When ‘Average’ is OK

In Garrison Keilor’s mythical town of Lake Wobegon, Minnesota, ‘all the children are above average’. And that’s where we’d all like our superannuation fund returns to be – above average. And that’s what the Productivity Commission is trying to achieve, by suggesting that all default schemes should be chosen from one of the ‘top 10’ or ‘best in show’ funds and underperforming funds should be closed. It sounds great! Where’s the flaw?How are ‘averages’ derived?

An ‘average’ is calculated by adding all the individual outcomes (eg heights, weights, sports scores, investment returns etc) in a group and dividing them by the number in the group. However, for an ‘average’ to be meaningful, there must be outcome variation ie low and high outcomes. So, if:
– 100 funds earn 2%
– 100 earn 5% and
– 100 earn 8%
the average return will be 5% (2+5+8/3). But 1/3 of funds will be below average, 1/3 above average and there will be a large variation of outcomes…especially if each fund got its same return each year.

So why not get rid of the below average funds?

So let’s say we forced the 2% funds to close and transferred their members and balances to the 8% funds, as the Productivity Commission proposes.

First, let’s assume – magically – that this had no effect on buying and selling prices of the underlying assets. Now we would have 100 funds earning 5% and 200 earning 8% and the ‘average’ has now moved from 55 to 7% (assuming all funds are of equal size)! Wow! Great! Let’s do that! Which is what the Productivity Commission is proposing.

But wait! If the 100 funds earning 2% transfer their funds as cash to the funds which have been earning 8%, those 8% fund managers now have to buy more of the higher performing assets they were investing in…which drives prices up…which reduces their returns…and probably the returns of the whole market too, as this would affect the 5% funds too.

So the end result would be:
– The 8% funds now earn less than 8%, so their members would be less happy
– The 5% funds now earn less than 5%, so their members would be less happy
– The 2% funds would now earn greater than 2%, so their members would be happier.
– ‘Happiness’ is spread more equally, but 2/3 of all members are less happy!!

And what if fund performance varies yearly?

The argument for closing low performing funds rests on the assumption that low performance by a fund is consistent. But in practice, over time, some low performing funds become high performers, and vice versa. And focussing on high performing funds through ‘best in show’ or ‘top 10’ for default funds will magnify the chances of this change, as money pours in and their managers suddenly have to achieve their performance over much greater amounts of funds.

So what should be done?

Measuring fund performance, publicising fund performance – good and bad – and providing better for default funds (either by allowing choice or making transparent which fund(s) are being chosen by trustees as default funds will increase competition. It will lead to less money going into currently low performing funds. This is ‘good’ for protecting people unwilling or unable to make a choice themselves. But it will reduce the performance of higher performing funds, as the overall performance of the underlying assets is unchanged.

Also the ‘average’ will increase…so some currently ‘average’ funds will now be ‘below average’. Should we now close those funds? And, if so, how long should this process continue? Till we only have one fund left…which is…by definition…’average’!

For some to be ‘above average’ requires – by definition – others to be ‘below average’. We can’t all be winners! Unless we are all happy to be ‘average’…

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