Relying on fund managers

I started out in the world of investing about 7 years ago. Thinking that it was wiser to get a professional to manage my money rather an amateur like myself, I started off using unit trust fund managers. Being an engineer with no formal financial training, I thought I had better steer clear of the financial markets because I have relatives who got seriously burned. Later, the more I knew about the investing business, the more I steered clear of them. I have nothing against fund managers. I sincerely believe the average IQ of mutual fund managers to be higher than mine and the bottom 5% of hedge fund managers to be much higher than mine. I also do not think they are a untrustworthy group of people. I think they are just normal people who will not place their clients' interests high on the list if the system does not reward them for doing so.

What makes me uncomfortable is that the nature of the money management business has conflicts of interests that put their clients at a disadvantage.

The annual fund management fees provide an incentive to grow the size of their asset under management. It is easier to make an investment returns of 20% on SGD200k than SGD200million. The universe of applicable investment ideas diminishes as the portfolio size grows. Liquidity becomes a greater problem. It is harder to find an investment large enough to absorb your funds to make a difference big enough to move the performance needle when you get it right. On the other hand, if you get it wrong, it is much more expensive to get out due to the slippage and commission fees caused from liquidating a large position. A growing portfolio size is sure to dampen investment returns. An incentive to grow the asset size under management works against the clients.

Career risk distorts fund managers' investing decisions. It makes sense for fund managers to follow the crowd to reduce career risk. If they follow the crowd and get it wrong, clients are more forgivable. If they go against the crowd and get it wrong, they may lose their jobs. During the crazy dot-com bubble, several fund managers of the Graham-and-Dodd school of value investing lost their jobs. If I were a fund manager, I will not invest the same way as I will with my own money. Even hedge fund managers whose stated goal is absolute returns may unconsciously strive for relative returns because of the career risk of disagreeing with the crowd. This could explain why clients of hedge funds who were promised alpha (outperformance over benchmark) ended up with beta (correlation with benchmark). One might as well buy ETFs which I think is the best investing instrument for non-DIY investors. Why pay so much for hedge fund managers if they end up trying to match the benchmark index? One might as well buy cheap ETFs correlated with indices which outperformed most fund managers anyway. The high IQs of fund managers cannot be put to maximum use because they do not solely buy and sell on investment merit but on career risk considerations as well.

I think the best money managers out there are still the hedge fund managers. However, they are out of reach for most middle-class income people like me. If I were eligible someday for their service, I will go for fund managers with zero annual management fees with most of their net worth in their own fund. Their profits will come from outperforming a high watermark. With such a structure, there will be no conflict of interests. There will be no incentive to grow asset size. Career risk takes a backseat to investment risk because if they lose 1% of my net worth, they will lose 10% of their own.

I shall now stop dreaming of that day when I do become eligible.