Open the money section of any newspaper and you will be bombarded with stock tips, tables of the best performing funds, and interviews with fund managers who claim they are “beating the market.” Most of this advice and commentary is misleading at best, and, at its worst, downright dangerous to your financial health.
In fact, the amount of nonsense written about investing in shares and mutual funds probably exceeds even the amount that you will read about the property market. This is a problem, because the level of financial literacy in our society is very low, and a lot of people are making important financial decisions without a proper understanding of the risks.
This is going to be the first of a series of posts looking at some of the problems that I see with the fund management industry today and the direction that I think the industry needs to move in the future. In this first post I am going to raise a couple of basic issues that will probably be familiar to many readers, but will hopefully set the stage for some more in-depth discussions in the future. These are all issues that I think get short thrift in the mainstream media.
Fees are VERY important
First, let’s start off by making a very obvious point. Investing is in some ways a zero-sum game. While the value of companies usually rises over time as the economy grows, for every investor that outperforms the market, there must necessarily be a loser on the other side. By this same logic, in aggregate, actively managed funds must underperform the market after subtracting fees. Interestingly, even many people in the industry don’t seem to understand or pretend not to understand this basic fact.
Let’s say that half of the stocks in the market are held by index funds, which are “passive” funds that simply buy all the securities in an index, in the same proportions. For simplicity, we’ll assume that the index funds don’t charge a fee. Now, by definition the return of the index fund will be exactly equal to the return of the market. Let’s now assume that the other half of stocks is held by active managers who are trying to outperform the market. No matter how smart they are, it is impossible for all of these managers to outperform. In aggregate, the one half of the market that the active managers hold has to earn the same return as the index.
This means that after fees, the actively managed funds must be collectively underperforming the index by an amount equal to the size of fees charged. Expense ratios of 1.5 to 2% are not uncommon. If the market only rises 3% in a year, that means that half or more of your return has been eaten up by fees. So from the very start, actively managed funds are — at least collectively — a losing proposition.
For anybody has read investing classics like A Random Walk on Wall Street, this won’t come as a big surprise. But it cannot be emphasised enough that fees take a huge chunk out of your cumulative returns over time. Most people have a vague understanding of this, but no idea what an enormous impact it can have on your wealth.
Let’s run a simple scenario. We’ll assume that the stock market rises by an annualized 6% for the next 30 years. One investor puts $10,000 in an index fund or an ETF with an expense ratio of 0.2%, while the other is invested in an actively managed stock fund with an expense ratio of 1.3%. These are the industry averages in the US. I suspect that both numbers would be higher for Australia due to a lack of competition, which simply means that you are being ripped off by even more. Feel free to chime in below in the comments if you have numbers.
In any case, after 30 years, the index fund investor would have around $54,300. The investor in the average actively managed fund would have just $39, 700. He would be nearly $15,000 worse off.
So what’s the point of managed funds? If, by definition, they must underperform the market in aggregate after fees, then the only reason to invest in them is if you have the ability to discern who the best managers are. But how easy is it to identify the next Warren Buffet?
We won’t get into that for now. Suffice to say that fees are a very big issue in the industry and the model needs to change. Which brings me to my following point.
You can’t eat a relative pie
Much of the fund management industry is still in thrall to the bizarre concept of “relative returns”. For example, if you are a large-cap US equities fund manager, your returns will generally be measured against a benchmark such as the S&P 500. The fund manager will try to roughly match the composition of this benchmark, while overweighting (or underweighting) certain stocks that he or she thinks will outperform (or underperform) the market. But this kind of approach leads to a very strange conception of risk, and it generally results in mediocrity.
For example, let’s say there is a stock that has a 2% weight in the index. If the fund manager thinks that company is going to go bankrupt, and decides to sell that stock and put the 2% in cash, assuming that his analysis is right, most people would say that this makes his fund less risky. And they would be right. But that’s not necessarily how it’s seen within the industry. In the strange world of fund management, such a decision would result in a rise in “tracking error”–a measure of how closely the portfolio tracks the index. When tracking error rises, the “active risk” in the portfolio has increased. This kind of thing tends to make fund managers very nervous, because it raises the chance that the returns of their fund are going to deviate a lot from the benchmark and from the funds of their competitors.
The result is a very conservative approach. After all, if you’re going to get it wrong, you might as well just track the market and get it wrong along with the rest of the crowd. In which case, what exactly are they doing to justify their fees?
The strange concept of relative returns is the reason why fund managers think they have done a good job when the market falls 40% but they only lose 38% of their customers’ money. Slap yourself on the back and collect your big bonus — that’s an “excess return” of 2%. But who cares? In the real world, relative returns don’t matter, and you can’t eat a relative pie. What matters is “absolute returns.” What people want fund managers to do – at a minimum — is to preserve their capital. And at the moment, most of them are not doing a very good job of this, as 2008 reminded all of us.
I’ll leave it there for today. There is a lot more to discuss.