The amount of evidence stacking up that hedge funds, mutual funds and even private equity do not provide value for their investors is just staggering. The latest figures reported in the FT showed that 70% of the profits of private equity had been gobbled up by the managers rather than the investors. While there are certainly signs that the public's tolerance of excessive fees and executive pay is falling, the likelihood of significant structural change in the finance industry is still remote. Given such a backdrop the probability remains that investors in funds will on average continue to underperform their benchmarks. So what is an investor to do?
We still believe that individuals who have the time and discipline to do their own research and think outside the box should look to invest the equity portion of their own funds directly in the stock market. We appreciate that not every investor has the interest or inclination to do this but a few more might be likely to if they seriously considered how compromised the alternative is.
Here follows a rundown of ten key reasons why investing in managed funds is such a losers game and then we propose a few alternatives:
- Underperformance. It has been shown that 75% of investment funds under-perform the stock market averages over the long term, not least due to the compounding impact of high fees and trading commissions.
- Hidden Costs. The real cost of owning a fund is not published - it is hidden away as reduced performance. Once transaction costs, tax costs, cash drag, soft dollar arrangements and advisory fees are added to the published expense ratios the total annual cost of owning a fund can be over 4%!
- Agency Issues. Most fund managers typically get rich on fees rather than from making good investments skewing their incentives towards asset gathering and retention rather than investment performance. As Fred Schwed wrote back in the 1940s,"**Where are the Customers' Yachts**"?
- Size Bias. Due to the above, institutions often get too big to invest meaningfully in smaller companies which much research has shown offer the best opportunity for outperformance.
- Career Risk. Fund Managers' careers may be at risk if they don't report consistent quarterly results. This bias promotes short termism, over-trading, 'herd' behaviour and the chasing of momentum stocks which can often end catastrophically.
- The 'Star' Issue.…