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By: Sam Instone

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January 19th, 2017

Successful investors don’t pay fund managers

Investment

[Estimated time to read: 3.5 minutes]

As an investor it’s critical to ensure that the interests of everyone you pay to manage your money are as closely aligned as possible with your own.

If you use actively managed funds, you are in effect giving up a proportion of your returns to a whole range of different people.

As well as the actual fund manager, the people you pay include brokers, custodians, consultants and researchers.

Successful investor

Successful investor

How do you know whether the interests of all these different people are in line with yours?

Let’s look at the individual fund manager first

Fund managers are motivated, to some extent, by financial incentives.

Fund management is very well paid so, as a starting-point, a manager wants to keep their job. But more than that they want to earn the largest salary and the biggest bonuses they can.

You might assume that these goals are best met by ensuring that you, as an investor in that manager’s fund, enjoy the best possible outcome.

But the evidence suggests the opposite is true.

Anton Lines, a postgraduate student at London Business School, recently produced a paper called Do Institutional Incentives Distort Asset Prices?

In it he demonstrated how performance-related pay often makes fund managers behave in ways not necessarily in the best interests of the investor.

Fund Managers

Mr. Lines analysed the relationship between the trading patterns of active managers and asset prices between 1980 and 2014.

He found was that as volatility rose in equity markets, active managers moved closer to their benchmarks by selling stocks in which they held overweight positions, and buying stocks in which they were underweight.

Conversely, he found that when volatility declined, active managers moved away from their benchmarks.

Mr. Lines then looked at index funds, and at institutional investors who do not earn bonuses for outperformance, and he found that they did not share that trading pattern.

He concluded that incentives do influence the way that active managers behave.

One of most the damaging unintended consequences of this, from your standpoint as an investor, is short-termism.

So, say for example a manager has performed well in the first six months of the year. Inevitably there’s a strong temptation for that manager to secure their end-of-year bonus by playing it safe in the second half of the year, and staying close to the index.

It works the other way as well.

A manager whose first-half returns have been disappointing has no option but to take more risk over the next six months in order to earn their bonus.

The incentive to take additional risk is even greater if the manager fears for their job.

In each case the fund manager is incentivised to act in a way that is not in the best interests of you, their customer.

Then there are fund houses

It’s not just the interests of the individual fund manager that might conflict with your own either! So too might those of the fund manager’s employer.

Fund managers and fund houses

Fund management companies have staff other than fund managers whose pay levels, to some degree or other, are connected to performance. As well as senior executives these might include, for example, sales and marketing staff.

Crucially, fund houses also have shareholders who want to see a healthy return on their investment, and the easiest way to generate bigger profits is to increase assets under management.

Because fees payable are as a percentage of the total assets managed, the more assets a particular fund attracts, the higher the revenues produced.

That’s why fund houses heavily market funds that have produced strong returns over a relatively short period. Impressed investors then pile into those funds - sometimes just as performance starts to revert to the mean.

Similarly, if an up-and-coming fund manager has enjoyed success managing a small fund, their employee will often try to capitalise on their success by giving them a bigger fund to run…  

…but, as the authors of Diseconomies of Scope and Mutual Fund Performance identified recently, that doesn’t always work out as planned either:

“We find that fund alphas are negatively related to measures of the scope of manager responsibilities,” the researchers concluded. “Results suggest that better performing managers experience increases in scope that eliminate outperformance.”

In plainer English that means the pressure to maximise profits sometimes means that genuinely skilled managers are given so much responsibility that, with all the additional distractions, they are unable to outperform.

What do we make of this?

In conclusion, active asset management is fraught with conflicts of interest.

As an investor you need to minimise those conflicts as much as possible.

Better still, eradicate them altogether by rejecting active management in favour of a passive, indexed approach.

Free download: Active vs Passive Investing

About Sam Instone

Sam Instone, CEO at AES International, is passionate about positive change and ensuring expat investors get the best results.

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