June 4, 2018

Monday Morning Memo: The Moment of Truth for Investors

by Detlef Glow

Every now and then some market risks capitalize and lead to falling prices that hit mutual funds—and therefore their investors—with losses to their portfolios. These market events are a moment of truth for investors, since in some cases they unveil that the particular fund has been exposed to risks that might not have been anticipated by investors. One of these moments happened on Tuesday, May 29, 2018. The spreads for Italian bonds widened when the designated prime minister resigned after he failed to build a government when his proposed finance minister was vetoed by the country’s president.

With regard to their nature, these kinds of market events should be used by fund selectors and investors to validate their decisions, since they unveil whether fund managers have taken risks they shouldn’t have in order to enhance the performance of their fund/funds; good performance is the main driver to generating sales for a mutual fund. Therefore, investors and their advisors/fund selectors should be careful when evaluating past performance in the fund selection process. These kinds of risks—which may not have been visible by analyzing the past performance—might not be suitable for the risk profile of the investor and may therefore lead to a broken a relationship; the investor may lose trust in his advisor.

Don’t get me wrong here; I am not saying all funds investing in riskier assets are badly managed products. Some of them are supposed to do so; they declare it in their investment policies and can be selected properly. But some fund managers may try to boost their returns by investing in assets that by definition are eligible for their portfolio but that are not suitable for the expected risk profile of the fund. On the other hand, investors have to accept some risk in their portfolios in order to generate returns that are above the money market or so-called risk-free rates. In other words, there is no excess return without adding risk to the portfolio, i.e., the additional return is the compensation for taking higher risks. That said, investors, advisors, and fund selectors must question the achievements of a fund with superior past performance, since this might have been achieved by investing in riskier assets than those appropriate for the risk appetite of a particular investor.

The views expressed are the views of the author, not necessarily those of Thomson Reuters.

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