What appears to be good qualities in a mutual fund manager often can be detrimental to shareholders.
We’re big fans of mutual funds, which figure prominently in the portfolios that we build for our clients. They’re transparent, giving us insights into a fund manager’s thinking and facilitating portfolio construction; they’re relatively simple to use; they put professional money management within our clients’ reach at a reasonable price; and they’re easy for us to monitor and measure.
The irony, though, is that these same qualities—transparency, simplicity, access, fairness, and accountability—can also impinge on how a fund manager makes investment decisions, sometimes to shareholders’ detriment. In this piece, we explore the potential pitfalls associated with these traits and how the issues reveal our approach to manager research and portfolio construction.
Though it might seem odd to knock a fund manager for being too transparent, we find there is such a Careful What You Wish For thing as “too much information.” Take for example, the manager who plays the firebrand on the speakers’ circuit, mincing few words and allowing no subtleties. Or the manager who spouts off at the market’s every zig and zag. For this manager, there is no issue or insight too inconsequential to withhold from the world.
The problem? It can be more difficult for these managers to backtrack their views, or even to incorporate new information. Behavioral finance wonks call this “anchoring”— these managers are more likely to get stuck.
Building-block funds that invest in a specifically defined market segments, such as the stocks of midsize European companies, are another example of transparency run amok. In situations like these, the client’s desire to construct portfolios brick-by-brick dictates the fund’s mandate and, thus, investment decision-making, as the manager can’t stray outside of the cordon that’s been drawn around the fund. This can make managers more susceptible to relativism, where the “least bad” option is acceptable and capital preservation takes a backseat. By definition, managers of these funds also forgo opportunities that fall outside of the dotted lines that have been drawn around their portfolios.
Clients generally crave simple solutions. Take management fees as an example. Fund companies tend to opt for flat management fees and eschewed performance-based management fees that vary based on the fund’s performance versus a specified benchmark. Why? One of the commonly cited reasons is complexity. A performance-based fee is said to be more difficult to administer and less predictable, as it can jump around based on relative performance.
But a thoughtfully constructed performance-based fee can more squarely align the manager’s interests with those of fund investors, rewarding the fund for producing a good outcome and penalizing it when results fall short. Provided it measures the fund’s performance over a long enough time period, a performance-based fee also helps ensure that management adheres to its longterm investment discipline.
A flat management fee courts another, less-cited risk: The manager is more likely to leave the fund open too long, as closing the fund would cap or at least curtail future revenue growth. Contrast that with a fund that levies a more meaningful performance-based adjustment, in which case the manager can continue to reap rewards, even if he has closed the fund’s doors. That’s a key difference, as it helps mitigate the risk of “asset bloating” setting in, thereby preserving the manager’s ability to effectively execute his strategy in the future.
While it might not be apparent, we pay a price for easy entry to and exit from, our investments. Academic research, including analysis produced by Morningstar affiliate Ibbotson Associates, suggests that investors in more-liquid fare, such as publicly traded stocks or highly tradable bonds, pay a premium. On the flip side, those who supply liquidity—either by selling those more-liquid investments or purchasing less-liquid securities— are able to command a premium.
Open-ended mutual funds are of course daily liquidity products, and thus must invest a significant portion of their assets in more-liquid assets in order to provide the access that investors crave. That is, they have to be able to quickly buy and sell investments in order to meet purchase and redemption requests, respectively. The upshot is that one could argue that fund investors are forgoing some return by the very nature of the liquid securities in which they invest.
Another often overlooked price of access is the cost of redemption activity that funds can incur. For example, a manager might keep some cash on hand in order to be able to meet daily redemptions in the normal course. This can be detrimental to the extent it keeps the manager from fully implementing the strategy, including putting money to work amid market distress (which is when redemptions typically spike). It might also make the manager less inclined to invest in controversial or misunderstood names, where the thesis takes time to play out.
We all want to get a fair shake. When it comes to mutual funds that means sharing ownership of the fund and thus a proportionate share of its gains, losses, and current income. Generally speaking, that’s worked quite well, as investors have gained access to professional money-management irrespective of their lot in life. But funds also have to socialize certain types of expenses associated with the most trigger-happy sliver of the fund’s shareholder base across all accounts. For example, trading costs and taxable distributions are spread across all of a fund’s investors.
There are less-obvious side effects as well. For example, all shareholders have the same rights of entry and exit. Thus, a fund might have to meet redemptions by selling its most-liquid securities first, the remnants being the portfolio’s harder-to-sell assets. This can be troublesome amid upheaval, when a fund might have to sell less-liquid assets at sharply reduced prices to simply meet redemptions, a process that can feed on itself. But it can also arise in garden-variety situations in which a fund has to meet a large redemption, which can punish remaining shareholders to the extent it exerts downward pressure on the prices of the securities that were sold. This can beget additional selling, pushing prices down even more and, thus, harming remaining shareholders.
To measure our return on investment, we must know two things—what the fund owns and the change in the value of those investments. This is only possible when those assets trade hands at readily ascertainable prices. Thus, accountability in the fund world demands transparent, accessible prices.
Sometimes, though, one has to wonder if we’d be better off just not knowing. Investors chronically overtrade their portfolios, often on the basis of short-term returns, reflecting a basic human desire to understand how they’re doing and comparing them with the alternatives. This behavior can reverberate widely. For example, seeing assets slosh around, portfolio managers might be more inclined to shorten their time horizon to bag a quick gain. But managers who try to appeal to the lowest-commondenominator in this fashion can end up short-changing all of their shareholders, including those who are investing for the long haul.
Many fund managers react to the very same stimuli as their shareholders, zipping in and out of securities, with changes in observable price being the catalyst. Wouldn’t fund managers also be better off simply not knowing? Paradoxically, research suggests many would. For example, “before and after” studies of funds—in which one compares the return of a frozen-in-time snapshot of a fund’s portfolio with the fund’s actual subsequent performance—finds that “before” trumps “after” to a surprising extent. BM