCRIPT
Robin Powell: If you’re lucky, it’s possible to make a quick killing from short-term speculation – but sensible investing requires time and patience. To quote Warren Buffett, “Someone’s sitting in the shade today because someone planted a tree a long time ago.” Here’s the behavioural finance expert Joe Wiggins.
Joe Wiggins: Long-term investing is critical to meeting our investment objectives. The benefits of compound interest, the benefits of investing because of the coupons you receive from bonds, because of the dividends you receive and reinvest from equities – they work over the long term. Over the short term, markets are driven by sentiment; they’re driven by flows and sentiment that are inherently unpredictable. So if we focus on the short term, we’re likely to be whipsawed around – changing our views very frequently, incurring very high trading costs, and also probably destroying performance through time as well.
RP: So, long-term investing is definitely the way to go. The problem is that many investors entrust their money to fund managers who are focused instead on short-term performance. In other words, the interests of asset managers and investors are often misaligned.
JW: There is a real and often hidden incentive problem in the asset management industry in that most investors want to generate strong, long-term returns and performance – and it feels like active managers want to do the same thing: they want to generate strong long-term performance. But actually, the incentives of many asset managers are about generating short run profits; particularly if they’re a listed asset manager and they’ve got quarterly or half-yearly profit targets. What are they focused on? They’re focused on gathering assets, attracting investors by generating strong short-term performance. So what they often do is engage in behaviour which is detrimental to investors’ long-term interests. So they’ll market “flavour of the month” funds, often thematic funds that are in the short-term sweet spot, they’ll sack underperforming fund managers, and they’re very interested in how can we attract flows in the near term?
RP: Investors should be especially wary of so-called “star” fund managers, who appear to have delivered exceptional returns over the short term. So what other warning signs should they be looking out for?
JW: Often listening to the chief executive of a fund manager or an asset manager is useful. Are they talking about short-term performance, short-term inflows? If they are, that’s a warning sign for how they’re positioning their funds and the types of decisions they’re making. Other useful indicators are: do they restrict asset flows into a fund? That’s obviously a difficult thing for a fund manager to do because it reduces their profits. It’s like Apple saying, “we’re not going to make any more iPhones because we’re profitable enough already,” but for the incumbent investors in a fund, shutting a fund is often the right thing to do because it might preserve their ability to generate returns. So there are certain key signs that you can see from asset managers that might make you think that they’re aligned with long-term interests or they might be misaligned with long-term interests.
RP: The good news is, you can avoid altogether the risk of choosing a manager whose interests are out of line with yours by choosing to invest in passive, or broadly passive, funds. Investing for the long term in the whole market is an option that everyone should consider.
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Active vs. passive: which is better?
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