Active mutual fund managers are getting desperate. Their latest gimmick to keep you in the fold is to offer “performance based” fees. Don’t fall for them.
Performance based fees
Investors are savvier these days. They recognize the importance of fees, placing pressure on high-fee actively managed funds.
While the details vary, the underlying premise of performance-based fees is similar. If the fund manager beats a designated benchmark, he (or she) gets higher compensation. If there’s underperformance, investors pay lower management fees.
In theory, it sounds good, but let’s take a closer look.
The premise is flawed
The premise of performance-based fees is that motivating the portfolio manager with higher compensation will result in higher returns.
Markets are highly efficient. There’s little credible evidence that active mutual fund managers can add value by stock picking or market timing, regardless of their motivation.
Every year, a minority of active funds outperform their risk-adjusted benchmarks, but the data on persistence is not encouraging, especially over the long term.
It doesn’t matter how incentivized active fund managers are. It’s highly unlikely they will generate returns higher than you could obtain by buying a comparable, low management fee index fund.
The temptations are great
If there’s money to be made, you can count on Wall Street to find a way to skirt ethical constraints and go for it.
With performance-based fees, unscrupulous fund managers can hype their returns by comparing themselves to the wrong benchmark or taking more risk.
If the right benchmark is the S&P 500 index, a portfolio manager who uses a risker benchmark in a rising market can easily show outperformance, justifying higher compensation.
It’s difficult for investors to monitor “style drift”, where the fund manager starts out by tracking the correct benchmark, but then “drifts” and takes more risk than originally represented.
No accounting for underperformance
Read this quote from The Financial Times on October 23, 2016 carefully and then post it where you can re-read it.
The suitability of investing with asset managers that try to beat the market has been thrown into question by figures that show almost all US, global and emerging market funds have failed to outperform since 2006.
When an actively managed mutual fund with performance fees underperforms, the fund manager and the fund family still get compensated, albeit at a reduced level.
What about the investor? They’re not compensated for underperformance.
For fund families, performance based fees are a “win-win.” Their downside is lower fees, not being held accountable for losses.
If you must invest in actively managed funds, choose those with management fees comparable to index funds. There’s ample evidence lower fees correlate directly to higher returns.
Do-it-yourself investors would be well advised to invest in diversified, low management fee index funds.
Investors who use advisors should consider passively managed funds that tilt portfolios towards factors research has indicated are likely to generate higher expected returns over the long term. The leading passively managed fund family is Dimensional Fund Advisors. Access to its funds is only available through authorized advisors. You can find an advisor with access to Dimensional funds here.
Resource of the week
This article by financial author, Larry Swedroe, provides ample evidence explaining why most actively managed funds fail to beat their benchmark.