Choosing The Right Investment Manager
Consumers benefit when an industry has fierce competition and innovation. The first commercially available mobile phone was the Motorola DynaTAC 8000X. It was appropriately nicknamed “the brick” and weighed just shy of a kilogram. Costing a whopping $3,995 in 1983, it would the equivalent of approximately $11,716 today.
Since then, economies of scale have helped drive the prices of mobile phones down and today, smartphones can be found in pockets all over the world. The same democratisation of technology also happened to the automobile, personal computers, and many other consumer goods.
The investment industry, on the other hand, is a curious animal, one of a kind — where improvements and innovations do not necessarily lead to better outcomes for investors.
Research from Jonathan B. Berk and Jules H. van Binsbergen (Professor of Finance at Stanford and Wharton respectively) shows that professional managers, as a whole, extract an average of $2 million in value from markets each year.
Yet it is clear that the majority of professionally managed funds regularly underperform the market.
Why is this so?
Underperforming Managers
Over the past 20 years, almost all (94%) of managers in the highest quartile of expense ratios underperformed their benchmark, as compared to 69% of the managers in the lowest quartile of expense ratios that similarly failed to outperform their benchmark.
A key reason could be because professional managers retain most of the outperformance in the form of fees that they charge. This is not surprising when you consider that about 20% of the Forbes 400 are investment professionals.
Most investors would conclude that investors should then only invest in the lowest fee investment products. Index funds have expense ratios so close to zero and yet by definition — as they mimic the benchmark — must underperform the benchmark after fees. Read about why index funds might not be the best solution for investors here.
Chance vs Skill
If low fees are not the answer to superior investment performance, then how should investors choose professional managers, or are they relegated to only make market returns less fees?
There are two important questions that investors must ask before they invest -
Does the manager outperform after controlling for known factors of returns?
The evidence shows that few funds have managed to produce benchmark-adjusted returns sufficient to cover costs.Does the manager exhibit consistent skill after fees?
Imagine a fund that outperforms the market by 5% a year after fees and expenses with a market-like volatility of 20%.To have confidence that the outperformance is reliable, you can use a simple back of the napkin calculation given by:
Plug in the numbers to the formula above using a T-statistic of 2.0 or greater, ((2*0.2)/0.05)^2), will give you 64 years.
This is the length of time required before you can reasonably infer statistically that a manager that outperforms the market by 5% a year with market like volatility has been due to skill and not chance.
The Effect of Shrinking Alphas
Whilst fund managers can be skilled, these benefits do not automatically translate into returns for investors. This is because the evidence suggests that fund managers retains most of the alphas in the form of fees. To exacerbate the shrinking benefits, other investors would swarm to skilled managers and compete the alphas away from other investors.
As such, identifying a skilled manager is not enough. For their skill to accrue into returns for the end investor, the fees must be commensurate with the magnitude of outperformance such that end investors still benefit.
A truly skilled manager can charge high fees and still deliver good outcomes for investors, while a poor manager can charge low fees and still underperform.
More importantly the question that investors should ask is:
Which manager will be around to deliver what she promises for my financial goals in 10, 20, or 30 years time? (The majority of funds do not survive past 20 years, read about it here.)
There is a better way to invest. Experience the difference today with an interest aligned wealth manager.
GYC applies the best ideas from financial science to develop a financial plan that is built upon a rigorously tested investment philosophy.