Professional managers have to deal with incentives and rules that could hinder performance
Professionally run investment funds can perform extensive market research and employ a deep bench of experienced managers. But that doesn’t mean they can always deliver better results. In fact, as one expert points out, the rules they play by can actually limit the returns they achieve.
“In March 2013, we offered clients our first Model Portfolio,” said Peter Hodson, founder and head of Research of 5i Research, in a piece on the Financial Post. “The portfolio has risen every year. In addition, our five-year compounded annualized return is more than any investment return I achieved at any of the mutual or hedge funds I managed during my long career on Bay Street.”
According to Hodson, the portfolio did well for five reasons that also apply for individual, do-it-yourself investors.
First, there’s less of a focus on calendar-year performance. Bay Street fund managers, he explained, often stood to receive bonuses that amounted to multiples of their salary. This meant those whose performances lagged late in the year were more tempted to add riskier positions that might let them catch up — or put them further in the hole.
Then there’s the lack of management fees. Citing figures from the Wealth Game, Hodson said $10,000 invested at 6% for 45 years, with 2.25% fees results in $85,230 lost to fees, with the investor getting to keep $42,416. “Fund managers thus end up with more than two times what you make,” he said.
Fund managers also have to wrestle with sudden sales and redemptions. To illustrate, he described how a fund he once managed did well in 2007, but he was forced to sell holdings in 2008 as investors started withdrawing their money. “There were no buyers. It was ugly,” he said. “Do-it-yourself investors, on the other hand, are totally in control of cash flows going into and out of their investment account.”
Canadian fund managers, Hodson added, often have their funds’ performance compared with the TSX Index, which he argued was a “bad index” to follow. “By not following the index, you are free to see your portfolio far more diversified than the Canadian market, which is having a very painful year so far in 2018,” he said.
Finally, fund managers tend to find it hard to do nothing even when it makes sense. They’re under constant pressure to justify their salaries and existence, and they “are staring at a stock screen all day,” which creates a bigger urge to trade something.
“Our model portfolio … has no such compelling need to do anything,” Hodson said. “Nothing says you have to buy that new issue, and doing nothing is often the exact very best course of action when the market experiences heightened volatility.”