When it comes to fund managers, the adage that “if you pay peanuts, you get monkeys” is broken, says Matthew Lynn – you get monkeys whatever you pay.
The vogue within the investment markets has been to pay for performance. If you pay peanuts, you get monkeys, has become the mainstream view, and asset managers have started to change their fee structure to build in a performance element. It started with the hedge funds a generation ago, with 20% of the profits typically going straight to the manager, and since then it has shifted into more mainstream funds offered to smaller investors. In the UK, close on 100 unit trusts now have some form of performance fee built into them and so do many hundreds more across Europe. They are common among investment trusts as well. Each time, the argument for them is the same. Sure, they will cost some money, but the incentives will also improve performance, and so investors will come out ahead.
But what if you pay big money instead of peanuts, and still get monkeys? A study from the London Business School looked at all the mutual funds offered for sale across the European Union, plus Norway and Switzerland, over a decade. Of those, 7% charged some form of performance fee, typically 20% of any profits made in excess of a chosen benchmark.
And how did they do? Not terribly well. The performance-fee funds actually did worse than their rivals by between 50 and 70 basis points per year. The funds that did especially badly were those that either set no specific benchmark, or else one that was easy to beat. Just as seriously, those funds also had on average higher expense ratios than their rivals. To put it in simple terms, investors were paying a lot more money for results that were below average. That is hardly a great outcome.
Something similar has been observed over the years among the hedge funds as well. Although a few funds achieve spectacular results – at least for a few years – and get a lot of headlines, most have not done very well at all. According to the Credit Suisse Hedge Fund index, from 1994 to 2018 a passive S&P 500 tracker outperformed every major hedge-fund strategy by 2.25% in annualised returns. The hotshot managers may well have huge incentives to beat the market. But it generally doesn’t happen. In fact, as with unit trusts and mutual funds, not only do they not justify the fee, but it was actually better to choose a fund with no incentive fees built into it at all.
Why the incentives don’t work
Why is this? After all, in most walks of life, we expect incentives to work. There are two big reasons. First, from the study it appears that most funds with a performance fee gamed the system so that they easily met the performance target; or else they set a benchmark that was really easy to beat. Most fund managers can choose their own benchmark, so it’s understandable that they are going to pick one they feel confident they can outperform. So the only real impact of the fee is to increase costs without making any real difference to returns.
Second, it is very difficult to beat the market. One or two investors can perform better for a few years, and the occasional exceptional one can do so for a whole career. But most will simply do a bit better than the index one year, a little worse the next. Markets are not perfectly efficient, but they are very close to it. An incentive might make a difference to a sales manager, who can simply work harder to beat his target and earn his bonus. But it possibly doesn’t make any difference to an asset manager. He simply cannot beat the market, any more than he can walk on water.
The conclusion for investors, however, is a simple one. With a very few exceptions, it is never worth paying someone else to manage your money. Either do it yourself, or else choose a low-cost tracker fund, where at least you will replicate the performance of the index, and at very low cost. The asset-management industry is very good at coming up with new ways of charging its clients – there is plenty of “incentive” for that – but it never works. And it is always smarter to avoid it.