Bet you never thought that Groucho Marx ever said anything bearing on mutual funds. Never did I till I pondered this quote (on Wikipedia): "Please accept my resignation. I don’t care to belong to any club that will have me as a member."
Why do mutual funds want us as members? The answer sadly for most mutual funds, is to collect management fees and not to provide the supposed membership benefit of a fair investment return. Consider the simple arithmetic. Funds charge a fee based on assets, such as 2% per year. Thus, for example, if a fund has $100 million in assets, the managers collect a $2 million fee annually. Boosting assets raises fee pay for the managers. There are two ways to boost assets - 1) investment return, 2) sales of fund units to the public. The question then is, which is easier?
For option 1 generating investment return, as long as the fund invests in something it will gain a certain return somewhere around the market, but beating the market is very difficult, some say impossible on average. Going from 6% market return, approximated by simply investing in a broad range of holdings within the particular asset class, to 7% (outperformance by 1%), requires a lot of effort and/or skill, or luck (if you believe in efficient markets). In fact, actively managed mutual funds have been shown in many many studies not to be able to outperform by much (e..g read Richard Ferri's new book The Power of Passive Investing which slices and dices US actively-managed mutual fund performance against passive index investing every possible way, citing those numerous studies) even before fees. The one-third of funds that were actually successful in outdoing a US S&P 500 index fund from 1985 to 2009 (graph p.38 of the book) only averaged about 1% per year extra return and the very best only attained under 5% per year extra return. Two-thirds of the active funds lagged the index fund - by an average 1.69%. That's before sales commissions and income taxes, which would knock a bunch more down into the lagging side. The net effect on fees of 1% outperformance / $1 million excess return (which raises assets by 0.01 x $100M) is 2% of that extra $1 million or only $200k.
Option 2 is to raise assets by marketing and sales. Through advertising tailored to highlight its winning funds, companies can stimulate fund inflow. Winning funds are defined advatageously - they are compared only to other funds, not market indices, which means half can be above average as opposed to only the third when compared to indices. When a fund's performance almost inevitably falls behind it gets terminated or merged into another more successful fund to incite investors to stick with it and not withdraw their money. New funds are constantly being created or incubated to find some that outperform so they can be featured to attract new money.
How much extra effort is required to gain more than $1 million in new assets - and thus be ahead in garnering fees - by advertising and marketing and what is the comparative chance of success? For one thing, the public is constantly being motivated to contribute, being told to save for retirement, especially at this TFSA/RRSP time of year, when the investment decision becomes only a question of which investment to buy. Those dollars are probably easier for the fund company to grab. Furthermore, the process is much more under the control of the fund company than fickle markets are, so it's likely a lot easier to generate more fees with option 2. In sum it appears that mutual fund companies are much more marketing organizations than asset management / portfolio management companies.
Maybe the search for successful active management amongst mutual funds is looking in the wrong place. Ferri himself remarks that "Most of the great managers aren't for hire by the general public. The truly talented managers like to fly under the radar as long as possible to keep their assets manageable." He also quotes famed Yale University endowment manager David Swensen, who said "Low-cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions." A book I reviewed recently, Pension Revolution by Keith Ambachtsheer, followed the same thinking when discussing pension funds. He found that good governance, which includes properly motivated fiduciary-bound managers, made a big difference to performance. Well-governed pension funds achieved 1% per annum excess risk-adjusted return (he thinks 3% is possible for the best governed), though even the average pension fund achieved 0.2% excess return after fees and expenses. The problem with mutual funds, as Ambachtsheer puts it, is the managers' conflict between producing good returns for clients and profits for themselves. If individual investors are the "dumb money" patsies of the investment world that the "smart money" active investor eats for lunch, then mutual funds are the "conflicted money" that they eat for dinner.
Maybe Groucho had the right idea with respect to actively-managed mutual funds.
Monday, 14 February 2011
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