The amount of money now invested in managed funds in Australia exceeds a trillion dollars. At a conservatively estimated average total management fee of 1%, this means that Australian managed fund providers & associated institutions now earn over $10 billion per annum in fees.

$10 billion for the fund managers – but how much for you?

Clearly there are a lot of people earning a nice dollar from managed funds, but is it just the fund managers? Are people who invest in managed funds getting a decent return?

Without doubt managed funds (called mutual funds by US investors) are excellent investment vehicles. But as the sector has grown, so too has the prevalence of below-par activities by some market participants. There are certain characteristics and issues that are illustrative of some parts of the industry that every investor should be aware of and that should at least raise concern.

Poor Performance

• We often see average or below average performance by most managed funds.
• Research shows that strong investment performance results in significant flows of new money going into those managed funds. If this is the case, why isn’t any managed fund company putting their hand up to say they are performing well? We believe it’s because they simply aren’t performing well. Instead we get advertising campaigns with comedians or well styled photos with luxury goods and little or no comment on investment performance.

‘Last Year’s Studs are This Year’s Duds’ (Morningstar)

• Most investors ‘chase returns’ when they invest in funds that have done well in the past when research shows that it is a failed strategy as managed funds do not often repeat out performance (beat the market).

Star Ratings Don’t Help

• Research also indicates that investing in funds with high star ratings does not result in higher returns, yet a significant majority of people invest - either on their own or with professional advice - using star ratings as a guide. The media often highlights funds with high star ratings.

Investment Managers Don’t Stick Around

• The average length of a CIO (Chief Investment Officer) staying in their job is only 3 years. The people who may have managed a fund well in the past often don’t stay. Here’s an example.
  
  Money Management article on ING fund that lost key staff June 2008 - http://www.moneymanagement.com.au/Articles/Three-INGIM-funds-on-hold-SampP_0C057611.html ]

Fees are High

• Fees are often too high, making poor returns inevitable, as your investments must at least recoup these fees just to break even.

Fashionable Investments Not Ideal

• Many of the latest trendy investment products are simply opportunistic reactions to recent market movements. In the wake of the Credit Crunch and drop in share markets in early 2008 we are seeing a whole raft of ‘Capital Protected’ investments being offered to the public. Of course, such investments would have been attractive before the market dropped, but not now. These investments are designed to exploit current investor concerns, but they may not be suitable long term investments, since any “protection” comes at a cost that may erode investment returns over time.

Fund Managers’ Interests are Not Aligned with Your Interests

• Fund managers care more about longevity than actual fund performance. The longer they hold your money, the more money they make, regardless of whether you see any returns. So their goal is to attract lots of money into their fund and keep it there for as long as possible. For example, a fee of 1% pa on $1 billion generates fees of $10 million pa, or about $200k per week. Even if you lose money in the fund, the fund manager still makes money, and the longer you remain involved in the fund, the more money they make from you.
  
  
• Even if no new money comes in, the fund will naturally grow in value so when the markets (eventually) increase by say 8% the $10 billion fund will grow by $800 million in one year. At a 1% fee, their income (not yours) goes up by $8 million.

Index Hugging – No Free Hugs

• With such manager-friendly business models, fund managers are very keen not to upset the golden apple cart and desperately do not want to let your money go. As fast as new investors come into their fund when fund returns are good, they leave even faster if the fund performs below the market. With that risk present at all times, fund managers have a significant business risk trying to beat the market, so some simply don’t take much risk and instead “hug the index”, generating average market returns and thereby ensuring there is no compelling reason for advisers to recommend that their clients’ funds be withdrawn. These index-hugging funds make money for doing very little, but, remarkably, they often charge high fees for doing it.

Survivorship Bias Artificially Inflates Returns

• The performance of certain fund managers, and the managed funds industry as a whole, is often worse than is reported due to Survivorship Bias. When a fund doesn’t perform well, the manager of that fund often merges it with a better-performing fund or closes it down completely. This widespread practice results in a surviving number of funds that on average show performance better than what would have been the case if the under-performing funds were not closed. (the above yellow highlight should be a link to wikipedia – for that topic)

Summary

For the above reasons we strongly suggest that anyone investing in managed funds should first invest in an independent PortfoliOK assessment. Find out How to Get Started.

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