If you are saving and investing, your focus is probably on achieving satisfying returns over your chosen time horizon without risking too much of your capital.
While you get to choose how much risk you are willing to take and what kind of returns are satisfying for you, when it comes to put in place an investing strategy there is a number of ways from which you can choose.
Mutual funds, index funds and ETFs became really popular in the last decades and there are good reasons for that. Even though they might not be the perfect solution for a long-term investment, they provide a wide diversification, freedom of choice and easy access to a large number of people.
But when you are evaluating which type of investment you will put money on, one of the key factors that most of the time is completely overlooked is the management fees component.
In this article, we’ll go through some root problems of institutional asset management and paint a wide picture of the industry from the investor perspective.
What Are Your Expectations?
Let’s say that you have a mutual fund and you are progressively investing capital each month.
First, let me say that it is great because you are saving and investing part of your income for the future. But have you ever stopped for a while and asked yourself if it’s really the best option available?
Does it really make sense to invest in mutual funds and index funds if you are in for the long-term? What kind of returns do you expect?
What kind of management style you would like to see from your investment manager?
If you rely on someone to manage your money is because you expect them to be managed in a way that you can’t, right?
Investing goals are extremely personal, but I am sure that you can agree with me on the fact that your primary investing goal is NOT paying somebody else’s management fees.
Funds Usually Underperform The Market
Let me ask you the following question:
What is the point of investing in a fund that yields less than the market?
I would really like to know your opinion, please comment below!
We could end up here. That sounds strange but it is the reality, there is indisputable evidence of that.
For example, check out this article by the Financial Times that says that 99% of US, global and emerging market funds have failed to outperform the market since 2006.
While it’s really a challenge for active fund managers, the truth is that the vast majority of funds underperforms the market, it is a well known fact.
Why Active Funds Underperform?
Let’s start by saying that an institutional asset manager has to be invested somewhere, even when the best option would be to stay out of the market.
In many cases, institutional investors buy whatever they can no matter the fundamentals. As a matter of fact, if you take a look at the portfolio positions of the largest pension funds you realize that they are basically market portfolios that own every stock out there.
The difference with an ETF is that the fund manager charges a significantly higher fee to keep the fund going. Paying a high fee is really a problem especially if your investing horizon is so long, because it compounds over time and erodes your overall returns.
Diversification is actually an issue here because it’s virtually impossible to outperform the market if you own the market. If you add fees, then it becomes incredibly hard, that’s why most of them never beat the market.
One last point here. Being so diversified eliminates the risk for the management because they do as well as the market does. If things go wrong it’s because everything is going wrong and when things are good the fund follows the same trend of the market (more or less).
Wall Street Interest
Who did you buy the fund from?
I guess it is from an institutional investor which business is issuing and managing the fund.
What’s important here is to clearly identify the interest at stake: a fund manager business it to manage the fund, his business is not your returns.
The aim of Wall Street is to generate money from commissions, not to generate money for you.
If you understand and make this concept yours, it’s like having an unfair advantage over the majority of small investors.
This allows you to understand some critical constraints that fund managers have and be much more mindful when it comes to investing.
The aim is not to perform, it is to manage as much assets as possible in order to collect more management fees. I am not saying that every fund is bad but it’s really hard for you to beat the market in this environment.
The icing on the cake is that many investment managers HAVE NO OWNERSHIPS IN THE FUNDS!
That is really something that should be checked before choosing any fund.
The Biggest Constraint For Fund Managers
Since beating the market over the long-term is possible (and for those who don’t think so, please ask the question to someone named Warren Buffett) and put in place strategies that don’t perform today but have higher returns in the future is also possible, why don’t fund managers adopt those strategies?
They simply can’t because otherwise they would get fired.
The average investor, like a large portion of market participants, looks for relative performance. Those people are actually very emotional and since they make the market there is little chance that they are willing to accept a strategy that is underperforming while all the others have a higher level of short-term performance.
Generally speaking, if an investment manager is investing for the very long-term but is underperforming right now compared to the market and the other funds, he would see withdrawals from the customers and would soon close his fund.
Taking the risk of trying to of overperform the market is something that very few institutional investors would ever do.
Mutual funds and index funds are very popular and easily accessible from all kind of investors. Although they offer an easy way to approach financial markets, they come with several drawbacks that is vital to consider if you are investing for the long-term.
Management fees are something that too often gets overlooked and could really have a strong negative impact on your returns.
The key point of this article was: does it make sense to pay fees for something that systematically underperforms the market?
I hope that the answer is no, but the reality shows a different picture.
Actively managed funds underperform the market for several reasons. The first is that they are too much diversified and they always have to be invested in something even when the best option would be to stay out of the market.
The second thing to understand is that Wall Street’s business is to generate commissions, not your returns. This is also one of the reasons why they own a large number of assets in customers portfolios.
Although beating the market is possible, there are few fund managers willing to try to do that because in a world where everyone looks for relative performance, it’s hard to afford to underperform in the short-term even if it would lead to better returns later.
What to do?
I think that the first step is becoming aware of those things and get an idea of the investing scenario.
Realize that most of the stock market valuations are based on short-term data, this opens up a whole new range of investing opportunities for you as you gain a different perspective.
Invest in your financial education, as I am doing right now, and shift to a long-term focus in order to get the whole picture and accept the short-term underperformance in favor of your long-term investing success.
This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.