I was interviewed recently by a major financial publication.  The reporter had read one of my articles bashing the media for generating misinformation harmful to investors.  One example I used was the endless parade of active mutual fund managers, giving their views on the direction of the market or which asset classes were likely to outperform.

I noted that journalists, who are typically skeptical, accept these views without questioning whether those espousing them have any legitimate basis for their musings.  When is the last time you heard a fawning interviewer ask a fund manager:  What is your track record for making accurate predictions?  Or, can you explain why your fund has consistently underperformed its benchmark index?

A bigger issue

One reason for this charade is simply “money.”  The securities industry is a huge advertiser.  The media is not eager to bite the hand that feeds it.

All this begs a question that has always troubled me:  Why are active fund managers so well compensated since the majority of them have dismal performance records?

An unsurprising conclusion

I found the answer to this question in a recent study that analyzed the mutual fund industry in Sweden.  The authors found only a weak relationship between performance of the fund and compensation of the fund manager.  In fact, even strong outperformance didn’t have a significant impact on manager compensation.

What caused a meaningful bump in manager pay was an increase in assets from investors in the fund.  Apparently, fund managers are paid to market the fund; not to beat their benchmark.

That’s a stunning finding, but it makes perfect sense.  Most fund managers can’t talk about their track record.  They don’t have predictive powers.  They don’t have the expertise to reliably and consistently pick outperforming stocks.  So how do they market their funds?

They pretend to have these abilities.  They have great credentials.  They are well spoken and expensively dressed.  It’s easy to believe they know what they’re talking about.

But it's all part of an elaborate wealth transfer scheme.  No one asks them the kind of questions that would expose the fact that they are emperors with no clothes.  A percentage of viewers will be impressed enough to give them money to “manage.”  These gullible investors don’t understand they would likely attain higher expected returns investing in a low-management fee index fund.

The fund achieves inflows.  The fund manager gets a boost in pay.  Everyone’s a winner.

Except you.

Resource of the Week

This article in BloombergView discusses the study of mutual fund manager’s compensation in Sweden.

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