A LARGE part of the value proposition of financial advisers is that they will earn you an investment return that is above the market average or index return.
The appropriate measure of this index return is usually the index measuring all the investments in a particular asset class. For example, when talking about the return of an Australian shares fund, it would be appropriate to compare that return against the average sharemarket return, say the ASX200 or ASX All Ordinaries Index.
But that is not what happens. The investment industry has somehow managed to avoid this comparison.
To put it bluntly: the financial services industry has managed to create its own index, by which funds compare themselves not to the market but to each other.
Inside the investment industry they call it a "peer index". There's nothing wrong with having this index, the problem is how it is used, and with so many managers underperforming the real index - any ASX indices - the popularity of peer indices has led to deceptive behaviour.
In Australia the most popular and by implication, most misused peer index, is the Morningstar Index. Take a look at the managed fund tables in this newspaper. Now look at the returns from Unit Trusts Australian Equity General.
In plain English, this means the returns posted by the general Australian managed fund.
The average return for the Morningstar Index related to this category of returns was 14.8 per cent a year for the past four years.
It sounds like a good return, but the average annual return for the ASX300 Index over the same period was 17.6 per cent. The return for the conventional market index funds, which do not more than mirror the index with the help of a computer program, like the Vanguard Australian Share Index Fund, for example, was 16.9 per cent a year.
The problem gets more severe when you map it over a longer time frame: The five-year returns from the Morningstar Index (average managed fund returns) are more than 2.5 per cent a year below the true index return (ASX300) in this category.
Think of what this means for investors using this table of managed fund performance. An investor in the AMP Capital Investment Equity Fund will look at the table and see that they received a return of 15.94 per cent a year over the past five years. They see that the Morningstar Index return in the same table is 14.84 per cent a year and they might be thrilled that their fund has outperformed the market return by 0.9 per cent a year. Instead they should be angry that their fund has underperformed the market return by more than 1 per cent a year.
They have paid big fees to AMP for active management, and yet their return over five years is less than the market index return by a significant margin.
Phillip Gray, Morningstar's spokesman, says it is important that investors use both a peer index and the relevant market index in assessing returns.