This major handicap holds back most fund managers – but it doesn’t affect you

I'm glad I'm not a wealth manager. Your customers can be a right pain.

One wealth manager recently told me that his life is always easier if he invests in quality' stocks such as Unilever, rather than bombed-out value plays.

You see, if an investment in Unilever performs badly, the client doesn't mind. It's a quality company, they think, so it'll come good in the end.

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But if a value play goes wrong, the client is furious. He'll say that the stock was obviously rubbish from the start and threaten to take his money elsewhere.

So guess what? My wealth manager acquaintance tends to focus on quality' companies that are often expensive.

This is just one example of how career risk' twists the investment decisions of financial professionals in ways that are not necessarily good for the likes of you and me.

It's a good illustration of why you should either manage your money yourself or choose very carefully when you give the job to someone else

Why fund managers don't always do the right thing by their clients

There are plenty of examples of how career risk' fear of losing client money, and eventually their jobs distorts the decisions of professional investors. The one that bugs me the most is known as hugging the index'.

This is a result of the fund management industry's obsession with benchmarks. The performance of any fund is measured against a benchmark. Say you're a fund manager with a fund in the UK All Companies' sector. Your benchmark will probably be the FTSE All-Share index. So if that index rose by 4%, you'd hope that your fund would rise by more than 4%.

That sounds sensible when you first hear it. But in reality, there are two serious problems with benchmarking.

Firstly, the average man in the street isn't that interested. I think most private investors (rightly) care much more about absolute returns. In other words, they want their investments to grow in value, ideally every year, and they want their investments to grow faster than inflation.

The fund management business sees things differently. Imagine the FTSE All-Share falls by 5% over a year. If you're a fund manager and your fund only falls by 4%, you're seen as a success because you've beaten the market. But, for most people, a 4% fall is a failure, regardless of how good it is compared to other investments.

Secondly, the benchmark obsession means that fund managers are often tempted to hug the index.' In other words, the manager creates a portfolio that is very similar though not identical - to the benchmark. If Vodafone comprises 6% of the FTSE All-Share by value, say, then the manager might put 5.7% of his fund in it.

Why do this? Well, if a fund manager builds a portfolio that differs dramatically from the index, he's taking a big risk. If it does well, he'll look like a genius. But if not, the benchmark could thrash his fund, putting his job at risk.

By hugging the index, the fund manager guarantees that his performance will never deviate that far from the benchmark. Sure, it might not keep up with the index, but it won't be far off, and that will probably be enough for the manager to keep his job.

But it's a very bad deal for the private investor. You could end up paying 0.75% a year to invest in this index-hugging fund (also known as closet trackers'), when a cheap index tracker fund would be just as good and might charge as little as 0.1% a year. (The index tracker explicitly aims simply to deliver the return on a particular index.)

I'm happy to pay 0.75% for a fund managed by someone with strong views, who is prepared to think differently from the crowd. But the manager of a closet tracker is ripping off his customers. He's not acting in their best interests.

Another example of how this career risk affects managers is the industry's obsession with the short-term. More often than not, when I meet a fund manager, they want to talk about what's going to happen this year. But, as an investor, I'm not that bothered.

I'm 46 years old and I'm investing for my retirement. So I want my money to be in the right place for the long-term. It makes no sense for my capital to be endlessly eroded by over-trading, short-termist fund managers.

But managers know they will be judged for their performance over the last year, or possibly three if they're thinking about what passes for long-term' in this business. So they can be tempted to over-trade to ensure that their performance is in the right area.

How to avoid investing in a closet tracker

Don't get me wrong. There are some fund managers out there who I admire. And it's not that hard to spot them. They're the managers who are doing the precise opposite of what I've described above taking big bets on a relatively small number of companies, and trading only when they see opportunities.

One good example is Nick Train, who manages the Finsbury Growth and Income investment trust (LSE: FGT), among other funds. His portfolio normally only contains around 25 companies, and the fund has absolutely thrashed the benchmark.

Over the last three years, the Finsbury trust has grown 75% while the FTSE All-Share has risen 30%. Train is clearly a man who focuses on the long-term and ignores short-term career bias' issues.

Of course, the alternative is to take charge of your own portfolio. You aren't affected by career bias no one is going to fire you if this quarter's results don't match up to the FTSE 100's performance.

With the recent BudgetIsa and pension changes giving more freedom and responsibility to savers to look after their own future, it's rarely been more important to make sure you're on top of what's going on. We have more details on the changes and what they mean for you in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, get your first three issues free here.

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