While the source of the above quote makes it an interesting paradox, the comment on its own is nearly irrefutable. No matter where we live or work, our actions & our choices are driven by incentives.
There’s been a great deal written about why mutual funds underperform their benchmarks. Many point to the managers to find fault. We wouldn’t necessarily agree. There are some tremendous folks working as analysts and portfolio managers at mutual funds. Their intelligence, effort, integrity, and logic are first class.
So why do mutual funds as a group underperform the major indexes? There are a number of reasons, especially as funds grow larger. But there’s one that’s seldom discussed…INCENTIVES. The incentive system is poorly aligned relative to your objectives as an investor. The incentives, from selecting a fund for an investor to the funds themselves selecting investments, have become twisted in ways that are not favorable to the investor.
There is no shortage of mutual funds with glossy marketing brochures. There is not a scarcity of mutual funds paying advisors, consultants, insurance companies, brokers, etc to get you invested in their funds. The world does not want for mutual funds or mutual fund strategies.
What you won’t find, however, is an abundance of mutual funds who have aligned their managers’ interests with their investors. Where are the mutual funds whose managers are required to invest most of their net worth in their own funds? Where are the mutual fund boards culling poor managers due to their inability to generate value for investors? Where is the incentive system that emphasizes how critical performance is to you?
Experience suggests that today the best analysts & managers tend to be at the smaller funds. Many of the largest funds struggle with the weight of a bureaucracy where politics and group think rule. Unfortunately, most employer-sponsored retirement plans must rely on these larger funds for the bulk of their offerings. This is not necessarily a fault of the employer-sponsored plans, but rather coincident to their need for certain liquidity & asset-servicing capabilities.
A good deal has been written about mutual funds underperforming the indexes. No matter the underlying cause, the numbers can’t be ignored.
There’s a lot to consider before purchasing a mutual fund. We suggest you consider the following in addition to information the fund provides…
1. Mutual Fund Ratings Systems
There are several services which rate mutual funds. They typically use a simple system to rate the funds & then provide a detailed write-up (the write-ups can be lengthy & sometimes confusing). Would it surprise you that the ratings method can be quite subjective? Would it be a shock that performance can be one of the lower weighted items they use to rate the fund?
Consider that for the major ratings services, their largest clients are the very funds they are rating. As a matter of fact, it might surprise you what a small percentage of their revenues come from folks like yourself (details are freely available in the 10-K filings that the public firms are required to file with the SEC). Have you ever wondered why some of the largest funds underperform their index but are very highly rated? Have you tried to make sense of a fund underperforming its index but a ratings service suggests it generates positive alpha?
There’s room for the mutual fund ratings services to provide more robust ratings to investors.
2. Why do advisors recommend mutual funds? Why do mutual funds have so many share classes?
There’s A shares, B shares, C shares, institutional shares. Why? You can find more comprehensive analyses of this subject than what you’ll find here. But, in general it comes down to how you pay sales commissions.
Now if the funds are such great deals for investors, why is the pricing structure so complicated? Shouldn’t demand be inelastic relative to price if so much value is being created? Wouldn’t institutional investors be willing to pay the same fees that you do?
Be aware of the incentives for anyone who recommends a mutual fund to you. A tremendous portion of the charges that you pay with a particular share class goes to the firm & advisor selling you that fund. Current regulations (April 2015) do not require the person selling you that fund to reveal to you the fees they receive. Rather, it is buried deep in the prospectus of the mutual fund.
3. What incentives do mutual funds have to outperform a comparative index?
The main reason funds lose assets is manager turnover. Look at what the mutual fund rating services say. Withdrawals aren’t typically recommended by the advisors & advisory services based solely on poor performance. But if there’s manager turnover, withdrawals follow.
Put yourself in the shoes of a mutual fund exec with let’s say $40 billion under management. You charge investors 1.25% annually in management fees.* This 1.25% of $40 billion is $500 million. Not bad, $500 million in revenues and your main costs are employee compensation. Your greatest concern is employee turnover. You’ve seen that funds generally don’t lose assets if they come within a couple percent or so of their benchmarks each year. So what do you do?
You likely compensate your managers like you never want them to leave. If you are one of those managers, what do you do? First, you don’t stray too far from your benchmark. Second, you don’t stray too far from you benchmark. Third, don’t stray too far… You get the picture.
The issue is not the compensation. It is the compensation without incentive. If an employee can earn a great living only having to nearly match a benchmark. And that benchmark is fairly easy to mimic. Why would an investor expect those employees on average to consistently beat their benchmark? There is no reliable incentive in place to drive that outcome.
4. A background on mutual funds might help elucidate things….
When the first mutual fund was offered in the US in the 1920s it was difficult for the average person to obtain reasonable information on publicly traded financial instruments. Let alone, create a diversified portfolio of financial instruments.
In the 1980s & 1990s mutual funds really took off. Why? First, there was in place a tremendous equity (and bond) bull market for many of those years. So naturally money which had been in bank accounts, CDs, etc found its way toward mutual funds. Second, the section of the IRS code which allows 401(k)s was enacted in 1978 & then “discovered” as a tax-advantaged retirement savings vehicle in 1980. Until a few years ago the mutual fund industry had a virtual lock on your 401(k), 403(b), 457 plans. Third, there were several funds which dramatically outperformed the market. That, along with a substantial bull-market captured the imagination & many dollars along with it.
Now, consider the fact that the ’80s saw explosive growth of mutual funds and company managements began to respond to these large holders of their stock on a more active basis. They would travel to the cities where the funds were managed & meet with the portfolio managers & analysts. This was not common practice prior to the growth of the mutual funds. At one point it was a novelty for fund managers to travel to company HQ to meet management.
As these relationships evolved, a level of trust and rapport would develop which would foster even better dialogue. Again, nothing wrong with it at the time. There are actually great benefits on each side to having a good relationship (for the company dedicated shareholders and less volatile stock maybe even higher valuation; for the fund managers the best knowledge available in the hopes of realizing better returns). But how far did this rapport go?
Before 2000, it was perfectly legal for Peter Famous Fund Manager to call up CEO of Super Market Cap Inc (SMC) after their quarter ended & several days before they were going to report & have the following conversation.
Peter: “Hey CEO, how’s business? Everyone says you might post 50 cents this quarter.”
CEO: “Gee Peter, great to hear from you. Hope your firm is doing right by my employees’ retirements.”
Peter: “Trying our best. Now how about that 50 cents, reasonable?”
CEO: “Good to hear, my folks have worked hard this quarter. Seems like 50 cents and maybe a little more. Our new products are selling almost as well as your funds. That trend could continue for some time.”
Peter: “Great to hear. Let’s talk if anything changes.”
…it’s not to say these conversations did happen, but there wasn’t much to prevent it. Prior to Regulation Fair Disclosure (ratified by the SEC in October of 2000, commonly known as “Reg FD”) there was a certain informational advantage to be had.
There were a number of mutual funds and their managers who gained great notoriety for their performance in the ’70s, ’80s, and ’90s. But where have they gone? Did they all retire? What about the managers that are still in it & now suddenly look human? Unfortunately, whatever the reason, the results have been quite poor for mutual fund investors.
The world has changed since mutual funds more commonly outperformed the indexes. Today, one can easily purchase a diversified asset for much lower cost…low-cost mutual funds, index funds, ETFs. Today, there’s plenty of information about companies available. The combination of “Reg FD,” technology, and discount brokerage (allowed in part by deregulation of brokerage commissions) have all dramatically leveled the field.
There is definitely a place for good mutual fund managers. But, until the incentive system is aligned with the interest of their investors, we believe there are more effective investment solutions.
* The average actively managed US stock fund has an expense ratio of 1.24% as of the 1st quarter of 2015.