Three managed funds you should avoid

Not every fund manager has your best interests at heart – here are three types to watch out for.

'The number-one job of the hedge fund manager is not to make sure that you can retire with a smile on your face – it's for him to retire with a smile on his face.'  — Mark Cuban

Don’t get me wrong: there are many high-calibre fund managers out there, some of whom I know personally – honest, hardworking, smart, and the type of people you would be happy to have marry into your family.

But there’s no getting around the fact that the industry has its sharks: those who are less interested in building your wealth and more concerned with increasing their assets under management.

Charlie Munger once said ‘All I want to know is where I'm going to die, so I'll never go there’. In that spirit, here are the three types of fund managers that don’t deserve your money.

The Gouger

As with any service, fund managers charge a fee. It may seem trivial – typically ranging from around 0.7% to 2.0% – but over long periods, fees can take a huge bite out of your wealth. The magic of compounding works on costs too.

Let’s assume you have 30 years to invest $100,000 and will earn 9% a year over that time. Paying your fund manager 2.0% would leave you with $761,000 at the end of that period, compared to $1.1 million if the fee had been only 0.7% – a 30% difference in retirement savings.

The average management expense ratio for the 500 largest funds in Australia is around 1.3%. If your fund manager is charging you more than that (we're looking at you MLC, AMP and Perpetual) you should think carefully about the costs and benefits of investing in those funds.

Our own Growth and Equity Income portfolios charge between 0.67% and 0.97% depending on the amount you invest. You can find out about investing in the Intelligent Investor portfolios by clicking here.

The Hugger

The biggest risk facing a fund manager is not losing you money, it’s losing his or her job. And one sure fire way to do that is to go out on a limb and then be wrong.

‘Safety in numbers’ is the catchcry of most fund managers. If both the market and the fund are down by 10%, you wont lose many investors. But if the market is up by 5% and the fund down by 5%, investors will abandon ship.

With this in mind, some fund managers – especially large funds with billions under management – tend to have portfolios that mirror the ASX 200 index, with the manager just fiddling at the edges. This guarantees they will never outperform, but also means they can’t underperform by a large amount. That is, before fees.

The real issue with the ‘index hugging’ fund is that you’re basically getting the market return, but paying higher fees than low-cost index funds, which ensures that you will underperform over time.

Where possible, look at a fund manager’s holdings. If they own 50 or more stocks, and the largest positions are the big four banks, BHP, Rio, CSL, Telstra, Woolies and Wesfarmers, the manager may be quietly trying to copy the index.

That said, concentration adds risk. It’s admirable if a manager is focusing the portfolio in their 10–20 best ideas, but you should be prepared for higher volatility.

The fund of funds

If the Hugger and the Gouger got together, their love child would be ‘The fund of funds’ – a manager whose portfolio is invested in other funds. The strategy seems reasonable enough: if a manager can pick top performing stocks, why shouldn’t they also be able to pick top performing managers?

The first problem is that, collectively, fund managers are too large to avoid buying the biggest stocks. As a group they will lag the market over time because, on average, they can only earn the market return, and then deduct fees. If a fund of funds owns, say, six funds in its portfolio – and each of those funds holds 50 stocks – the underlying portfolio starts to look like the index, meaning there’s no room for outperformance.

The second problem is that you are layering fees on fees because you need to pay each individual fund their 2%, and then pay the fund of funds manager its 2%.

In 2008, Warren Buffett made a $1m bet that the S&P 500 would outperform five fund of funds chosen by a management firm over 10 years. And so far he’s killing it – 66% to 22% at last count.

Bottom line: always read a fund manager’s product disclosure statement, watch out for managers charging fees above 1%, and beware any fund whose holdings mirror the index or include other managed funds and ETFs.

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