Secrets of Success: A fund is little more than a commodity

Whatever its wider consequences, the fashion for hedge funds in the past three years has at least prompted some serious rethinking of the way in which investment funds are managed.

Whatever its wider consequences, the fashion for hedge funds in the past three years has at least prompted some serious rethinking of the way in which investment funds are managed. Over the years the industry has allowed itself to become dominated by the notion that what matters most was relative performance - the extent to which a fund could or could not outperform a given benchmark or index.

This has long been the basis on which funds are marketed, and the way that the performance of fund managers has been measured and rewarded. The trend began with pension funds, from where it spread to other parts of the business. Yet, as hedge funds have shown, it is not the only - and arguably not even the most sensible - way to approach the issue of what funds are for.

The reason for investing is to make money, not to lose it, and while it is inevitable that anything which involves stock market investment will produce volatility, including periods of loss, there are times when the fund management industry seems to have lost sight of this fundamental fact. It is relatively easy to understand how this has happened: among other things it demonstrates the old management law that what can be measured most easilytends to become the performance norm. But that does not make it any more acceptable. As one prominent fund manager put it to me recently, "I think we must be the only industry in the world where people are persuaded to invest for a relative return. You wouldn't go to an auction house and say 'In relative terms I am going to lose less money on this one picture, so that is the one I am going to buy'. It is a barking-mad way to operate."

He is right. Hedge funds, which mainly operate on the basis of seeking absolute returns, offer an alternative approach, although the irony (or paradox) is that the methods they use are mainly short-term trading and speculation, which is not investment at all in the strictest sense of the word. Most hedge funds are trying to exploit a series of smallanomalies, which they often find with the help of highly rewarded brokers and market makers. They then try to rack these small returns up into modest but consistently positive returns with the help of gearing (that is, borrowing). It is a perilous and fragile way to operate, as the margins for error are very fine, and the rewards that the funds demand by way of management fees are very high.

But the paradox with the fund management industry is that its commercial imperatives are so often at loggerheads with its responsibilities to the people it is aiming to serve, namely those who buy its funds. This is true whichever type of fund you are looking at, be it a hedge fund, a pension fund, an actively managed fund or even a tracker fund.

A recent survey by the IFA magazine Money Management of actively and passively managed funds underlines two trends that have been highlighted here before. One is how many tracker funds fail to do their job properly, almost invariably because of their high charges. While owning tracker funds is in theory a cost-effective way to gain diversified exposure to the stock market, in practice you have to shop around every bit as carefully as you do with actively managed funds to avoid the ones that are going to damage your wealth.

The impact of excessive annual charges compounds over time. According to Money Management, during a ten-year period in which the market, as measured by the FTSE All-Share index rose roughly 100 per cent, the average tracker fund achieved just 73 per cent growth. Unusually, this performance was marginally worse than the performance of the average actively managed fund over the same period.

It is worth repeating that you should never pay more than 0.4 per cent in annual charges for a tracker fund and preferably even less. If you can find a fund with that level of charges, and the tracker fund does its job in tracking the market efficiently, you should be able to achieve at least 95 per cent of the market's return over a 10-year period. I can see no way in which any fund management company can seriously say it is acting in the interests of its clients if it charges more than 0.5 per cent per annum as a management fee, though many do charge much more than that.

The second problem highlighted in the survey is the problem of so-called "closet" tracker funds. These are funds that purport to be actively managed and charge an active management fee of up to 1.5 per cent per annum, yet in practice run portfolios that differ only marginally from the market index they are ostensibly seeking to outperform. In statistical terms, these are funds that display a tracking error of less than 1 per cent per annum relative to the FTSE All-Share index. It is no surprise to find that the actively managed funds with the ten lowest tracking errors are mostly offered by the high street banks and life companies.

These are traditionally the firms that offer the worst value in fund management, largely one suspects because of their captive customer bases and their (dare one suggest?) willingness to extract as much as they can from that source.

In an ideal world, customers would recognise that most funds are merely tools for capturing the returns that are on offer from different types of asset class, and choose them as they would any other consumer product, on the basis of cost and value for money. The vast majority should be regarded as commodities, and purchased accordingly.

It would still be worth paying a little more for the handful of funds that are run by the most successful and genuinely talented investment managers around. But this is not the way the business works at the moment, as the industry's agitated response to Ron Sandler's report into savings has made clear. The last thing the fund management business needs right now is millions of educated customers.

jd@intelligent-investor.co.uk