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The unhappy investor: Sources of discontent Add to ...

Recently, I hosted round tables with affluent investors in Toronto, Calgary and Vancouver, talking about the investment managers who take care of their money. These investors all delegated some of the management of their savings - whether to mutual fund companies, to investment counsellors focusing on $1-million-plus accounts or to individual investment advisers.

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Given the dramatic bounce back in markets over the past year, most investors were generally satisfied with the performance of their accounts, although everyone I spoke to could identify at least one area they wanted to see improved.

Reporting

One common cause of dissatisfaction is the reporting of returns.

Some investors maintain that it's impossible to calculate the rate of return on their investments, particularly those who have made frequent additions to or withdrawals from their account.



Calculating rates of return on investments is more complicated than it might appear on the surface; it's particularly difficult for investors with long-standing accounts, where there are legacy computer systems involved.

All of that said, with today's processing power, investors believe they should be able to get better reporting. And until that happens, many will suspect that the investment industry is choosing to obscure rates of return because it doesn't want them to know how they've really done.

Heads I win, tails you lose

A second source of unhappiness relates to investment managers making money regardless of performance - they receive the same fees if the account has gone up or down, whether they've outperformed or underperformed.



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And for most investors, the industry's response that the asset base on which they charge those fees is lower if assets go down, so they suffer too, simply doesn't wash.

Many investors are looking for a different structure, in which compensation to money managers is more closely aligned to the investor experience.

This "performance fee" model is one that hedge funds use - although when presented with the "2 plus 20" structure common in the hedge fund world (a 2-per-cent annual fee plus 20 per cent of returns above a predetermined level), many investors reject that as a "heads I win, tails I lose" arrangement where managers participate in the upside but still do well even when investors suffer.

More appealing is a lower annual fee (say 1 per cent) to cover basic costs with managers sharing in the upside and only doing well if investors make money. A complication here is that over time stock markets have risen, so managers could have done well even if they underperformed the market as a whole.



Getting performance fees right is trickier than it might seem and unless carefully structured, performance fees can create perverse incentives for money managers. That's one reason that regulators are typically hesitant about performance fee structures.

Still, the sense that money managers make money regardless of how they do is one area that many investors are unhappy with today. And it represents an opportunity for the investment industry to bring innovation to bear.

Protecting capital

The third area of dissatisfaction among some investors relates to protecting the downside - this is an especially hot topic given the market meltdown of 2008 and early 2009.

The difficulty here is that many investors are looking for their money managers to predict markets - to stay in markets when they go up and to go on the sidelines when they decline. This sounds attractive in principle, but is incredibly difficult in practice - and investors are often unrealistic on this issue.

First, managers who make macro market timing calls to get into and out of markets have an atrocious track record - you're hard pressed to find anyone who has a long-term record of consistently being able to get market calls right.

And even when managers do make accurate assessments of when to enter or exit markets, they're almost always early - and investors often lose patience and pull their money as a result. As just one example, recall the "he's over the hill and has lost it" abuse that Warren Buffett and other veteran managers took when they stayed on the sidelines during the tech bubble.



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In still other cases, such as hedge funds or balanced funds with a mandate to protect the downside, investors tend to forget this during rising markets - and only see the underperformance that arises from a conservative, low-risk stance.

Despite these challenges, this is an area in which investors are looking for better solutions. The most sophisticated investors such as large pension funds are leading innovation here - and over time advances on money management techniques from the institutional space will inevitably be available to retail investors.

When it comes to innovation, identifying problems is easier than coming up with solutions. But the first step to change is to recognize areas of dissatisfaction - and then having done that, for the investment industry to make addressing those areas a priority.

Dan Richards is president of Clientinsights. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. dan@clientinsights.ca

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