The Evidence Against Actively Managed Investment Funds Is Staggering

Hannah Johnston/Getty ImagesThe 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:

1. 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.
2. 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%!
3. 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,quot;**Where are the Customers' Yachts**quot;?
4. 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.
5. 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.
6. The 'Star' Issue. Evidence is growing that traditional 'star' stock picking fund managers like Bill Miller and Anthony Bolton are struggling to adapt to the evolving 'risk on, risk off' market structure. Many have been registering significant underperformance in recent years.
7. Time Weighting of Performance. The average dollar invested in a fund radically underperforms the reported return. This is primarily due to the fact that funds report their returns in a time weighted rather than dollar weighted fashion - a statistical trick chosen to inflate apparent returns to potential investors.
8. Mean Reversion. Attracted to a fund with strong historic returns? Don't be returns have a tendency to mean revert and underperform in future. A recent study showed that quot;when managers were compelled to invest extra cash from investor inflows in stocks, they were unable to beat the market.quot;
9. Redemption Delay. It can often take days or even weeks to sell a fund. As many investors found out to their great cost in the credit crunch, in times of poor liquidity the possibility of getting your money out of less liquid funds at all can be significantly reduced!
10. Lack of Transparency. While some funds do publish their 'top holdings' many funds are clothed in secrecy begging the question of what is it that you actually own? The Bernie Madoff saga clearly showed how such a lack of transparency can end disastrously.

As we've discussed elsewhere, the reason fund managers can't beat the market is NOT because the market is unbeatable. Essentially, as John Bogle has always explained, the fund management industry shows evidence of institutionally bad decision making, herd behaviour and excessive compensation. If investors are looking for long term security, then they should take matters into their own hands by learning to invest their portfolio themselves.

If you can't find the time and discipline to dedicate to stock market investment (which is probably likely!), we still recommend investing in the stock market, but you should focus on the very lowest cost passively managed funds. ETFs and Index funds are the best bet and have been shown to beat 75% of actively managed funds. Warren Buffett has been quoted as saying quot;If you have 2% a year of your funds being eaten up by fees you're going to have a hard time matching an index fund in my view.quot; In fact, Warren Buffett believes so strongly that index funds will beat hedge funds over the long run that he's even put a $1m bet on the Samp;P500 beating a fund of funds over a 10 year basis.

The good news is that the growing social clamour over high fees and excessive pay is leading to an increasing number of low cost ETFs and quantitatively managed funds hitting the market for investors. The future certainly is looking a lot brighter for investors in funds, but stay vigilant, always think of the costs and think before you act!

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