In 2008-2009, my wife and I felt the urge to connect with the mother country, and decided to spend a year at the heart of the old British Empire, London.
We were a bit younger then, recently married, and without children, and if I was asked the question I would have to say that that was the best year of my life so far. It’s not that my life isn’t good now (it’s great actually), but the sense of freedom and adventure was something that I haven’t been able to match ever since.
I will elaborate on our time in the UK in later posts, but with the investment slant of many PF blogs (including this one), I am often surprised at the lack of knowledge/understanding of some key criticisms that I have of the whole managed fund/mutual fund industry. I’m therefore hoping that I can at least enlighten people about some of the key downfalls of managed funds from my exposure to them.
My experience in the managed fund industry
When we arrived in London I was very fortunate to be given interviews with two Wall Street banks and offered a job with one of the most prestigious banks in the world in their asset management division. Coming from a Big 4 accounting background I didn’t know a lot about investment banking, but figured that the role sounded alright, and the money was pretty damn good, so I thought I would give it a shot.
For those of you who don’t know, “Asset Management” is just another term for the “Managed Fund” or “Mutual Fund” division. My bank had a stack of managed funds with a lot of Funds Under Management (FUM), which pre-Global Financial Crisis (“GFC”) was somewhere around US$50bn. There are certainly bigger fund managers around, but we still had a good critical mass of funds from mainly large institutional investors like pension funds.
Some (not so good) things I learned about managed funds
Early in my career I had personally invested in managed funds before switching my investments to real estate (taking advantage of the Australian property boom of the early-mid 2000s), and this experience really opened my eyes to a number of things that outsiders wouldn’t know and would be quite disappointed to find out about managed funds.
I have put together a list below of some of these concerns, and while I am sure that not all funds have these issues, plenty of them would:
- Investors from multiple jurisdictions just increase costs: As many funds can have investors from all over the world, they will often have to comply with tax regulations of the countries in which the investors are domiciled, which greatly increases the compliance burden and the risk of NAV (“i.e. Net Asset Value”) errors. Do investors really know that the management fees are so high just to pay these costs?
- “Equalisation” (or lack thereof) means that some investors can be unfairly allocated a higher share of the taxable income of the fund: Many European countries give the option of not applying “equalisation”, which is where the investors in a fund are fairly attributed their share of the fund’s taxable income irrespective of whether they entered or exited the fund during the year. In Australia this is worked out accurately on a pro-rata basis. However, if “equalisation” is not applied for European funds (and it is not for many of them due to the additional cost), in the case of where many investors leave a fund, a small number of investors left at the end of the year can be attributed an excessive share of the fund’s income for tax purposes, which is a pretty crappy outcome for them.
- Huge tax compliance burden from multiple jurisdictions: Tax rules for some jurisdictions vary greatly. German tax in particular with respect to “German Tax Transparency” (which I understand is sort of like their version of “equalisation”) was very costly for our funds in 2008. Most funds must apply for “German Tax Transparency” as a way of attracting investors, however in 2008 this actually resulted in a worse tax outcome for all investors, and so the fund would have been better off not applying for transparency. However we could not change this stance as the sales staff said it would have made it very difficult for them to attract investors in future even if we went back to transparency in future years. Too bad about the investors, hey? It’s all about attracting the new money to the fund.
- Inaccurate accounting: Some funds suffer from serious problems due to estimates with accruals, which if inaccurate can result in unfair allocation of fund income where investors have left funds and aren’t around to receive the benefit of adjustments later on. One fund was paying regular cash distributions for a whole year but then when audited it was found that the fund hadn’t actually made a profit and the distributions were therefore illegal. Some investors had also left the fund in the mean time so there was still no decision on how to correct the situation. Can you believe that this can happen in such huge organisations?
- Money Market Funds – what is the point? Money market funds are often used by institutional investors without actually considering why they are using them. These funds purchase government and other debt (sometimes Asset Backed Securities), pay interest daily and therefore have a stable Net Asset Value (“NAV”), and allow investors to enter and exit a fund with little notice. However, when the US dropped cash rates to zero on their treasury bonds in 2008, some money market funds still subscribed to these bonds. This resulted in some funds having large assets that were paying no interest, yet they still had to cover fund expenses, therefore producing a negative yield. It appears as if sometimes people don’t sit back and look at the bigger picture and question “why would I invest in this when I could just put the cash in a bank that has an unlimited government guarantee?”
- Investing in countries with unclear or yet-to-be-determined tax regulations: One of our funds invested in China where we understood their “capital gains tax” regulations still hadn’t been written. The fund therefore had an accrual on real estate investments it held (“land-rich companies”) for capital gains tax, however this was not accrued for over two years. This resulted in a huge NAV error, and where investors had left the fund already we had to request that they pay back large sums of money to cover the accrual, which may not end up actually being payable. What a mess!
- Multiple similar funds for no apparent reason: We had many funds open that were extremely similar, and it appeared as if there were times when no-one could actually justify funds being open. However, the cost of opening and closing a fund seriously affected the decision to keep a fund going, and so logic from an investor’s point of view did not prevail. We really should have consolidated funds to reduce costs for investors, but that would have hurt the bank so we left them as they were.
- Fees to related parties: Most of our funds paid out large sums to related parties, including Investment Manager fees, transfer agent fees, Management Company fees (trustee fees), Directors’ fees, Shareholder services fees, performance fees and custodian fees. Add to this audit fees, legal fees and tax agent fees and a significant portion of an investor’s return is eroded in order to cover our risk management policies. An ordinary individual investor could make the same or better stock picks and not have to cover all of these costs, and if investors knew that this was where their fees were going they would surely choose to invest elsewhere.
- Performance fees: Performance fees are levied when a fund’s performance exceeds that of its benchmark (i.e. the base return that they are trying to achieve), and will normally be around 20% of the excess return over the benchmark. However, if the fund’s performance falls back below the benchmark in the following period then we did not have to pay back the performance fees. Also, if the benchmark return was negative (e.g. -10%), but our return was greater but still negative (e.g. -9%), our bank still received a performance fee. In what world does someone get paid for doing a bad job that just happens to be a less-worse job than others are doing? The Asset Management world!
- Expense caps: Most funds have expense caps, where if a fund’s expenses exceed a set percentage of assets we need to refund the difference to the fund. This tended to be our bank’s only motivation for closing funds – when we were having to reimburse funds back to the fund and this resulted in us not making enough money.
- Poor performance against benchmarks: Most of our funds did not outperform their benchmarks, and were usually well below these benchmarks instead. This was a result of excessive expense ratios in the funds and also poor investment selection. I’m sure the bank’s representatives/sales teams would argue that it was because of market conditions, but the benchmark should reflect current market conditions so this is not really a valid argument. Also, I got the impression that the board were more interested in risk management and getting the financial statements right than the fact that the funds are being poorly managed, as evidenced by the ridiculously small timeslot allocated to discuss fund performance at each board meeting. In my mind the fund performance should have been the most important topic of discussion but this was not the case.
- Tax benefits are often a poor reason to invest: Many funds are set up to supposedly obtain tax benefits from investing in countries that have favourable tax treatments for the funds. However, this still does not address the fact that in many countries, the investor will still be taxed on distributions from the fund, and the only benefit is therefore that there is reduced or limited withholding tax on the distributions received from the fund as they come out of the offshore location. Depending on the countries involved, if a distribution has had withholding tax deducted then it may not be assessable in the investor’s country of residence and the withholding tax credits are not taken into account, however the benefit of this can be negligible and it depends on the Double Taxation Agreement between the two relevant countries.
- Elaborate derivatives – an elaborate scam: Many funds trade in elaborate derivatives, which often do not generate noticeably better returns over other types of investments (e.g. stocks) but do bring about exposure to counterparties (i.e someone else on the other side of the transaction). In the case of the Lehman Brothers collapse in September 2008, the exposure for some of our funds was very significant, with one fund losing 80% of its value (i.e. approximately $80m) as a result.
- Excessive diversification: Almost all funds engage in what I would call “excessive diversification”, where diversification is taken so far that there will be hundreds or thousands of different equities in one fund, when the benefit of diversification could be achieved by investing in far fewer equities. A rational individual investor would choose far fewer equities to diversify their portfolio and this would not result in such significant administration, accounting and auditing costs.
- Churning of positions before reporting dates to cover their backsides: Some funds are required to disclose their holdings at period end and the unrealised gain or loss on these holdings/positions. In order to avoid disclosing positions with an unrealised loss, managers will often exit these positions at the end of the period and then enter back into them at the start of the following period. This avoids the need to disclose the detail of loss making investments, and the loss generated can only be seen in one line in the Profit & Loss Statement under something like “Realised gain/(loss) on disposal of investments”. This strategy also generates increased brokerage revenue for the manager.
- Fund investment strategies reduce their ability to capitalise on obvious opportunities: Most funds have a particular investment strategy that they are required to abide by, even if this is illogical in a given market. For example, with daily management of a fund and with considerable losses being generated throughout 2008 and 2009, many managers could have reduced losses by transferring into cash or instead entering into short positions on common equities (say for large financial institutions, while this was still permitted) to make easy profits. However, most funds have strategies that limit the amount of cash that can be held (or invested in Money Market Funds) or prohibit the holding of short positions, and they therefore had to miss these opportunities and also invest their excess cash reserves in assets that they knew were going to be smashed for some time.
- Board members often have a very different focus to investors: Our funds had very active board members with a particular focus on risk management and therefore accuracy of almost everything each fund did and reported. This varied greatly from funds for other large banks where our equivalent division either did not exist or had half as many people or less. While this focus was admirable in some ways, so much of their time was spent on risk management/compliance and so little on encouraging better financial performance, and I believe they were therefore very “out of step” with what was important to their investors.
So why am I telling you this?
All of this paints a pretty grim picture for managed funds, but the lack of awareness on PF blogs really gets to me so I feel like I need to say something to at least make people more aware.
I’m not telling people this to stop them from investing in managed funds, as they are often the best investment vehicles for people without the desire to learn or the discipline to stick to a decent strategy. But what I would say is do your research into the managed funds you are investing in before you jump in.
A lot of PF blogs talk about Vanguard as the good guys of the industry, and that certainly appears to be true, but I will still steer clear of managed funds when selecting my own investments.
And for your information, I prefer to pick my stocks directly to avoid all of the above drama. I still aim to have a (sufficiently) diversified portfolio of blue chip stocks, which I feel that I can do without having the nasty side-effects of managed funds.