Choosing a managed fund involves plenty of contradictions. On one hand, each fund boasts how well it’s done in the last year … or three years … or five years. But underneath the glossy advert the regulator has forced it to write: “past returns are not a predictor of future performance”. Which should you believe?
Ask for advice and you’ll regularly be told that managed funds are for idiots anyway. Overall, the average fund underperforms the market once fees and expenses are taken into account. For this reason, supporters of passive investing insist you should forget the whole idea of managed funds and just buy the cheapest tracker fund you can. No manager is a better choice than any manager, they say.
So it’s understandable that a lot of baffled investors make one of two simple decisions. Either they take the advice of just buying trackers, because the tracker argument makes sense. Or they plump for a managed fund from a big, well-known fund manager, because it should be reliable.
Understandable – but wrong. You can do better than either of these options. But successful investing requires work and the same applies to picking funds.
You need to get to grips with how the fund management business works, understand why the vast majority of funds are a bad investment and then put in a bit of time to pick a few that aren’t. This article will explain how to do that.
The four flaws of fund management
The crucial mistake that many investors make comes from not grasping four simple facts about funds and fund management:
First, the goal of an average fund management company is not to make you wealthier. It’s to make itself wealthier, through gathering as much money as it can from investors and charging as high a set of fees as it can for looking after those assets. A fund company’s true business model is to be an asset gatherer, not an asset manager.
Second, this means that the average fund manager is not incentivised to manage your money in the way that’s best for you. Instead, he or she is incentivised to draw in as much money as possible from new investors, while losing as little as possible to existing investors taking it out. That is what his bosses want and doing what his bosses want is the best way to secure his career.
Third, it is not possible to beat the market consistently over short periods. A good investor will outperform over five years, but quarterly performance is essentially random. Unfortunately, the industry is becoming increasingly short-termist. If a manager underperforms significantly for a couple of quarters, they will come under pressure from their bosses, because weak performance could lead to impatient investors pulling out their money.
Fourth, the simplest way for a manager to avoid this risk of a rapid end to their career is to avoid underperforming the market too much. However, to have any chance of outperforming the market, you need to take out-of-consensus decisions that could lead to you underpeforming the market, at least temporarily. So the manager’s best bet is stick quite closely to the overall market, avoiding the risk of underperforming too much, but giving up the chance of outperforming.
It may sound cynical, but this is how fund management works. If you talk to managers who have been around the industry for a while and they are sufficiently candid – usually when they’ve retired, they’re drunk or they just don’t care anymore – they will agree that fund management looks after its own interests and often does a terrible job for investors in the funds.
Why most managed funds underperform
What’s the outcome of this? Most funds from most fund management companies are trackers in all but name. The manager sticks relatively closely to the benchmark and what his peers are doing and avoids taking big bets. They may outperform by a couple of percent one year or underperform by a couple of percent the next year, but they will never take the kinds of investment decisions that mean they are likely to outperform significantly over the long term.
Managers disguise this. They talk up the merits of certain stocks or sectors – but very rarely will they overweight these to the extent that might make a real difference to performance. And regardless of how bad a major sector is, rarely will they leave it out of the fund entirely.
Meanwhile, they follow dubious practices such “window dressing”. This means buying shares that have done well towards the end of each quarter so that they can say to their bosses and investors that they own these successful stocks. Never mind they’ve owned them for all of three days and missed out on all the gains.
So in most cases, advocates of passive investing are correct. The average fund charges much higher fees – and trades more actively, creating higher costs – to end up more-or-less following the market. Over time, you will do better with a low-cost tracker than a typical fund that follows the same benchmark, since because costs will be lower.
Ten tips for choosing better funds
So if you want to do no more work, stick to buying low-cost tracker funds, such as exchange traded funds (ETFs). You will probably do better than you would through a typically managed fund.
That said, there are opportunities for investors to beat the market over the long run. The further you go into areas such as small cap stocks and emerging markets, the greater these opportunities are. But they exist even among the biggest, most liquid stocks.
However, finding a manager who worth the higher fees that come with managed fund takes work. You need to analyse funds, work out if each is really an asset manager or simply an asset gatherer and discard the vast majority to indentify the few that are worth investing in.
There are no simple shortcuts. But the following tips should give you an idea of what to look for:
1. Ignore most of the big names. The large fund houses tend to be the worst when it comes to the asset gathering mindset and their funds are usually determindly mediocre. And superstar fund managers may well just have got there by being a bit lucky and very media-friendly.
Instead, it’s the boutiques that manage just a couple of funds or the specialists that focus on a single area that are more likely to have the right investing mindset. This doesn’t mean that all of them are good – most still aren’t. But you’re more likely to find a good manager in a small outfit than a large one.
2. Go small. This is often related to the first point, since boutiques are likely to have smaller funds. But why is this useful by itself? Because a smaller fund has more flexibility to take decisions that can make a big difference to performance.
A large fund often can’t put 5% of its assets into a small cap stock, however good the prospect is, because there isn’t enough liquidity in the stock. A smaller fund sometimes can. So it can make bigger, more concentrated bets on what the manager thinks are the best prospects.
3. Look at past performance – but carefully. Past performance certainly isn’t a predictor of the future, but it tells you something about what the manager does. If his returns are consistently very like the index, that suggests he’s running a tracker in all but name.
You shouldn’t necessarily write off funds that have underperformed. You need to work out why. Did the manager underperform because he focused mostly on staid stocks while racy ones were outperforming? That tells you something about his investment style and the kind of conditions in which he might outperform the market.
4. Look at the portfolio and compare it to his benchmark. Does he hold mostly the same shares in the same weights as the index? Are his sector weightings very much like the index? If so, that supports the idea he’s running a quasi-tracker.
On the other hand, if the two are quite different, it can be much more encouraging. Assume only three of the ten largest stocks in the index are in his top ten holdings. And his biggest sector is consumer staples at 20%, versus 5% in the benchmark, while he has just 5% in financials, which are 30% of the benchmark. That points to a manager who isn’t afraid to buy whatever he thinks is best.
5. Look at the size of the portfolio. How many shares are there? We want a manager who takes concentrated high-conviction positions in his preferred stocks, not one who half-heartedly owns lots of companies. That’s the only way to outperform.
Around 40 is typically a good number (even lower is fine for a very small fund). That’s diversified while being few enough that some stellar performers can make a difference. Given a couple of research assistants, a manager can keep on top of that many firms. But 60 is starting to look a bit high and 100 is far too much – at that point, it might as well be a tracker.
6. Look at portfolio turnover – the percentage of the portfolio bought and sold every year. This can be a bit harder to judge, because there are some strategies that revolve around relatively short holding periods. But for most funds, you want it to be low – say around 20%.
Why? First, it means that manager is making a high-conviction decision and giving it time to pan out, not jumping in and out on a whim. Second, turnover affects trading costs: lower turnover means lower costs and thus less drag on performance.
7. Try to understand what kind of companies the manager buys and why he does. After all, you’re looking for a manager who will invest your money with a similar level of risk to the risk you’d take if you were doing it yourself.
So if you’re a conservative investor, you’re probably looking for signs that the manager invests in high quality firms. If he doesn’t invest in certain high profile firms or entire sectors because he thinks there are severe corporate governance issues or other problems, that may be an encouraging sign. Obviously, if you’re less conservative, you may be willing to accept more speculative investments.
That said, every investor – regardless of risk tolerance – should be aware that managing other people’s money is very different to managing your own. Many managers are willing to hold something in their fund that they wouldn’t trust with their own money. Regardless of your investing outlook, you’re still looking for evidence of prudence and quality control in a manager’s decisions.
8. Read what the manager says in his investor reports and in media interviews. Look back at past comments. Then compare what he said to reality: how the fund performed and what it is invested in.
Are the two the same? Try to establish if the manager is candid, with a coherent and consistent investment style. Avoid those that seem to change their minds often, talk up the merits of the latest hot topic constantly and buy any old junk, never to mention it again when it goes wrong.
9. Be realistic about what you expect from a fund. It’s impossible to know what will perform best in the short term and performance can be volatile. That affects both good and bad managers.
If you’re investing in the stock market, your time frame should be quite long – a matter of many years, not a few months. So your focus should be on whether a manager seems likely to outperform in the long run, not whether he’ll do okay in the next quarter. In fact, the more investors fixate on short-term performance, the harder it is for managers to make good long-term decisions.
10. Don’t ignore fees. While this article is mostly about choosing a manager for better performance, never forget that the fees you pay also have a big impact on long-term investment returns (one percentage point more in annual fees can make a 10% difference over a decade). A good manager can be worth the higher fees relative to a tracker fund, but you should still try to keep these down.
Where possible, look at buying funds through fund supermarkets and discount brokers to get reduced fees. Remember that the extra savings you make this way were usually not going to the fund manager in the first place, but to a middleman – and they’re certainly not doing anything to help your fund perform better.
Do your research or stick with trackers
If you follow this approach, it will probably lead you away from many of the hot investment ideas and funds you see touted everywhere. It will probably lead you to conclude that 90% of managed funds are worthless and many of the ones you want to put your money are relatively small, obscure and unfashionable ones that few of your fellow investors know.
In short, it’s rather like investing directly in stocks. It doesn’t require quite so much ongoing analysis and monitoring, but the initial selection of a fund needs detailed research, just like investing in stocks.
If you don’t want to go through this process, then you should consider sticking with trackers. You won’t outperform the market – but after costs, you’ll outperform the typical managed fund.
If you’re prepared to put in the time to pick good managers, you have a realistic chance of better than this. But if you don’t – and you just go with the first funds you see advertised or talked about – the odds are that you will simply pay extra for worse performance.