The Case Against Mutual Funds Part 2

How Money Managers Keep Their Jobs.

Mutual funds make money by charging its unit holders a fixed percentage each year (typically between 1% to 3%) for managing its investment portfolios. Total revenues of the fund company is a fixed percentage of all Assets Under Management (AUM) of the company’s funds. The greater the AUM, the greater the revenues (and profits) for the company.

For this reason, fund companies employ large marketing departments to sell its funds in order to grow AUM. The more funds they sell, the greater the AUM, the greater the revenues and profits.

In order to keep their jobs, fund managers must make sure their funds are “marketable”. That is, their funds would have historically performed reasonable close to (or better than) the market index they were meant to track. For example, if a fund is supposed to invest mainly in large U.S. companies, fund companies know that its customers will likely compare the funds performance agains the S&P500 index (a basket of roughly the largest 500 US public companies). Any deviation in performance in the short term (1-3 months) or long term would make the fund unmarketable.

Suppose you are a smart and honest mutual fund manager. The constraints on your investing activities are numerous.

  1. Your fund must track a market index or benchmark (e.g., S&P 500 index);
  2. In order to survive, your fund must not significantly underperform its benchmark over the long term in order to survive;
  3. In order to avoid unit holders selling your fund and moving to a competitor, your fund must not significantly underperform its benchmark in the short term (1-3 months);
  4. You must deal with inflows of cash (new net sales) by purchasing stocks even if you don’t see any good values to buy;
  5. You must deal with outflow demands (new net redemptions of fund units) by selling stocks even if it’s not a good time to do so.

Being “smart”, you know that there are only two possible ways to satisfy the above constraints. One is that you must be truly prescient. That is, you can accurately predict the short and long term movement of stock prices. In this case, you likely wouldn’t waste your time managing a mutual fund. Rather, you’d invest your own money and eventually accumulate all of the money in the world.

Closet Indexing

The second (and only) way to manage your mutual fund is by using your investors’ money to buy a basket of stocks that closely resembles the benchmark your fund is trying to track. Yes, you can try to be smart around the edges of your portfolio by buying a bit more of this and a little less of that (a practice commonly refereed to as “closet indexing“). However, since you cannot accurately predict stock prices in the short term, you know that the bulk of your investment must mirror your benchmark. Otherwise a particularly unlucky month or quarter would result in massive outflows of money from your mutual fund. This would reduce AUM and decrease revenue. Worse, you could lose your job.

To further protect yourself from poor (unlucky) performance, you reduce your risk by creating not one, but five different mutual funds. Each roughly resembling the benchmark, but each making different “bets” around the edges of your portfolio. This way, you increase the likelihood of having one or two funds that will actually beat the benchmark. After some time, you shut down the poorer performing funds, wipe away their existence from your website and marketing materials and roll their assets into your top performing funds.

The above scenario is the norm in the mutual fund industry. Under the constraints presented, it really is the only reasonable way to manage a fund company that markets mutual funds to the masses.

Mutual fund managers would do a better job if investors would just leave them alone. However, investors don’t leave money managers alone. For this reason, managers are constrained by short-term (monthly, quarterly) performance and have little choice but to mirror an index (while charging a much higher fee). Finding a good money manager who is not constrained by short term performance targets is very difficult for the average investor. For most of us, it’s better to save the 1% to 3% annual fees and stick with low-cost index funds.

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