The cost of active fund management

I recently met a friend who was a new investor. He had a pile of spare cash and wanted to generate a return on it. However, he didn’t know where to start and didn’t want to actively manage his investments. As a result, he approached a bank, told the branch manager that “Hey, I have this much of cash, I want to put it all into unit trusts.”

Sounds familiar? I’m pretty sure that’s a situation most people face and end up deciding to do as they want to be “passive investors” and not want to spend time learning to invest. Well today I shall discuss the cost of active fund management (ie giving your money to somebody to manage for you) and why it is prohibitive to long term wealth accumulation.

To my friend if you’re reading, please note that this is not a smackdown on your decision, I’m just seeking to educate others and hopefully, you will reconsider.

Management fees and expense ratios

Orchard.jpg

Let’s imagine you own a orchard. You plant fruit trees/seeds in your orchard, hoping one day they will bear fruit for harvest annually. Let’s say you take the seeds from the fruit and plant them right back into your orchard, to potentially have more trees and a larger harvest the following year.

You face a choice, put your own time and effort to manage the orchard or you can hire a gardener (orcharder?) to manage it on your behalf. Let’s say the gardener wants to be paid in seeds/fruit, which means you have less seeds to be planted back into the garden every year.

My question to you is, which approach will result in a larger orchard 20 years later?

Similar to growing your own orchard, portfolio management has similar traits. Substitute the following terms and you’ll get what I mean:

  1. Orchard – Portfolio
  2. Trees – Investments
  3. Fruits – Dividends / Returns
  4. Gardener – Fund Manager
  5. Seeds for the Gardener – Management fees / Expense ratio

Management fees is the fees charged by the Fund Manager for his services. This is typically a fixed rate annually based on the value of the assets under management. For example, if the management fees is 1%, it means 1% of the value of your investment is deducted and goes to the fund manager’s pockets annually. This happens even if the manager did not make any money for you in the past year.

Another fixed cost is called Expense Ratio of the fund. This cost relates to the operating costs borne by investors including legal fees, administrative costs, utilities, etc for operating the fund. This cost is also charged at a fixed rate annually based on the the value of the assets under management.

Different funds call it differently, some have management fees, some have expense ratio, some have both. In total, the fixed cost of simply investing in funds can range from 1% – 5%. That’s 1 – 5% of your returns gobbled up annually without fail.

Profit for the year? Chomp, 1-5% gone. Loss? Om nom nom, take another 1-5% loss. So scary.

When the power of compounding goes against you

You know what’s more scary? Most people think that “Aiya, its only 1%, just pay them and forget about it”. However, most fail to realise that just like your investment benefits from compounding, expenses and costs do compound too.

To illustrate, here’s a chart of market performance of 6% versus 3 funds with fixed expenses of 1, 3 and 5% respectively over 20 years. It assumes that the funds invest in the same stocks of the index, reinvest gains in the same stocks and start with an initial 10k investment.

Market vs Funds Market vs Funds Summary

As you can see, at the end of 20 years, a few percentage points actual makes a significant difference. The only way a fund is able to beat all of this is by generating returns in excess of (market + fees)%. Unfortunately, this generally does not happen as explained later.

Fund managers are not really remunerated correctly

Another point arising out of our discussion of management fees is that it does not necessarily drive positive behaviour. By pegging management fees to assets under management (AUM), a fund manager may simply seek new investors to boost their AUM, instead of seeking grow the fund through gains, to increase his management fees. He is also secure in the fact that he doesn’t have to deliver great performance to collect his management fee. A counter argument would be that a fund manager would find it difficult to attract new investors or collect increasing fees without good performance. Fair point, but the risk is always there.

Actively managed funds generally under-perform the market

Due to a combination of the above reasons (mainly due to fees), funds find it difficult to beat the market for their investors.

SPIVA is a bi-annual scorecard the Standard and Poor’s publishes that measures the performance of active fund managers against their market benchmarks. As noted in the website, most fund managers (>80% for most markets) under-perform the markets over the long term (3-5 year) time frame. This is mainly due to cost compounding as discussed earlier.

To reinforce this point, Warren Buffett famously won a bet against hedge fund manager Ted Seides in 2017. Buffett had put up USD500k in 2007, saying that a low cost Exchange Traded Fund (ETF) mimicking the performance of the S&P 500 (an index tracking the 500 most valuable companies in the US) will outperform any portfolio of hedge funds over 10 years due to fees. Seides put up the other USD500k and picked a portfolio of hedge funds as part of the bet. The bet turned out to be not even close in Buffett’s favour.

If that’s the case, is active fund management dead?

Obviously not, if not you would see a dearth of fund managers by now. The magic and mystery of hopefully beating the market will always allure investors to “smart money”. My advice to people who are considering unit trusts / funds is this:

  1. Don’t do it. Invest in a low cost (preferably < 0.5% fees) index ETF instead if you want a more cost effective passive investment.
  2. Die die want to buy? Do remember you are paying a high cost for what you’re getting. Also, do your research on the funds you are considering. Factors to consider:
    1. Low Management fees and expense ratio, preferably less than 1.5% total, the lower the better.
    2. Consider the track record of the fund and fund manager, especially during crisis periods like 2009. I believe the true skill of a fund manager is demonstrated during a crisis and not during a bull market.
  3. Do not buy from a financial adviser / bank. You will usually incur a sales charge and they tend to direct you to funds that give them the most commissions. Consider buying online from a site like Fundsupermart where there’s no sales charge. Do note however that there is a platform fee chargeable quarterly for unit trusts, so do factor that into your calculations.

“But wait, that’s a lot of work! I just want to be a passive investor!”

To that I say, there is no such thing. No matter the type of product you invest in, you have to take the requisite time to fully understand what you are getting into. If not, it’s no different from gambling.

Happy Hunting,
KK

PS: As usual, any website or service I suggest is based on my own opinion and I am not paid in any way. For blog matters, email me at risknreturns@gmail.com and I will consider it.

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