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Investment Management Incentive

Investment management is not necessarily looking for the same performance of your assets as you are. It is looking at your assets as a business in which it can prosper regardless of whether you make money. Depending on the type of management, this profit incentive can work against you.

Mutual Funds and Professional Management

At one time, in the ’50s and ’60s, when giants such as Dreyfus and Fidelity were rapidly growing, the incentive to attract assets, as with hedge funds today, was the performance of the fund. It was this background that generated the Peter Lynches and Gerry Tsais who had high-profile performance far outstripping the market averages. However, these managers were few in number, and when other funds attempted to compete, they could not find managers who could perform much better than the market. At that point, different methods of sales and marketing developed. Fidelity and other fund management companies, for example, spent money on advertising and formed new funds every year to soak up the money intended for each investment fad. Different industry groups or themes come and go as “hot” industries in the markets. For example, if airline stocks are strong, people generally want to buy airlines. Fund management formed an airline fund to soak up that demand. Never mind that when the public finally recognized that a new trend was in process, it was near the end of the trend instead of at the beginning. To fund managers, the industry fad was irrelevant. To them, the money (your money) was captured and paying a fee. Later, when a new industry fad roared, your funds easily could be switched to another newly created fund, and the fees derived from this captive money would continue to flow to fund management.

When brokerage commissions declined, other mutual fund management companies developed close relationships with stockbrokers, who, for a portion of the trading commissions (until they became too small) and a portion of the sales fees, would push the funds to their clients. To some extent, this method still exists today. When the SEC discouraged these kickbacks, the brokerage firms and banks began their own in-house funds and pushed their clients into them, capturing both the management fees and brokerage commissions. However, neither the fad fund nor the brokerage sales methods were, or are, beneficial to the interests of the client. Indeed, they almost guarantee that the client’s investments will fall behind in performance because of the high costs and poor management. In Table 1.1, I show the possible fees you may pay for the privilege of owning a mutual fund. Not all funds have all the fees outlined in the table.

Table 1.1. Mutual Fund Fees

Mutual Fund Fee

Brief Description

Sales loads, including Sales Charge (load) on purchases and Deferred Sales Charge

Brokerage sales charges come in two forms: 1. a charge when you buy the fund (front-end sales load) or 2. a charge when you redeem the fund (back-end sales load). The front-end load means you have less of your money invested in the beginning. The fund must perform well before your investment is even. This is limited to 8.5 percent.

Redemption fee

Fee paid to compensate the mutual fund for costs associated with the redemption. This is limited to 2 percent.

Exchange fee

Fee paid for transferring to another fund under the same management.

Account fee

Fee paid for maintenance of an account.

Purchase fee

Fee paid for purchasing shares that goes directly to the fund, not a broker.

Management fee

Fee paid for management of the fund.

Distribution (12b-1) fees

Fee paid for distribution expenses and shareholder service expenses. Distribution fee includes marketing and selling fund shares (using your money to raise more money for management) and is limited to 0.75 percent. Shareholder service fee for responding to questions by shareholders and is limited to 0.25 percent. (In 1997, $9.5 billion in these fees paid by mutual fund invesors.)

Other expenses

Expenses not included in management or distribution fees, such as custodial, legal, accounting, transfer agent, and other administrative expenses.

(source: www.sec.gov/amswers/mffees.htm)

Most investors do not consider the motives of money management firms competing for their accounts. In the past, for example, stockbrokers made their income from commissions on trades. Performance was not as important to them as the number of buys and sells they could generate. It was called “churning,” which is a terrible (though profitable) incentive that encouraged high turnover in accounts and worked directly against the interests of the client because commission fees were high. Today, these commission rates have been reduced to extremely low levels and are no longer a major concern to investors. To combat this decline in income from commissions, stockbrokers have joined with the mutual fund industry (directly or indirectly) and are now interested in how much of your assets they can gather under their management. Their economic incentive is the management fee, wrap fee, or 12b(1) fee. John Bogle, in a 2003 interview with Motley Fool, said:

  • “It [the mutual fund industry] has a profound conflict of interest between the managers who run the funds and the shareholders who own them ... Management fees in this industry run about 1.6 percent for the average equity fund. By the time you add in portfolio turnover costs, which nobody discloses, the impact of sales charges and opportunity costs because funds aren’t fully invested, and the out-of-pocket fees, you are probably talking about another 1.4 percent of cost, bringing that 1.6 percent management fee or expense ratio up to 3 percent a year. That is an awful lot of money.”

At least in the old days, brokers had to know something about the markets. Today, the markets are almost irrelevant to them. A broker is more interested in getting your money under house management and collecting his percentage of the management fees; and, by no small coincidence, the types and names of the fee charges are staggering and complex. A broker doesn’t need to know about markets, just as a car salesman doesn’t need to know the intricacies of an engine, but a broker does need to know about financial jargon to impress you with his “special knowledge.” As a test at your favorite brokerage office, ask how many of the brokers receive the Barron’s Financial and actually read it. You will be surprised at how few modern brokers closely follow the market. It is unconscionable that brokers generally have separated themselves from direct contact with the markets and are now so closely involved in selling investment management by others.

The incentive of payment for gathering assets under management is also not in the best interest of the client. Fees have tripled since the late 1960s. When I began in the business in 1966, ½ of 1 percent of stock assets and 09fig01.jpg of 1 percent of bond assets were the standard fees. Compare those fees with the 2 percent or higher fees of today when performance has not improved at all. In addition, these fees are unrelated to the success of the client’s asset growth. They are flat fees, paid regardless of whether your investment in the fund rises or falls. The fund can perform poorly, but as long as new assets are added to the fund pool, the fund management profits despite the performance for the individual client. Today, the definition of “broker” is what you will be when these modern-day experts are done with you.

The management of your investments on a fee basis only is not necessarily in line with your objectives. You pay the fee whether you profit or lose. There is no incentive for the manager under such an arrangement to perform better than the markets. He is paid no matter what happens. The better fee arrangement is when your manager profits when you do and doesn’t profit when your investments fall behind. In this arrangement, you and the manager are on the same side and your fortunes should coincide. Unfortunately for you, but fortunately for the investment management business, the Investment Act of 1940 prohibits this arrangement. When challenges to the act are raised, the mutual fund industry fights vehemently against them. Quite obviously, they prefer the current arrangement of profiting despite your success or failure.

Hedge Funds

The hedge fund industry began as a way of avoiding the 1940 Act. Hedge funds enable the manager to participate in profits and to use investment methods, such as short selling, that are otherwise prohibited. A hedge fund is simply a partnership arrangement between limited partners, the investors whose legal risks are limited, and the general partners (the managers who profit above the investors when the fund does well). The partnership avoids the restrictions of the 1940 Act by operating outside of it. The hedge fund industry has grown considerably since the days of the original fund created by A. W. Jones who used the classic hedge fund formula that bought strong stocks and sold short weak ones.

The name “hedge fund” has remained for most investment partnerships, regardless of their investment style or methods. Because the incentive of participation in profits is attractive to investment managers, and was especially during the great bull market of the 1990s, many managers quit the mutual fund industry and began their own funds. They wanted to profit from their decisions rather than receive just a salary and perhaps a year-end bonus. Unfortunately, the Securities & Exchange Commission (SEC) impose limits on the amount of money an individual can invest in these funds, usually a million dollars, putting such investments out of the reach of most people.

There are developing problems in the hedge fund industry as well. Fees are still very high, often 2 percent of assets invested in the fund plus 20 percent of the profits. In addition, because the fees are so attractive to investment managers, the industry has attracted some less-than-scrupulous people. Finally, the market no longer rises every day as it did in the 1990s and easy money is no longer available. Indeed, average hedge fund performance over the past five years is only slightly better than that of the stock market. This means that fund managers will take larger risks with your invested money because they want more than the fixed fee. Generally, they risk the assets of the fund with leverage (borrowed money, sometimes as much as 200 to 1,—that is for every dollar invested they borrow $200) and open themselves to the risk of failure. If they fail, you lose, and they generally walk away.

ETFs (Exchange Traded Fund)

In recent years, tradable securities called ETFs (Exchange Traded Fund) have been introduced to replicate the action of stocks in a known or associated basket. The securities or commodities in the basket are known to the ETF buyer, and unlike mutual funds, they remain in the portfolio. ETFs can be bought long, sold short, margined, and may even have tradable options and futures. Standard orders, such as market, stop loss, and limit, may be used that are not available for mutual funds. They are priced immediately in the marketplace, not periodically as in mutual funds, and there is no minimum investment required. The components of each ETF follow themes as different and diverse as the Brazilian stock market, high growth stocks, the S&P 500, utilities indices, commodities such as gold or petroleum, and even municipal bonds. The number of possible themes is limitless; thus, these instruments have been introduced at a speedy rate. The costs of ownership are less than mutual funds because there are no high-priced managers (the portfolio is run by a computer). ETF operating costs are usually between 0.1 percent and 1.0 percent. They are generally easy to buy and sell because they are listed on exchanges and Nasdaq, and brokerage costs to trade them are low. Finally, they are taxed for capital gains like a common stock, unlike a mutual fund that must distribute net taxable gains through to you, the shareholder, despite the performance of the fund. You may invest in them based on a theme or as a hedge against an existing portfolio, or you can trade them like stocks. Investment in them is either mechanical as a hedge against another investment, purely technical as is used in a trading system, or speculative as a concentration in a specific theme.

If you insist on owning different funds, perhaps because it is easier and less expensive, the ETFs are far superior to mutual funds. Just remember that with ETFs, you still need a method to decide when to buy and when to sell as they come in and out of favor.

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