Martin Hawes: Two sides of risk and return

Mike Taylor runs a managed fund called PIE which produced returns last year of more than 100 per cent. Taylor was recently reported to be wondering why there was not a flood of money pouring into PIE for investment.

The answer is that Kiwis have cooled when it comes to managed funds.

Part of the reason is that some funds have given poor returns. However, some fund managers have given excellent returns and Taylor is not alone in making good money for investors.

What many investors do not understand is that investment returns and investment risk come from two sources. From the market average return and from fund managers trying to beat that average.

The average risk and return from the market is called beta and the performance of the manager is called alpha.

Most investment returns and losses come from beta, i.e. the market performs at a certain level and this dictates most investment performance. You can neither give credit nor blame to the fund manager for this; it is just the way the market performs.

There are lots of managed funds that replicate the market average - getting beta is as easy as buying into the passive index trackers.

However, actively managed funds try to get alpha - the managers try to beat the market. You can certainly give blame or credit for how the fund deviates from the market average in this case.

Some are stunningly successful. Taylor's fund is very successful. However, plenty under perform and cause investors a lot of grief.

In my experience, Kiwis do not seem to distinguish between alpha and beta. They judge managed funds on the basis of absolute performance without reference to the index (the market's average performance).

And this is the nub of Taylor's problem - he is providing investors with plenty of alpha so can't understand why his fund is so poorly subscribed.

However, Kiwis have seen market slumps and poor fund management performance and lump both together. The result: any loss, whether the fund manager's fault or not, causes an erosion of trust.

As investors, we have to compare fund managers' performance by looking at how they have done against their benchmarks. We should trust the ones who do well and reject the rest.

* Martin Hawes is a financial adviser. His disclosure statement can be found at www.martinhawes.com