The brochures of most professional investment managers promise “above average performance” by an experienced and dedicated team. Their “proven” investment strategy “picks stocks with strong underlying fundamentals”.
Clever marketing works. Unfortunately, not all firms perform above the average, nor can they by definition. Novice investors must distinguish the phoney brochures from the honest ones. Sometimes investing directly outperforms the professional funds.
Before you entrust your savings to the professionals, try to understand the temptations they face with your money.
Most realise that the fees they charge bear little or no relationship to performance. Instead, their rewards come from the money they attract into the portfolio.
When the dotcom bubble was at a peak, many novice investors suffering investor envy were lured by brochures that promised spectacular returns from technology. Some invested when the sector was glaringly overpriced.
Were the fund managers worried? No. They made more fees by tapping into “investor envy” than by researching an underpriced sector.
A fund manager that understands investor emotion can probably generate higher fees than one with investment skills. It’s hard to believe now, but Irish property funds were the rage in 2007 and tempted even experienced investors.
Front-running is another problem. A fund manager might launch a “green fund” restricting his investment to environmentally friendly companies. If the fund is oversubscribed, he knows that, within the coming weeks, there will be a huge demand for “environmentally friendly” companies. So, he buys in a personal capacity ahead of the fund and earns a huge profit.
If too many people are doing this, the fund ends up buying overpriced shares. Regulations are designed to stop this but – where there are regulations there are all too often lucrative loopholes.
Leverage offers more temptations to the fund manager. Suppose he is paid 1.5 per cent for funds that he manages and raises €10 million from investors. That is a fee of €150,000 per annum.
The temptation for the fund manager is to double the funds under management. If for instance he borrows an additional €10 million on top of the €10 million he has raised then he has €20 million under management and the annual fee charged jumps to €300,000.
Many funds, particularly hedge funds, are permitted to borrow in this way. Sometimes the policy makes sense but often the fund manager is motivated by the increased fee and ignores the extra risk that leverage brings.
Many fund managers attempt to conceal leverage. This allows them simultaneously to sell funds to risk-adverse investors and award themselves huge fees based on the hidden leverage.
Fees may appear small but they can accumulate. Many Irish pensioners learned towards the end of last year in a report published by the Department of Social Protection that a person with a moderately-sized pension of say €400,000 can see up to 30 per cent absorbed in fees. The advertised fee in the brochure often underestimates the real fee.
A fund manager may say his fee is 1.5 per cent but to this you must add custodian fees, day-to-day expenses and an administration charge. Together they can add an extra 1 per cent. The total of all the fees is known as the Total Expense Ratio (TER). According to Goldcore.com, the average TER across Europe is 1.91 per cent. The fees creep up even higher when fund managers themselves invest in other funds.
Additional costs
It doesn’t end there. An additional cost is when the fund manager starts to “churn the portfolio” – ie buying and selling shares for no other reason than to earn more fees.
Stockbrokers charge around 0.5 per cent when they buy or sell shares. Very often the fund manager and the stockbroker are connected parties: thus the fund manager is tempted to maximise the brokerage fees of the stockbroker by buying and selling regularly.
High rates of churn also means additional stamp duties. According to Goldcore – a specialist in precious metals and wealth management – these expenses borne by the investors are not always disclosed.
Despite all this, some professional investment managers are worth their fees. Many have built up years of experience working on Wall Street or in London’s square mile. Some, for instance, were aware of the state of health of the banking system and protected their investors before the banking crisis hit the headlines.
Often, fund managers hold meetings with companies they invest in and this gives them valuable insight not available to the individual investor.
Blindly delegating your investment decisions to investment firms with strong brand names though is risky. Some are good but not all are and research is required. Avoid those brochures promoting sectors that have done well in the past – they are probably overpriced and it is a signal that the investment manager is more interested in fees than performance.
Also, pay close attention to the fee structure. If it is hard to understand or lacks transparency, this may be deliberate.
Finally, consider going alone. Many investors with moderate intelligence who require stable, as opposed to instant, returns can often perform better than the professionals.
* Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options
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