Be careful when you are being sold mutual funds (equivalent to unit trusts in Singapore).
Since you do not have the expertise and time to invest on your own, you may feel it is better off to leave your money with the professional fund managers who do it full time. It seems like an easy way out, but there are 5 important issues that you need to understand before you think it is the best way for you to invest.
1) Most actively managed funds cannot beat the benchmark or the index over the long run
John Bogle, the founder of Vanguard funds and a strong supporter of index funds, analysed the performance of US mutual funds in the 36 year period from 1970-2006. At the start of 1970 there were 355 equity funds.
By 2006, only three out of the original 355 funds beat the index consistently over the 36 year period. Hence, your chance of picking the 3 winners is 0.8% and how slim is that?
You can easily beat 352 funds by buying the index fund instead.
2) High fund management fees eats into your earnings
This is one of the reasons why it is so difficult for funds to beat the index because the annual management fees (2-3%) reduces your returns.
Moreover, the fees are fixed no matter how the fund performs – even if the fund had a negative return, the manager still gets paid. Overtime, compound interest can aid you but on the other hand, your annual fund management fees can compound against you as well.
3) Randomness of the market
Burton Malkiel (author of the once controversial book, “A Random Walk Down Wall Street”) and many other efficient market believers feel that you cannot predict the market and profit from it.
Fund managers are therefore, no different from monkeys throwing darts to select the stocks to buy. They may have their own investment system and philosophy, but they cannot disprove the luck factor in their success or failure.
The randomness was further addressed by Nassim Taleb in his book, “Fooled by Randomness”. He mentioned that randomness very much determines the success or failure of managers. To answer how some managers managed to be spot on in stocks, he drew the analogy of coin throwing where everyone has a 50% chance of the correct answer.
For e.g., we begin with 100 managers, after 1 throw, 50 managers (50%) were right. After second throw, 25…third, 12… fourth, 6…. fifth 3. Thus, this is a simplified example of how the top 3 funds can be spot on for 5 years in a row.
So how long more can they sustain their luck? It can be the moment you put your money in, they start to choose the wrong side of the coin.
4) Restrictions for fund managers
Fund managers have restrictions on what they can invest in according to the promise and description of their respective funds. Even if a golden opportunity comes knocking, they may not be able to seize it due to these restrictions.
Secondly, if a particular sector or country is undergoing a downturn, they may have to stay invested as stated in their fund objectives.
An additional problem also arises when the popular fund gets too big – they have too much money and they cannot just sit on the cash. They are thus pressured to keep the money invested even when there are no good options.
In the end, they may end up with second rated investments. It just goes to say, the restrictions and pressures are piled on top of the effect of randomness to make managers more difficult to beat the market.
So, if you’re thinking about buying into ARK invest, you might want to research deeper and see if you’re truly confident of their investment strategy.
5) Sales charges
Like management fees, sale charges (when you buy and sell) eats your earnings away.
It is true that there are few funds that can beat the market each year (and it is often true that this year’s top 5 funds will not be the next year’s top 5). You may believe that you just need to identify these top funds each year, you can earn big gains.
As we know that there are hundreds of funds out there, your chances of finding the top performing ones are slim. Coupled with the fact that you buy sell frequently, you incur many sales charges, which greatly reduces your returns even if you managed to pick one or two correct ones.
In the future, if someone tries to sell you mutual funds, maybe you can pose these challenges to them. I think if they can defend their products convincingly, they deserve your investment.
Even this famous fund manager agrees…
Reading Peter Lynch’s “One Up on Wall Street” rekindled my thoughts on mutual funds.
As a fund manager, Peter Lynch believes an investment professional may not do as well as an ordinary retail investor. In his book, he provided elaboration that was not covered in my post and it was his view from the inside that made it even more convincing.
Here’re some takeaways:
1 – Analysts may not be qualified after all
Peter Lynch was hired at Fidelity (a fund management company) as an intern while he was at Wharton University. He sounded very critical against the investment professionals like the research analysts (which I believe not all are bad):
“Summer interns such as me, with no experience in corporate finance or accounting, were put to work researching companies and writing reports, the same as the regular analysts. The whole intimidating business was suddenly demystified – even liberal arts majors could analyze a stock.”
He even called professional investing an oxymoron but redeemed himself speaking of a handful successful ones like John Templeton, Warren Buffett and a few others.
2 – Professionals are slower to recognize business success than commoners
He argued that it takes a longer than desired time to identify a business that has tremendous growth potential. He termed it “Street lag”. “Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.” He substantiated with the example of The Limited, where many analysts missed the stock in it’s early days. It was up eighteenfold from 1979 to 1983, but only 6 analysts were tracking it from 1981. It was only until 1985, the stock came under the radar of the analysts and institutions chased after it at $15, up from the initial 50 cents.
He reckoned that many commoners visiting any of the 400 The Limited stores back in 1981 would have realized it’s thriving business earlier than the professionals.
3 – The need to keep his job
Fund managers have big clients and bosses to answer to and they have to justify for their fund performance and stock selections to these people. “With survival at stake, it’s the rare professional who has the guts to traffic in an unknown La Quinta. In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Succes is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”
“If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with the damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?””
In other words, fund managers find it easier to justify their losing positions on big recognized companies than losing positions on almost unknown companies. And it is often that the greatest growth comes from the small companies.
Hi Alvin,
Its been awhile. Hope you are well.
I must say that UTs did it for me man… I started off with UT and learned the ropes from 2000 – 2006. I made enough to pay off more than half of my house mortgage.
UTs have its advantages.
I got into a BRIC fund around Mar this year, within 4 months I was looking at 40% profits.
UTs gives me access to some counters and exposure that I could not have normally gotten.
It has its downside, but if you managed it well like all things, it can do wonders.
Cheers!
Please allow me to correct myself, I meant Mar last year.
The market took a beating then.
Happy that it worked for you.
Mar and Apr in 2009 was the market bottom. And market recovered almost 100% by end of 2009.
I believe BRIC fund giving 40% is below the market rate. But nonetheless, 40% is still good money 🙂
Thank you for the interesting read. I believe all of your points are valid and are definitely something I would ask myself if I was about to invest in a fund (choosing between a mutual fund and an ETF). However, below are a few counterpoints that I feel need to be mentioned for the sake of accuracy:
1) As stated in “A Random Walk Down Wall Street” (a book you mentioned) and a number of other prominent books, most funds are unable to beat the market in the long run. However, there are funds that manage to outperform the market (in the long run) , and while they are relatively few in terms of percentage of all the funds available, I believe one of the most crucial tasks a mutual fund/unit trust consultant or a financial planner needs to help an investor with (besides determining the right level of risk to be taken, of course) is to dig up these few well-performing funds and suggest them to the client. Of course, this doesn’t happen every time (or most of the time?).
2) Management fees should be justified by and potentially tied to the long-term performance of a fund (compared to a relevant benchmark) – I absolutely agree with that. However, I don’t agree with the note “even if the fund had a negative return, the manager still gets paid”, because if a fund’s return is negative, this doesn’t mean anything on its own. If the S&P is down 30%, and a mutual fund invested in US equity managed to keep the losses at -5%, that would actually be positive performance.
3) The efficient market hypothesis (EMH) is a very controversial matter in the finance world, and much more empirical evidence exists against it than in its favor, and the ratio is constantly growing in favor of the anti-hypothesis stance. What could be agreed on in terms of the efficient market hypothesis is that as long as investors’ behavior is rational (i.e. profit-maximization is the main objective), and a market is liquid, there will be some imaginary equilibrium stock price to which the stock will sooner or later rebound every time it goes one direction or another as a result of incoming information. This is exactly the same as the intrinsic value of stock suggested by Benjamin Graham, and is something Peter Lynch likes to refer to as “correction”. In this sense the EMH is not incorrect. The main point which the hypothesis got wrong is the part where it states that through fundamental analysis (or any kind of analysis for that matter) an investor cannot achieve superior results in the long run, especially in the so-called “strong efficient” market environment. On this matter I suggest reading the 1984 article “The Superinvestors of Graham-and-Doddsville” by Warren Buffett (you can find it here: https://www8.gsb.columbia.edu/rtfiles/cbs/hermes/Buffett1984.pdf), which pretty clearly proves that the randomness theory cannot be applied to stock market performance in the long run (in the short run it definitely can).
4) I absolutely agree that one of the biggest downsides of investing in a mutual fund is that usually the limitations to what the management of the fund can or cannot do in terms of investment decisions are huge. Of course the reason for that severe regulation is the nature of a mutual fund itself – a large pool of money of an equally large number of small, usually financially unsophisticated investors. Here comes another important job a unit trust consultant or a financial planner needs to do – advise a potential investor on which type(s) of funds an investment should be made in according to the timing of the investment. My personal preference would generally be towards funds that have more freedom per their prospectuses, but funds in industries in which a rebound is expected and NAVs are still low could also be considered, depending on a number of additional factors.
5) Obviously a sales charge needs to be worth it for an investor to pay it. That is why if I wanted to invest in a mutual fund I would ask the agent tens of questions and only when I was sure that the person knows his stuff and he is dealing in my best interest would I put my money in the funds he/she suggests to me. The worst thing one could do is buy a fund (or pretty much anything) just based on the fact that it is his/her auntie or friend (or friend of friend) that is selling it.
One more important factor not mentioned above is that it is part of a unit trust/mutual fund consultant’s job to review on a regular basis the portfolio of an investor and suggest adjustments or outright changes where and when necessary. Thus, it is generally not necessary for one single mutual fund to outperform the market in the long run. It is more important that an investor invests in the right funds at the right time, which might be one and the same fund all the time, or it might be different funds at different times depending on the stage of the business cycle in which a fund that invests in particular types of stocks is.
Overall, if a person wants to put in zero effort in figuring out how to best invest their money, ETF is by far the best option if an investor is ready to keep their money invested long-term (if they would pull them out during the first crisis, then it’s a very bad option for them). However, if they get a consultant who would serve in their best interest and who understands their job, they would definitely stand a chance to get a long-term return of more than what they would get from an ETF. It really boils down to how well a person does his/her due diligence (both the investor when choosing a consultant, and the consultant when advising), rather than to how near-randomly difficult it is to find those elusive funds that manage to outperform the market long-term. At least this is my opinion.
Thanks for writing a detailed view of yours. Appreciate the effort.
1) Picking the ‘right’ fund might be as difficult, if not, more difficult than picking a right stock.
2) Warren Buffett actually bear some of the losses with the clients when he loses money, which was early in his partnership days. We also know a hedge fund that only charges performance fee and zero management fee. So there are people out there who do it.
3) We do not believe in a pure EMH. Agree that EMH is stronger for liquid and highly researched stocks, and less so for the neglected ones. We believe in factor based investing, value / size / momentum / low volatility / quality factors. And the good thing is that there are smart beta ETFs to exploit these excess returns. Which brings me back to the point that expensive funds are less justified now than ever.
4) no comments
5) agree. The most difficult question to answer is how much fees is worthwhile? Or in other words, how much more to pay for how much excess returns?