At this time, when the world at large is starting to rethink some of the big assumptions and theories which have driven economies for decades and longer (e.g. capitalism is cool, money can buy you love, etc), many smaller investors are re-evaluating and questioning some pretty important issues themselves. One concern which I have been asked to answer lately is this: Why do I pay fund managers so much?
This is a tough one... Fund managers give you greater diversification, greater access to markets, lower administration requirements, greater access to experience, research and knowledge, relatively low transaction costs… and all that does come at a price.
But let me take a quick Benji Marshall mid-air sidestep here and change subject slightly. Now, there are 2 major streams of fund managers out there – active and passive. Most fund managers actually fall somewhere in between, with the extremes being absolute fund managers (fully active) and index fund managers (fully passive).
The term passive refers to the fact that the fund does not make any major decisions or conduct any research determining which securities it will invest in. Instead, its portfolio is determined by external parameters. An index fund is the most passive of funds and all the fund manager does is invest in line with a set index. For example, an Australian share index fund will monitor the S&P ASX 200 index weightings and will purchase shares so that its portfolio is the same as the index. Thus the main skill of such a fund is at the transactional level, with no research necessary, and its returns should very much be in line with the ASX 200 index.
The term active refers to the fact that the fund does make decisions and conducts research determining which securities it will invest in. An active manager may take notice of an underlying index, but there is also some degree of research done with the goal of outperforming the index, or in the case of absolute funds, producing returns that are not correlated with an index at all.
Most fund managers claim to be active, but many are really semi-active – that is, merely passive with a touch of pizzazz. What I mean by this – for example, take an Australian share fund which tries to outperform the ASX200 by 1%pa. What this type of fund might do is simply place 90% of its funds as per the ASX200 index weightings, and then play around with the other 10% with the goal of picking up shares that will outperform the market and thus give the fund a return greater than the index.
Compare this to a fully active fund that pays no attention to the index, and conducts research on industries and companies, and invests according to this research. Their goal may still be to outperform an underlying index by 1%-5%pa, but they don't do so by simply tracking the index with a bit of variance. For example, this type of fund might first conduct research on which industries might outperform in the medium term (e.g. energy, health, retail) and then might look at the companies in these sectors to determine which are the best value. They might also choose stocks based on other criteria such as high franked-dividend yield, or size of company.
A truly absolute fund will also use mechanisms such as short selling and derivatives to achieve its goal, which is often a flat rate (e.g. 8%-9%p.a) - unlike the above examples, which are index related goals (e.g. index + 1%-3%pa). For example, this type of fund might compare industries and then short sell shares in sectors that it believes are over valued and buy shares in sectors that might be undervalued. They could also follow this approach for shares within the same sector, and also might use options and futures to gain the exposures desired.
The point of this quick analysis is to show just what you are actually paying for when you use a fund manager to invest. You are paying for not only their research, but also for exposures to mechanisms that you would not otherwise use. Accordingly, a passive fund manager will charge a lower management fee as it does not need to do any research and uses quite low cost and simple mechanisms to invest. A fully active fund will charge more, and an absolute fund even more so. A standard fund that for the most part tracks an index, will charge somewhere in between the 2 extremes.
So the big question is "do you really get what you pay for"? I remember reading quite a few papers back in my university days which tried to prove that in the long-run, an index fund will perform just as well as an actively managed fund. Could it be true? Could all those 1,000's of funds out there really be charging more fees and not be producing better returns? Would we just be better off investing entirely in index funds and do away with active fund managers all together?
There are some structural flaws with index funds that dispels such arguments to some extent. One flaw is the fact that they will almost always lag the market. The reason for this is simply due to how index weightings are determined by S&P or MSCI, etc. One major determinate for weightings will always be past performance of company, industry, country or region. The better the past performance, the more chance of an increase in weightings, and vice-versa. Thus, an index fund will have the tendency to purchase stock in securities that may have already increased in value (and may therefore be fair or over valued). A good example of this is the relative overweighting US stocks hold in an international share fund. Most global share indices have US weightings at 40-50%, thus an index fund will also hold such a large weighting. On the other hand, many active funds over time might hold only 25%-40% of US shares with higher exposures to emerging markets, and other countries.
So are there fund managers out there that are not worth it? Yes. As with any industry, there are funds that are bargains and there are funds that are not good value at all. Probably the worst value lies with those semi-active funds who really should be charging closer to that charged by an index fund. It's harder to place value on the fully active funds, and as long as fees are within reason, it's probably more important to focus on investment theology, practice and experience of these funds rather than the amount they charge.