Mehrab Irani
Tata Investment Corporation
A common man believes that an investment guru, research analyst, market strategist or for that matter a Fund Manager is invincible. He has a very good educational background, vast experience, an army of personnel to assist him and all the tools required in the world to manage people's wealth in the most effective manner generating above average market beating returns.
But is it really true? Is the Fund Manager really able to beat the markets, year after year? Is the Fund Manager's performance better than the common investor? Is the Fund Manager invincible? Probably not. Because if that were the case, then why over a periods of a decade or more, approximately 75% of all "actively" managed stock funds underperform the passively constructed stock indices? But then why is it so? After all a fund manager has all the wherewithal to be successful and easily win the battle against a common investor – education, knowledge, experience, team, support, resources etc. So, let us now understand inspite of all these added advantages, what are the side-effects of being a Fund Manager which actually stops him from beating the common investor on the street.
Side Effect 1: Outperformance not possible – Humanly
Fund managers suffer from side effect number 1 of trying to consistently and continuously
outperform the markets which are humanly not possible. I humbly submit that it's very difficult, if not impossible, to beat the stock market indices consistently over a longer period of time. Its not possible – humanly. If that were not the case, then why over periods of a decade or more, approximately 75% of all "actively" managed stock funds underperform the passively constructed stock indices. The fact of the matter is that most people have no reason whatsoever to believe that they can pick winning stocks or time the markets and their success at it would be the same as it would be like throwing darts at the financial pages. I would like to quote Dr. William Bernstein who told that "there are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know where the market is headed. Then again, there is a third type of investor – the investment professional, who indeed
knows that he or she doesn't know, but whose livelihood depends upon appearing to know where the market is headed". Nothing more succinctly explains the real world of professional investing and stock picking. Mr. Merton Miller, Nobel laureate and professor of Economics of Chicago commented that "if there are 10000 people looking at the stocks and trying to pick winners, one in 10000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful, but they're really not". Then I would quote Mr. Rex Sinquefield, co-author of Stocks, bonds, ills and inflation that "we all know that active management fees are high. Poor performance does not come cheap.
You have to pay dearly for it". Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices! Then for the investors who are always on the look out for the next hot fund, the next great sector fund or so, Bethany McLean, columnist for Fortune magazine wrote "skepticism about past returns is crucial, the truth is, much as you may wish you could know which funds will be hot, you cant and neither can the legions of advisors and publications that claim they can. That's why building a portfolio around index funds isn't really settling for the average. It's just refusing to believe in magic". And let me further quote Mr. Jon Bogle, founder and retired CEO of the Vanguard group "Index funds eliminate the risks of individual stocks, market sectors, and manger selection. Only stock market risks remain". In other words, when you invest in a passively managed index fund than all the risk relating to the fund manager, his / her stock selection and market timing, individual sectors etc all go and the only risk
which remains is the risk of the whole stock market and that is precisely the risk which would like to expose yourself to when you invest in equities. Nicholas Taleb has written an excellent book titled "Fooled by randomness" wherein he explains the role of chance in life and in the markets and I will recommend that book to anyone who believes that he can consistently pick winning stocks and / or time the markets to perfection. Last but not the least I would like to jot the words of the great legendary investor Warren Buffet who once said that "most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to bear the net results (after fees and expenses) delivered by the great majority of investment professionals".
Side Effect 2: Success linked to "AUM" and not "returns"
This is a sad reality of the fund management industry. There is no strict alignment in the interest of the fund manager and the fund investor. Return is the prime objective of the fund investor while "assets under management (AUM)" is the prime objective of the fund manager. Its simple, for the investor the fund returns is the money what he makes from the investment while for the fund manager his returns are linked to the asset he manages. Hence, there is a clear dichotomy in the structure itself. Yes ofcourse, if the fund performs well than it would be able to garner more assets and thus more return for the fund manager. However, notwithstanding this, the fact of the matter is that in the quest of garnering more assets, funds do compromise on quality and objectivity in the quest for raising their AUMs.
Side Effect 3: Launching NFOs
Today with hundreds of existing schemes is there really a need for a new scheme for the
investor. Is it really that the fund manager is able to offer something new through a NFO. Take the example of equity schemes, today a plethora of funds are available – large cap, mid cap, small cap, multi cap, diversified, sector funds, theme funds, asset allocation funds, growth oriented funds, value oriented funds and many more. So after the availability of such a bouquet of funds is there really a need for a new NFO. Ofcourse yes. There is investor fatigue with the existing funds as their performance would not be up to the mark. Its difficult for the fund distributors to market those funds. However, the fund house has to somehow garner new funds because their return is linked to the AUM. The fund distributor has to sell funds because their commissions and fees are dependent on the quantum of funds sold. So what is the solution out of this deadlock. Simple. Take an old product, give it a new packaging, use heavy impressive financial jargons to lure the common investor and then aggressively sell it through the loyal fund distributors. Although a fund manager may know that there is no need of a new product but then he has to keep launching new products so as to remain in the minds of the investors and garner fresh funds from them. This is yet another side effect of being a Fund Manager.
Side Effect 4: Cannot practice what they preach
A fund manager will educate an investor to be patient with equities as they are ownership in a business which create wealth over the long term. But are they themselves able to actually follow what they preach? May be not always. This is because the net asset value (NAV) of the fund is declared on a daily basis and their performance is measured on a weekly, monthly or quarterly basis. If the fund manager were to follow his brain and do the right investments then his heart would cry as he loses the AUM and probably his job. Therefore, the fund manager has to sacrifice long term value creating investments in the quest for achieving short term unsustainable profits. In the market, while most of the people being successful in the short term, actually end up as losers in the long term and it applies to the fund manager also. This is a very sad situation. A fund manager invariably is forced into this side effect with the result of the investor losing a very good opportunity of creating long term wealth.
Side Effect 5: Advocate Market Timing Funds
Fund managers advice that we should never time the markets. Theories like superior returns from stocks are generated not by "timing" the market but by "time in" the market are propagated. But do these erudite fund managers themselves follow such principles. Not always. This is simply because they themselves advocate "market timing funds". They derive new formulas to invest like dynamic asset allocation funds, low P/E funds etc. These are nothing but market timing funds which aim at investing or changing asset allocation based on some pre-determined formulas. Kindly note that historically we have seen that almost 90% of portfolio variability is due to asset allocation while only 10% of the variability in portfolio performance is due to market timing and stock selection. The only thing in our control is asset allocation and the good news as just mentioned is that 90% of portfolio variability is due to asset allocation. All assets move in business and economic cycles of their own and while one asset might be in a bear market there
might simultaneously be another asset class in a big bull market of its own. The broader asset groups of equities, bonds, commodities and real estate (others being art and currencies) will lead you to the gateway of long term wealth creation and sustenance. Therefore, instead of promoting asset allocation for long term wealth creation, many a times, funds promote market timing fund strategies.
Side Effect 6: Mis-selling of Income Funds
Income Funds are nothing but interest yielding debt products. But, when someone deducts high fees from interest rate then what would happen – substantial fall in the income yields. That is what happens with income funds which are loaded with high fund management expenses. Now, when should you invest in an Income Fund? Investments in income funds should ideally be done when the interest rates are high because of dual factors – firstly, the inherent yield of the income fund would be high which will ensure high accrual income and secondly, if interest rates are currently high then other things remaining constant, there is more likelihood of it going down in the future. However, unfortunately Income funds are not marketed when interest rates are high or moving up. Infact, income funds are widely promoted when interest rates have already moved
down. This is because of faulty outdated advise from fund managers. The reason is very simple – when interest rates have already moved down in the near past, the return from Income Funds would be unsustainably super normal. This high untenable return is then projected as the likely future performance of the fund and sold along with the notion of "safety of capital". And mind you, the returns shown are "annualized returns" – I fail to understand that how can someone annualize the return of a market related product, it can be done only in the case of an accrual product. For example, if say the stock index goes up by 2% in one day then can by any stretch of imagination someone just annualize it and say the annual expected return on it would be 730%! Certainly not.
But then this is done and an accepted norm for marketing Income Funds to the innocent
unsuspecting investor. Hence, investing in income or gilt funds is nothing but paying heavily for buying an interest paying security and then hoping to earn capital gains on it! But then income fund are seldom sold based on this premise but rather as a safe debt product which is likely to yield higher than liquid funds.
Side Effect 7: Mis-management of Income Funds
Any fund manager hates when his fund underperforms. And the fund manager would certainly not like when there is negative return on a debt product like an Income Fund. Hence, during an increasing interest rate environment, the fund manager would just reduce the maturity of the fund and start managing an income fund like a short term plan. But, that was not the objective of the fund. That was the view of the investor – when the investor wants to take interest rate risk and entrusts his money to the fund manager then who is he to take the call on behalf of the investor? And the worst of them are dynamic funds which give the right to the fund manager to increase or reduce the maturity of the fund based on his interest rate outlook. Needless to say, predicting interest rates is a risky bet in which most of the fund managers miserably fail leading to substantial loss of investor money and trust. There is gross mis-management of income funds from which fund managers suffer.
Side Effect 8: Promoting relative performance
A fund is marketed on the basis of relative and not absolute performance. What does it mean? Simply put, it means that if a Fund Manager looses 5% while the market looses 10% than the fund manager has done an excellent job. But, does this serve the purpose of the investor? Is the investor putting his money for getting positive returns or for getting lesser negative returns!Ofcourse for getting positive returns. But then the fund manager's performance is measured against a so called "benchmark" and if he beats the benchmark which includes generating a lower negative return than he becomes a "star fund manager" and is able to garner huge funds because finally the fund and advisor's income is related to the AUM and not its performance. In this AUM game, the investor is a sad loser.
Side Effect 9: Taking unwarranted risk in Liquid Funds
This is another side effect of being a fund manager. A liquid fund may have negligible interest rate risk since it runs a very short maturity but it certainly has credit risk as it primarily invest in corporate papers. And mind you, for getting 5 to 10 bps of higher return, many times a fund takes unnecessary and avoidable risk of investing in not the best quality of papers. A liquid fund is for parking surplus funds and an investor would not want his capital to be put at risk for getting a few basis points of higher return. But then the fund manager suffers from this side effect of trying to generate that extra 10bps return in expectation of higher AUM; in the process subjecting the gullible investor to unnecessary and unexplained risks.
Side Effect 10: Eternally Bullish
Yes, whether it is life or money, we have to be bullish or optimistic and it's a very good quality but in the investment world we also have to be realistic. There are times when the underlying conditions like GDP growth, macro numbers, inflation, interest rates, currency ,movements etc are positive while at certain times they are actually negative. A fund manager is supposed to give a true picture of the underlying economic and business scenario so as to allow the investor to take an informed educative decision. However, we hardly see any fund manager being out rightly negative on the above mentioned economic and business conditions; the underlying variables are the same, only the method of portraying them is different. Why the fund manager suffers from this "ever bullish" side effect is very simple – a fund manager's return is based on the AUM and his job is to attract maximum funds; if he himself is not bullish then how would a common investor be
bullish and invest in his fund? Hence, a fund manager suffers from the side effect of being
"eternally bullish".
To conclude, we saw the side effects from which a fund manager suffers. However, are we to completely blame them from it. Probably not. In our quest for getting the best returns for our money, we "force" the fund managers to take undue unwarranted risk. Having said this, the fund managers also have to assume more responsibility and take utmost care while managing funds – finally they are not just dealing with other people's money but also trust – money lost can be earned back but trust lost might never be able to be earned back.
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