It can't be fun to be a typical mutual fund manager, going to work every day knowing you don't add any value no matter how hard you try. The arithmetic makes it brutally obvious. If stock indices, on average and over the long term, generate 8-per-cent annual gains, a money manager has to be awfully good to match them.
Why? Because he's charging investors 2 per cent or so to render his services. That doesn't sound like much, right? But it's an impossible burden for most managers. It's a full 25 per cent of the average return on stocks.
Put another way, if you buy a stock mutual fund at the start of the year and stocks go up 8 per cent, the manager has to outperform the stock market by 28 per cent for you to earn the same amount as the stock market.
And I'm being kind. Fund fees are often higher than two percentage points and they're typically withdrawn daily, not at the end of the year. The true hurdle is north of 30 per cent.
Few money managers would claim to be that much better than "the market," and fewer actually are. It's one of the great secrets of the fund industry. The fees on average funds are like unseen leeches, quietly sucking out the life blood. You may not notice until you're woozy from loss, often years later, sadly. (This is a good time to point out that not all of the fee goes to the money manager; plenty of it goes to the adviser who sells you the fund.)
It doesn't help the fund manager that investors tend to throw money at him when stocks are expensive, or well on their way to being richly priced, and take it away from him precisely when stocks are bargains.
That's what happens, though. As markets rise, investors get excited and invest more; when markets inevitably take a periodic tumble and bargains are available, investors redeem their funds in disgust, or they have no cash to buy low.
That's not to say that no professional money managers are worth the fees they charge; some are, and more on how to choose one in a moment.
Mutual funds or ETFs?
First, some statistical evidence on the value of mutual funds. National Bank Financial took a look at the returns of mutual funds versus exchange traded funds, which are like stocks that faithfully track the performance of an index or sub-index. You can buy ETFs that track the market generally (for example, the main Toronto index, the S&P 500) or smaller indices, such as the Toronto Stock Exchange's financial services index, which consists of bank and insurance shares.
The report compared the returns of mutual funds with those of ETFs from 2002 to October 2009, and found that in the case of blue-chip stocks, for example, mutual funds were embarrassing laggards: Only 5 to 10 per cent managed to beat or even match the index after the fourth year. In other words, your odds of picking a fund that will outperform are very low. The average stock mutual fund gave investors only roughly two-thirds of the market's return after eight years.
Investor Education on mutual funds:
The knock against ETFs is that's it is mathematically impossible for them to beat the index because they track it and charge a modest fee, meaning they, too, underperform the index. But they do much better than mutual funds when it comes to equities.
National Bank's report does redeem some types of funds, however. When it comes to precious metals, natural resources, small and medium-sized companies and U.S. stocks, mutual funds were a better option, although by a slim margin in some cases.
But for your basic exposure to the bigger Canadian indices - Canadian equity, dividend and income, financial services and real estate - ETFs were superior.
Money manager tips
There are good money managers out there and, if you find them, you'll likely do better than with an ETF. But how to find them?
1. First, get them while they're small. Big funds are typically poor performers because they can't be nimble and their hands are tied by their size. Money managers who want to stay small are worth your time.
2. Make sure they have consistent track records. Avoid those that have eye-popping returns for a few years; they're likely taking huge risks and will inevitably crash. Avoiding big mistakes is more important than hitting home runs. A 20-per-cent drop requires a 25-per-cent recovery to get you back to where you started. Big drops are easier to trip over than big returns.
3. Make sure the returns are consistent, meaning that they didn't come from a couple of lucky bets on one or two stocks. And be suspicious of numbers: It is possible for a money manager to have lost huge amounts of money and still have a healthy average annual return.
4. Look beyond mutual funds. Some money managers require high minimum investments but they also tend to do better and (no coincidence) charge lower fees. They don't manage public funds whose unit values are published daily, but do you really need or want that? No.
5. Look for personal motivation. It should go without saying but probably doesn't: Make sure the manager has all or most of his money and his family's money in the funds he manages.
6.Make sure you agree with what he says. If he can't explain to you in simple terms how he sees things unfolding and what he plans to do, take a pass.
Fabrice Taylor, Chartered Financial Analyst, is a principal in Capital Ideas Research and writes the blog fabricetaylor.com