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THE SCARY TRUTH ABOUT MUTUAL AND HEDGE FUND FEES


Fees are a treat for mutual fund managers, but a trick on you

T'is the season for scary stories, and nothing is scarier than the fees charged by professional money managers.


Hedge funds charge success fees and mutual funds charge fees based on a percentage of the assets under management (often in excess of 2%). Exchange traded funds (ETFs) also charge fees based on a percentage of assets under management, but at a much lower rate than mutual funds (often below 0.5%). So the question becomes, are the fees paid to active managers worth it?


The research suggests no.


It is difficult to judge hedge funds, either individually or as an industry, because the reporting is not as consistent as for mutual funds and ETFs. Hedge funds have much more relaxed reporting requirements, and so a lot of the reporting is biased to years with good returns. That said, there is good evidence that from 1980-2008 hedge funds (6%) struggled to consistently beat broad index investing (S&P 500: 10.9%/year), or even the risk-free rate of return (5.6%/year) (http://www.people.hbs.edu/gyu/higherrisklowerreturns.pdf).


Now, the information about hedge funds may not be the end of the world, or at least their managers would try and convince you of that. Hedge funds are very unique vehicles, offering complex and risky strategies. In fact, many hedge funds are designed to try and take advantage of good and bad times. The goal of many of the managers is to offer returns that are not necessarily correlated with the stock market for wealthy investors who otherwise have large portfolios of investments very much correlated to stock market performance.


Less defensible is the terrible performance of mutual fund managers. Three common benchmark indices are the S&P 500 large-cap, S&P 400 mid-cap and S&P 600 small-cap.


As a quick aside, each of these three indices track the performance of a basket of companies equal to the number in their name (i.e. 500, 400 or 600) that have a total “market capitalization” (i.e. the total value of all their stocks) above, below or between the following amounts:

  • S&P 600 small-cap: $250 million to $1.5 billion

  • S&P 400 mid-cap: $1 billion to $4.5 billion

  • S&P 500 large-cap: $4 billion or more

Mutual fund managers generally pitch themselves as investing in one of these three pools of assets, with the idea, in theory, of beating the relevant index. From 2000 to 2016, virtually none of them did.


“Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.” (https://us.spindices.com/documents/spiva/spiva-us-year-end-2016.pdf)


Even though the evidence seems pretty strong that hedge funds and mutual funds don't beat the market, the above number may actually be generous. A key aspect of both of the above-cited research pieces highlights the phenomenon of “survivorship” bias (on top of hedge fund biased reporting in good years vs. bad years). Survivorship bias is the idea that unsuccessful hedge funds and mutual funds are usually merged or liquidated out of existence, so the full impact of their subpar returns are generally cut short. The net result? The results cited above may be more generous than the truth of the matter.


What does all of this mean? It means that we here at Fiscal Frontiers plan on using ETFs that track large indices as our “benchmarks” to compare our investment performance in our various pursuits. We’ll do our best to also keep our finger on the pulse of mutual fund and hedge fund performance, too.


Next week, on our Wednesday post, we will outline the indices we’ll be using. Before that, though, look forward to a post tomorrow on how some of our investments did in October. That's right, even though we haven't yet started outlining what we will be investing in, we have started investing, and we want to give you a sneak peak at what we have been up to.

 
 

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