KEY POINTS:
Just when you thought that nothing new could be written on the subject, research has been published that sheds further light on the debate as to whether Mum and Dad should invest in actively managed or passive funds.
Actively managed funds buy and sell stocks depending on their fund manager's view of the stockmarket, whereas a passively managed fund just owns all the stocks in the index it tracks.
With KiwiSaver about to begin, this topic has more relevance than usual for Business Herald readers.
The new active/passive paper by Professor J.B. Berk of the University of California and Professor Ian Tonks of the University of Exeter tests Professor Berk's theory that a managed fund's performance depends directly on how popular it is.
This is radical thinking about an old problem, but it actually seems to explain reality pretty well, and it is also consistent with the tendency for stock prices and investor behaviour to adapt immediately as new information becomes available.
For example, a few years back a paper was published noting that small companies outperformed large companies over the very long term.
As soon as this "effect" was well known, it promptly disappeared and small companies underperformed for an extended period.
The Berk/Tonks paper differs from many in that it acknowledges some fund managers do have genuine skill - but it also suggests that as soon as it becomes well-known that a certain managed fund is a top performer, every man and his dog invests in that fund, which makes it extremely hard for the manager to continue to outperform.
As the Berks/Tonks paper puts it: "Ability to deliver superior performance is assumed to feature decreasing returns to scale, as the inflow of funds degrades performance.
"This continues until the fund size is such that the manager is no longer expected to outperform in the future at which point the inflow of new money stops."
The other significant finding in the Berk/Tonks study, which looked at 9380 US managed funds over the period 1962-2004, was that poor-performing funds are likely to keep on going despite the fact that the "market" tags the fund a dog.
The authors explained this on the basis that the flow of new money into top performers can be limitless, while the funds that can be withdrawn from a bad fund are limited to that of current investors who are normally slow to react to bad news.
In a stockmarket context too, investors are more likely to sell winners than realise a loss.
So what, if any, relevance does the new research have for Mum and Dad in Rotorua saving for their retirement?
Professor Berk said by telephone that one implication of the research is that investors in actively managed funds should carefully monitor the performance of their managed fund relative to similar funds.
If your fund is in the bottom 20 per cent of performers ranked by one or two-year returns, you should switch to one which is in the top 20 per cent, but only if you incur low transaction costs.
If, like most NZ retail investors, you are subject to significant transaction costs or simply can't be bothered with all the work that properly managing active funds entails, there is an easy way out - buy an index fund.
However, it is important to be sure that your fund is a genuine poor performer.
It could be that that class of investment has generally had lacklustre returns for the period you have owned it, and that is the reason for the fund's poor performance.
You need to compare your fund with the right benchmark - a subject we will cover in detail in the future.
So there you go: as soon as the thundering herd piles into the most recent "fund manager of the year", his/her performance is likely to decline - which is why just about all the best hedge funds in the world are shut to new investors.
This latter fact prompted one comedian to say that "he wouldn't invest in any hedge fund that would take his money"!
* Brent Sheather is a Whakatane-based investment adviser.
