The trouble with fund management

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.

26 Responses to “ “The trouble with fund management”

  1. Jake says:

    Thanks for the article. It raises some interesting discussion points. Being a fund manager myself I have a bit of an insiders perspective.

    Fees are a big issue in the industry and as you say, are probably the biggest single factor influencing an investors returns. I reckon most of your readers would be surprised by the number of groups that ‘touch’ their portfolio and hence cream a bit off the top. Here is a typical flow from investor to market, with fees being charged at every level:

    Investor->investment advisor (e.g. Centric Wealth) -> Investment Consultant (e.g. Towers Watson) -> Fund Manager (e.g. Platinum Asset Management) -> broker (e.g. Macquarie Bank)

    There are a few others in there also such as custodians, fund of funds, administrators, lawyers (of course). As you can see lots of people getting paid. I’m not familiar with the inner workings of ETF’s but I imagine that there’s less layers, which means less fees.

    I have to take issue with your other comments, as I think they are a little simplistic. While I don’t think active management is necessarily the best way to invest your money, it is true that active managers can beat their index on average / overall. Here’s 2 reasons:

    1. Your example presumes that all the money in the market is chasing the same index. This is not the case.
    2. Many active managers are allowed to invest in assets outside of the index that they track towards

    Whether or not active managers can consistently use the above to outperform is another matter (I think some can, but working out who these guys are is very difficult, and expensive – but that’s worth a whole nother article). I just don’t think you can dismiss the possibility based on a simplistic view like the one you presented.

    I also think it is a bit of a cheap shot (and I am sad to say, very ‘smh like’) to have a go at fund managers for looking at relative returns and tracking error. It is, after all, what their customers have requested they look at. It is the investment advisors, their customers and institutional consultants that dictate the way fund managers will behave – I might think a certain strategy will outperform, but if my mandate says I can’t follow that strategy then I’m not going to follow it – I’d likely get the sack if I did (sacked by my customer not my employer).

    I find it odd that you would imply index funds are a good thing, and then bag out the type of active fund that resembles index funds most closely.

    People need to understand that you can’t have it both ways (unless you invest with Bernie Maddoff). There is no silver bullet – if you see a fund that posts great returns no matter what the rest of the market is doing you should be running the other way not singing it’s praises.

    cheers

    • Rotten Apple says:

      Jake — You make some very good points, and in fact, I am almost entirely in agreement with you. If my post came across as simplistic, it is because I haven’t made my arguments properly yet. It is going to take more than one post for me to do this because it is a complicated issue.

      My point about relative returns is actually not to bag fund managers, but to suggest that the industry as a whole needs to move towards more of an absolute returns mindset. And in order to do this, the customers, consultants and advisors have to loosen the mandates that govern what fund managers are allowed to buy.

      If you want an active manager to add value, then there is no point paying them considerable fees and then handcuffing them to a benchmark that virtually guarantees they will underperform an index fund. (again, in aggregate).

      Hopefully I will make all of this a bit more clear in future posts.

      • BurbWatcher says:

        I personally don’t have a problem with the idea of relative returns; but I would just wantndisclosure on what exactly is what relative to!

        Doing slightly better than something that has gotten slaughtered is not really that good at all!

      • Jake says:

        In that case, I look forward to the rest of your posts.

        I guess performance measurement will be an interesting one to discuss – for example how would you measure someone who runs around claiming expertise in Australian equities if not against some sort of Australian equities benchmark?

        cheers Jake

      • The Prince says:

        Jake, we use a risk-adjusted Required Rate of Return for our investing philosophy, which is absolute return based (even though we use the S&P/ASX200 Accumulation Index to compare performance).

        More here. http://www.empireinvesting.com.au/?page_id=514

        Personally I think any fund that returns less than the prevailing 10 year Aussie bond yield should return 100% of their fees – including administration/compliance costs, unless they are an index fund/ETF.

        We started Empire Investing because of the very points raised above: relative returns and benchmark following (under/overweight etc) is extremely risky for the investor, but not for the fund manager.

        Unlike the vast majority of managed funds, we have most of our own personal capital in our fund, so we are after the best, risk-adjusted returns possible.

      • Rotten Apple says:

        Prince – This is exactly the kind of direction that I would like to see the industry head in more broadly. In my observation it is a lot of the smaller managers such as yourselves that are most innovative in this regard.

      • The Lorax says:

        I read the above comment from The Prince and thought: I should put some money here!

        But it turns out I can’t.

        At this stage, Empire is not taking on clients or additional shareholders or opening an investment scheme for wholesale or retail investors.

        So what is the point of Empire Investing?

      • The Prince says:

        Lorax – please read that statement again.

        At this stage….

        :D

      • The Lorax says:

        When does the next stage begin?

  2. Nathan Webb says:

    Rotten apple, in the interest of disclosure, are you able to say which style of fund management you work for?

    • Rotten Apple says:

      Yep, no worries. I work for a large US active manager. Most of our AUM is in long only strategies. If my post gave the impression that I am advocating for index funds, that is not the case. I have no affiliation at all to any index fund managers.

  3. bills says:

    I am continually amazed that society tolerates the massive difference in compensation for this industry given the lack of value add, though perversely they must make a large contribution to GDP. I can only assume there are quite large barriers to entry. My few encounters with them on a professional basis reinforces the stereotype that money is no object – the top restaurants, best wines, etc. and their compensation is eyewatering. I’ve decided that the average investing punter is way down the pecking order after company management take and occasional wasteful capex, M&A etc decisions (Australian management just don’t look up to being able to expand successfully overseas and particularly when there’s lots of cash burning holes in company coffers eg current situation in the mining industry) and funds gouging. At least with RE, you are directly responsible for the value of the asset but guess it just pays to diversify.

  4. Chris says:

    I think superannuation is a big ticking time bomb for most people. At some point they will realise that a lifetime of contributions have been chipped away so much by various fees et al that there is nowhere near enough to finance a retirement.

    No wonder there is an explosion of SMSFs these days. Certainly if my meagre super portfolio was larger I’d set one up myself.

    • BurbWatcher says:

      I started my SMSF with $25K…

      No problems keeping ahead (admittedly I have had two years of fees waived, and have made some good choices so far, but nonetheless, you don’t actually need much to viably take control via your own SMSF).

      Just some thoughts!

      • Justin says:

        Let’s assume the annual accounting fee for your SMSF is $1,000 (which would mean your accountant has probably cut his usual fee by 60%). And your annual SMSF audit fee is $400 (again, substantially lower than you’re likely to find in the real world).

        So annual costs (before you factor in your time or your brokerage) are already $1,400. As a percentage of your $25k that works out at an annual fee of 5.6%.

        Makes a fund manager’s fee of 1.3% seem pretty reasonable to me (plus there’s zero guarantee that you will perform any better than the fund manager, in fact I’d wager that you’re probably like to perform even worse).

      • The Prince says:

        $25K seems low, but I started with less than 100K.

        Within an SMSF, your admin costs are fixed – so as your balance grows (through your employer contributions and internal growth), this cost reduces dramatically.

        I am now below 1.3% annual costs, but I’ve reduced my tax rate from 15% to below 8% and suffice to say my returns are slightly higher than the APRA average (which was 9.8% for last financial year, I don’t have this years published averages. I usually get double that – but I do trade a little bit within super. My required rate of return in super is 12% p.a pre-tax.)

        Its a furphy that you need a minimum of 200K – I’ve written about this extensively in the past – that threshold is put there so the financial advisors and accountants can justify their fees in advising/auditing a SMSF. The average from memory is over 600K.

        There are benefits and traps in running your own super.

        I do encourage it for younger investors as you won’t need much if any advice to do so (just stay within the two major rule groups) but for those over 45-50, it becomes a toxic minefield of problems as you transition/plan for your retirement. You definitely need a super specialist.

        I treat my SMSF as my long term healthcare plan, because I am wary of relying upon the government’s good graces to “allow” me to access it at 65 or 67 or 70, or maybe only a small portion thereof, for my own “good”.

        For the same reason I do not put an extra DIME of my income into super, because I have no idea when I’ll be able to access it, or if its taxation status will change (given the lack of revenue and the demand for retirement services due to demographic pressures going forward, I can see all sorts of “fingers” wanting to get into the Gen X/Y superannuation pie….)

  5. BurbWatcher says:

    Good article, with a good angle – keep peeking behind the curtains, please!

    Look forward to more.

    Stewart

  6. BB says:

    I hear an absolute return debate on the wind! I currently work for the “distribution end” of the wealth business, the side responsible for selling, sorry advising the public on the very issues touched on here. Let me just say that I 100% agree with your general points, and most likely those to come.
    However this debate is mostly academic, and you have already explained exactly why! Be it here in Australia, the US, UK or anywhere for that matter, the general population will always have a low degree of financial literacy, especially given financial innovation will almost always outpace any degree of financial education for the masses. It is for this reason that the general public IS NOT INTERESTED in the issues you raise here, as sad as that may be it is the truth. Sit your average Mum & dad down and explain the issues of drawdown’s on compounding returns, the need for true diversification vs illusionary attempts…. bottom line they are not interested.
    As pointed out by another reader, there are many hands in the wealth management pot and the coal face takes a very big chunk of those profits, although let me clarify two things, the end investors ARE NOT the fund managers clients! Asset consultants, trustee boards and Financial Planning distribution business are! And each of these parties has their own vested interests (which is why the debate on financial planning commissions is so laughable). Secondly, for the most part these institutions dictate to the end client what it is “they want” and not the other way around, your average investor does not walk into CBA or Westpac and instruct the bank sales staff as to what they want, the advisor tells (sorry educates) them!
    In the advice/product distribution game “buy&hold” “relative return” “set and forget” etc etc. Are the most scalable and profitable methods to sell financial investment products to end consumers. So combine financially illiterate, time poor consumers, with a highly profitable 100% sales focused advice based distribution industry and what do you get….. everything we are complaining about today, and I don’t see that changing at a rate any faster than human evolution!

    • Rotten Apple says:

      BB – All very good points. The poor state of financial literacy on the public’s side, combined with the high profitability of the current model on the industry side argue for a continuation of the status quo. So sadly I share your pessimism about the chances of widespread change any time soon, but we can always live in hope!

  7. Peter says:

    It should be noted that ETF’s are not perfect either. These are derivative based instruments, that attempt to reflect the real-time price movements of an index. But when external shocks occur to the financial system, the gap between the actual index the ETF is tracking, and the price of the ETF listed on an exchange can differ widely.

    Take the Japanese earthquake for example:

    http://www.indexuniverse.com/sections/news/8960-japan-etfs-at-big-premiums-tuesday.html

    Leveraged ETF’s, or Geared ETF’s, do not double your returns in volatile markets – you can get burned:

    http://www.fool.com/investing/etf/2008/05/21/triple-your-returns-dont-bet-on-it.aspx

    ETF’s are compiled using complex mathematical algorithms that, for your layman, can be described as “black box systems”. That is, bogans on the street are not going to be able to understand how the an ETF works. So, for John the bogan, I’d say it’s a pretty big call to invest in something that you don’t fully comprihend. Better to get some equity behind ya, gear up, and buy some houses :)

    • Jake says:

      Peter, the recent experience with etfs in Japan was due to the underlying markets not being fully open, and some of the stocks in the underlying market hitting trading limits and hence not trading. The ETF and futures markets were merly priced towards where then underlying markets were poised to end up.

      Cheers Jake.

  8. macrobear says:

    Yes yes and yes….. I agree with you all however there are EFT’s that hold the physical stocks and are not derivative based.

    I have seen some research in my past life showing the performance of fund managers over 35 years in the US…. not pretty!!!!

    I wonder if anyone here has done the research on the FM industry here (PhD anyone?)
    With active fund managers of course you need to look at the tax implications as well

    Having been in the advising ( retail end) prior to selling my business I had moved a great deal of my client’s funds from MF to eft and direct share investment .
    cheers
    Macrobear

    • bills says:

      People at APRA wrote a working paper on 115 Australian superannuation funds in 2009, table 12 is most interesting: Working Paper
      Investment performance ranking of superannuation
      firms
      Wilson Sy and Kevin Liu – 23 June 2009

  9. Stephanovic says:

    From an Adviser perspective the funds are very much on the nose. I now buy the index + some quality shares for clients.

  10. SuperBamboozled says:

    So one of the primary issues is a lack of consumer financial literacy … any good advice on where to start? I have been one of the apathetic masses, and need to start getting on top of this!

    • The Prince says:

      SuperB, I’ve sent you an email.

      I have started a series on superannuation aimed at improving literacy and understanding. I hope to have the next article out in a few days time.