Why Aren’t Money Managers Paid Purely On Performance?

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I recently received an e-mail that went like this:

“It’s not expenses that matter, it’s total return after expenses. You could charge 1% but if I make you 30% who cares? Why don’t people understand this? I offer my clients superior performance for my fees.”

This irked me. I thought about sending him a few articles about why there’s no proof that any consistent market-beating performance by money managers exists. But instead, I said okay, fine. Here’s an open invitation. I give you my money to manage. You can choose whatever investments you like – mutual funds, individual stocks, whatever.

Instead of a flat fee, you choose the investments, and you get to keep 80% of how much you beat a benchmark portfolio where I try to match your level of risk using index funds. If you fail to beat my portfolio, you must pay me back the difference. So let’s say an advisor would charge 1% of assets. All they would have to do is beat the market consistently by 1.25%, and they’ve got that made already. If they kick butt and beat the market by 5%, they get 4% of assets!

Yes, all the risk here is held by the manager. So what? If you’re so confident you can do better than my portfolio of index funds, put your money where your mouth is. It’s like working for straight commission. You make me more money than my no-brainer portfolio, I make you money. I feel this is much more fair than the current setup, where we pay a relatively fat fee regardless of ensuing performance.

You might be thinking: “But no manager would have enough money to guarantee against that kind of potential loss”

Again, very true. I’d need some collateral to make sure he wouldn’t cut and run. The risk could be mitigated if you could buy some sort of insurance policy to hedge against catastrophic losses. Now, it would probably be expensive, as going back to my original point, as historical statistics show that market-beating performance is unlikely to happen. Maybe Lloyd’s of London is balking, and that’s why I haven’t heard back from him yet…

A more reasonable option?
Although I still wouldn’t buy such a mutual fund, here’s a more reasonable option for actively managed mutual funds. If you fail to beat the relevant index, your expense ratio should be 0%. No need to make people “whole”, but you have to refund all fees taken from the last year. Otherwise, you can earn a pro-rated amount of any market-beating gains with a cap of say, 2%. I know some mutual funds vary their expense ratios slightly based on performance, but none as harshly as this.

Ever wonder why this isn’t how mutual funds are set up?

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  1. 1) People will pay 2% because they don’t “understand” the market. They feel as if they are reducing their risk premium by paying someone else to manage their money. This is not true.

    2) The market will bear it.

    3) Decision inertia. I think you have written a post on it before but I couldn’t find it.

    4) One of the major problems I see with mutual funds is as soon as a manager can create a system to ‘beat’ the market, he instantly has too many assets to effectively work his strategy and his performance tails away. rinse. repeat.

    that’s my 4 cents πŸ™‚

  2. I have always felt this is how actively managed funds should determine their expense ratio: anything above a percentage above the underlying index. But when you take into account the turnover in the actively managed fund, the after-tax return will be less than that of the index.

    How about actively managed funds attempt to beat the after-tax return of the index?

  3. This is a very interesting idea. But the manager may take the money and go for investment that is extremely risky but with high potential for the gamble.


  4. Very interesting point – it reminds me of a recent book I read, Freakanomics. Author comments that real estate agents don’t have incentives aligned with your interests. They stand to make money on closing the sale fast vs. waiting for a better offer. Seems advisors may have the same incentives… getting your money, making lots of trades, etc.

    Great comeback to an arrogant advisor! πŸ™‚

  5. I read Confessions of a Street Addict (by Cramer) a couple years back – and he recalls that his hedge fund did so poor one year that he actually chose not to pay himself

  6. CFO Dad you hit the nail right on the head. The same holds true with any management, be it financial or people. The managers must have goals aligned with the customer (be that the investor or employee or board of directors). I recently bought a home and found the same to be true in that as in management. Most % fee based positions have a vested interest in short term highs as opposed to consistent returns.

    I think the best scenario would be that the fund manager must own a certain % of the total fund. This way his assets would increase as the performance increases. That is supposedly why managers are given stock options as part of their compensation.

  7. This is pretty similar to what a hedge fund is, no? Except for the repayment plan, which is an interesting twist. But what you talk about in a more reasonable option sounds exactly like a hedge fund.

    The problem, like Ed said, is that these fund managers tend to make riskier investments; hence hedge funds only being open to select investors.

  8. Hedge funds typically charge fixed fee and one where its tied to profits… that’s how it should be done everywhere.

  9. Ted Valentine says

    I have read a lot recently about the merits of indexing. Why are good managers not like good football coaches? Why are good fund companies not like good organizations? When you combine a good coach with a good organization, you get outstanding results in football more than not. Why doesn’t this work in the financial world?

    I understand that if you compare all managed funds vs the index, the index typically wins by the expense fee. But in that group of “all funds” some are winners and some are losers. Has anyone ever compared good managers in good organizations to indexes? I realize I haven’t defined those terms.

    Does anyone that doesn’t sell actively managed mutuals suggest that active management is superior to indexing?

  10. Ted Valentine says

    CFO Dad – Kind of off topic, but I found your realtor example to be true. When we sold our home last year we had a few come for a tour and give us a proposal with a suggested sales price. I had already reviewed comps in my neighborhood and had a good idea what it could get. You quickly determine which realtors want to work for you and which ones just want a quick commission. The realtor suggested list prices varied by as much as 20%.

  11. It’s illegal under SEC rules to guarantee performance, so no money manager could legally make such a guarantee. You would have to go to a source not regulated by SEC rules. Because of the guarantee, these would be classified as insurance products, so you’d be talking about annuities, and there are some which do guarantee that they will at least match the returns of the different indices, but you will pay a stiff penalty for pushing the risk onto the insurance company.

    The other way to go is to a hedge fund, as Jim pointed out. He says it’s “how it should be done everywhere”, but it’s not a simple as he makes it out to be. They do not guarantee the downside and when they have a bad year, the hedge fund closes and then re-opens under a different name so the “high water mark” is re-set, denying you the opportunity to potentially enjoy their strong returns the next year.

  12. That “superior performance” this manager talks about is LUCK. I’ll argue all day long that equity markets are random and by definition, 50% of active money managers will ‘beat’ the market any given time period. That doesn’t mean they had some special knowledge or skill, just that they were on the right side. Put a few time periods of that luck together and you look like a genius. It doesn’t mean you are. What it means is for that period of time you were lucky.

  13. These “money managers” are usually salesmen who minored in finance. I am sure there are some good ones out there, but the majority of them work more on obtaining clients than they do managing your portfolio. Most just go into MorningStar and pick “5 star” securities based on past performance. 9 out od 10 times you’re better off going with an index fund or ETF.

  14. broknowrchlatr says

    I’ve always thought this is how it should be managed. An additional qualification should be that they must be beating the long term returns of the index. Based on the above, they may try to go too aggressive. They have no penalty for doing really bad but they have a gain for doing good. This way would require that they make up for past failures. If they are under the index by 2% one year, they have to be over the index by 2% the next year before they get a profit. This could easily spiral out of control.

    I definately think they could incorporate this in to acocunt to an extent. Say, decrease their expense ratio by .5% and they get 50% of anything they gain over 1% more than the index. Say their current expense ratio is .5%. If they beat the index by 2%, they get the 1%. If they don’t beat it, or beat it by 1% or less, they only get .5%.

  15. My understanding was that one of the main reasons arrangements like the one you proposed are never done is that they are illegal.

  16. Steve, I didn’t say it was an original idea πŸ™‚
    Yep, Taleb among others.

  17. Steve Austin says

    Mutual funds don’t do it this way because they have a cash cow business model that they’d be foolish to just drop. They rely upon investor ignorance to maintain this status quo. The current model does not penalize mediocrity, and does not reward anything but artificially finishing the year with or near the pack.

    I like the comparison to benchmark that you propose, but ever notice how mutual funds compare themselves to *each other*? If they don’t beat the market, they just say “well, we had a bad year, but 80% of the fund managers in our space did, too. we’ll do better next year, so why not just stick with us instead of taking a chance with those other underperformers?” I’m thinking of those Lipper ratings here.

    I am more fond of a comparison to an absolute benchmark, such as the risk-free 10-yr US treasury coupon. And I wouldn’t be happy with a manager who just beats that, even on a year when stocks did not beat it (if we’re talking about a stock mutual fund). I don’t want a money manager who just barely beats the risk-free rate and expects me to pay her/him for a result which could very well be the result of luck. I want a money manager who has a consistent record in both bull and bear markets of outperforming the risk-free rate by at the very least one full % point. Since I’m putting up the capital, and she/he is putting up the brains (supposedly), I’d share profits 50/50 beyond the 1% above the risk-free rate.

    Note that this is easy money for any manager during a bull market, but hard earned money during a bear market. That’s why I would demand the consistent record during both types of markets before I’d invest anything with a money manager. Otherwise, I might as well go it alone.

    Fees on % of assets under management has to rank as one of the greatest financial scams still in-flight. Benchmarking on performance relative to some asset class (or worse, some class of like mutual funds) is high on the list, too. What matters in investment is absolute performance. Just because everyone else is losing money with me does not make me happy, or even less unhappy. I am willing to incur some risk to exceed the risk-free rate, but I am not willing to put my money with someone who is going to ride the market (+/- a few % pts) and expect me to pay them for it. I expect much more from a professional, for I can ride the market myself at a rock bottom expense ratio.

    Buffett’s rules of investing, paraphrasing, from memory:

    1. Don’t Lose Money
    2. Never Forget Rule 1.

  18. Steve Austin says

    KMC, we owe a huge debt to Nick Taleb for understanding these things, don’t we? πŸ˜‰

  19. Man………oh MAN!!!

    Jonathan?? (I assume it’s you who handles this entire blog.)

    I swear, we might be spiritual twins. I am a total Vanguard Diehard. And, yes, I invest with them heavily & regularly for my taxable $$, IRA, Roth IRA, etc.

    BUT………I have to invest with Morgan Stanley based on my company’s S.I.M.P.L.E. retirement plan………in order to acquire the “matching” they offer. That’s all fine & good, but in the meantime I’m stuck w/ their funds which are RIDICULOUSLY overpriced.

    Yet, no matter what *I* think…….(or other Vanguard Diehards)………you can go on over to morningstar forums & notice that there are sooooooooo many other fund folks out there who are trying to beat the market every day. Some will swear that it’s even EASY! 20% you say? No problem!

    I’ve argued w/ folks ’til I’m blue & very few ever listen to me.

    /rant :^)

  20. I agree with the advisor, to a point. I look for total returns that consistently beat the market, rather than comparing supposedly similiar funds based on expense ratios. However, the other side of that coin is that a manager never has exclusive access to an investment, and therefore never has exclusive ability to provide a certain level of returns.

    I take issue with the claim that no manager can consistently beat the overall market, based simply on my own ability to research and purchase a dozen funds, each which have subsequently outperformed the market both on an overall basis and more often than not on a year-by-year basis.

    I do like the main ideas posited, but as for why funds don’t take fees based solely on above-market or positive performance, I think the answer is quite simple: they don’t have to. If there was significantly greater competition for investors, you would see managers going to greater lengths to acquire these customers. Right now, however, I can’t imagine a manager taking on such risk when the market doesn’t demand it, and I would hesitate to invest with one who did so.

  21. I agree, if there is only a lot of reward for winning and only a small penalty for losing (hedge funds), then the manager may just take a crazy amount of risk.

    “Has anyone ever compared good managers in good organizations to indexes?”

    Yes. If by “good” you mean taking the best performing funds over the last 10 years and buying them. There is still no indication of superior performance.

    “I take issue with the claim that no manager can consistently beat the overall market, based simply on my own ability to research and purchase a dozen funds, each which have subsequently outperformed the market both on an overall basis and more often than not on a year-by-year basis.”

    I believe you. However, I also believe that has no bearing on anyone else. Hundreds of articles examining the performance of hundreds of managers dating back from the 1960s (and some to the 1920s) until today have shown that beating the market is like flipping a coin, for the most part. Should a random person take the example of “I beat the market, so it’s possible” or these articles as sound advice? Is some who manages to flip a coin “heads” 5 times a row especially skilled at flipping coins?

    “I do like the main ideas posited, but as for why funds don?t take fees based solely on above-market or positive performance, I think the answer is quite simple: they don?t have to.”

    I totally agree. It’s a world driven by marketing.

  22. Does anyone have the current version of The Intelligent Investor by Ben Graham? The guy who writes the synopsis of the chapters (I can’t remember his name) writes a little paragraph about Vanguard SP 500 Index fund. In the less than 5 year range, that fund is in the 50th percentile, meaning that it’s exactly in the middle. In the 20 year mark, it goes to the 85th percentile, obviously making it a great choice for a long-term investor. However, in the short-term, it’s not always the best fund to choose, nor are any of the index funds. I’m not saying that no one should own index funds, but making a blanket statement like mutual funds should all be governed by how well they do. In a way, they are already…because no one is going to buy them and their prices won’t go up.

    However, one thing that I always laugh at is that everyone likes to give the fact that “80% of actively managed funds don’t beat their respective index” or something like that. Looking at that from another perspective, 100% of index funds don’t beat their indexes…

  23. Active fund management is a skill. There are too many money managers. Few are really good, some mediocre and rest pathetic. Compare VHGEX vs CWGIX vs TEDIX – all three are excellent funds. But CWGIX and TEDIX have 5.75% front loads and greater expenses invovled. This would make a strong case for VHGEX. But still CWGIX and TEDIX have billions of dollars invested in them, the initial investment in them can be made only through a broker and both are at the top of their packs. This is simply because people are ready to pay a premium to broker and the fund so that they do not have to worry where in the pack they will end up. As in any market place, the price on a skill is determined by the performance reward obtainable by availing it.

  24. Steve Austin says

    I think you refer to Jason Zweig? (editor of 4th ed. of Graham’s Intelligent Investor)

    That figure about 80% active managers not beating their index doesn’t account for survivorship bias. The figure is probably higher if one were to include all the formerly active managers who could not cut the mustard and whose poor performance statistics no longer register when tabulating who has beaten and is still beating the index.

  25. Gates VP says

    KMC says: “That ?superior performance? this manager talks about is LUCK”

    Jonathan says: “Is some who manages to flip a coin ?heads? 5 times a row especially skilled at flipping coins?”

    To which I say that there are professional poker players the world over who will claim that it is NOT LUCK. And not only do these players have a consistent, proven track record of “beating the market”, they have successfully trained other players in “beating the market”.

    Jonathan, you used to have a poker blog, poker and the markets are both zero-sum games. The markets are just significantly more complex and have way more viable strategies.

    As for your question about “why don’t we run funds this way”, some do. My late step-father ran just such a hedge fund. He started the fund after several years of significantly beating market performance. In fact, shortly after his firm (Midland Capital) was bought out by Merrill Lynch Canada, they investigated him for account churning on his biggest client. Turns out that he was up over 40% for 2003-2004 but about 15% of profits were being eaten by Merrill’s. They basically scolded him and asked him to start selling Merrill’s mutual funds.

    However, there were some issues with the hedge fund. You see, as a previous poster noted, he could not guarantee losses as a mutual fund (he also couldn’t use options) so he had to start a hedge fund. But here in Canada, those funds are only accessible to “sophisticated investors” or those investors with more than 100k to invest. And the whole fact that nobody would believe that he was “actually doing this” also made sales of the fund quite difficult. Of course, the grand experiment died with him (major stomach cancer). But he has left the investing world with a least a few more well-informed investors :).

    End of the day, Steve Austin pretty much hits the major points. Investors are not demanding performance. Heck to most people it’s all just numbers in a book. Investing is “just more work”, and it’s really hard, emotionally demanding work. So the average person just gets snowed on their investments. But hey, they don’t really care! I like Steve’s idea of using treasury bills/bonds as a baseline (and inflation as another baseline) and gauging performance based on that. And that’s the easiest gauge I can use to explain to my fellow 20-somethings how this whole investing thing actually works.

    BTW, at the end of the day, mutual funds are bound by some very serious SEC rules on how they can manage money, which is one of my issues with mutual funds. For example, they must all use very similar methods for selecting stocks, they have a limit on the amount of cash they can carry and they can only make money by picking stocks going up (no options). Truth is this is much like a poker table where everyone plays their hands exactly the same. Which is why I maintain that there is a lot of room to “beat the markets” consistently, b/c we actually have a pretty good idea of mutual fund strategies.

    But that’s a blog post in and of itself πŸ™‚

  26. I see the poker analogy thrown around all the time, but I don’t see any evidence that investing skill has the same permanence as poker skill. This seems based purely out of vague observation, and not based in any data at all. Just because two things are both zero-sum games doesn’t mean skill plays a role. Flipping a coin is also zero-sum. Again, I’m happy to be proved wrong.

    I must repeat, things like “I beat the market” or “He beat the market” don’t help. LOTS of people beat the market (less over longer periods). The critical question is – can you pick those people out ahead of time? If someone thinks so and are confident of this, are you willing to take me up on my offer?

    If beating the market and picking winning managers is so possible, such an offer should be a slam dunk. It would be like being able to bet on a coin that hits heads 60% of the time instead of 50%.

  27. Independent George says

    I believe that some individual investors are indeed capable of beating the market over the long haul. The operative question here is (a) are you one of them, and (b) how can you tell?

    As far as mutual funds, I have almost no confidence in any actively-managed fund based on one simple reason: if an individual could indeed beat the market consistently, do you think he’d be wasting his time managing a mutual fund? And if he did decide to manage a fund instead of making a fortune investing his own money, how confident are you in your ability to pick him out of the crowd?

  28. Chris H. says

    I was writing a reply when I read Independent George’s post and realized that he already said the exact same thing that I was going to say. The preeminent example of an individual investor beating the market is Warren Buffet.

    I also agree that finding that individual fund manager who does beat market returns is a difficult task. Even if you do find that one manager, are you going to put all of your eggs in his basket? Probably not, and if that’s true then the results will likely be weighted down by the other funds in your portfolio, meaning that over the long term you come out even with index funds at best.

    Also, not that five or ten years is not long enough to gage the performance of a fund and/or manager. Actively managed funds tend to beat indices in upswings and trail indices in downswings by roughly the same amount. The difference overall: the costs of the fund. Since actively managed funds cost more, a portfolio of actively managed funds will almost always trail a portolio of index funds over the long term.

    Of course, if you pick that amazing manager and complement that choice with index funds, then you are assured to beat a portfolio of index funds in the long term. If I were going to put my money on anyone being that manager, it would be Ken Heebner over at CGM Funds. He will take you on a wild ride, but in the end I think you will end up ahead.

  29. enonymous says

    I am glad that people are trying to beat the market. Why? Because if no one tried to beat the market, there would be no market in the first place. Or to put it another way, ‘the efficient market hypothesis’ is based on the fact that over time, any anomalies in prcing will eventually be resolved by discovery and subsequent market forces. If everyone indexed, these anomalies would persist, and the markets would be highly inefficient. Without the trillions of dollars spent on trying to ‘beat the market’ there would be no market, and that would be terrible for me, because… I index πŸ™‚

  30. BackOfficeMonkey says

    I know of a portfolio strategy that has the potential to beat the S&P 500 by 100-150 bps net of fees over the course of a year (assuming the risk free rate stays the same) with no additional market risk but with marginally more operational and liquidity risk (liquidity risk could actually be eliminated depending on the financial instrument you use). It?s a strategy mainly used by hedge funds for institutional investors but the retail investor can implement the strategy as well.

    Dare to try?

  31. Mark Rosner says

    I’d like to say that I can agree entirely with you post, but the fact is that it’s a bit slanted. For instance, you can bring articles that says the average money manager cannot beat the market. However, there are individual money managers that do offer a better proposition than index investing. Let’s face it, index investing is average.

    When it comes to risk and risk versus return, many people look at systemic versus non-systemic risk. It’s really tough to say that casual movement in stocks is actual risk when the truth is that it’s likely liquidity.

    I said that I had a few bones to pick, so I’m mentioning them here. Also, note that I don’t necessarily believe that index investing is bad. It’s good for autopilot investors (at the moment, myself included).

  32. Wow, some seriously passionate feelings about this topic.

    Someone mentioned being stuck with their employer’s broker who has crazy fees. My wife is in the same boat and I about flipped when I got the statement….if it wasn’t for the match, no way we’d be contributing there!

  33. Buffett (by which I mean BRK) hasn’t been doing all that hot lately, so I wouldn’t really use him as an example.

  34. First of all, the system suggested in the article makes no sense. Under that system an average performer gets paid zero and the worst performer gets paid zero. Ridiculous.

    Also, a money manager getting paid on asset size is not incentivized to implement inappropriately risky strategies. If that was not the way it worked, who would ever put a person close to retirement in conservative income fund? Managers do get paid on performance, because if the performance is good, assets increase, if the performance is bad assets go down.

    And the e-mailer is correct — fees do not matter – only total return does. There are a number of hedge funds out there that take no management fees, but take 50% of all returns. They stay in business because their returns justify it. Would you rather earn 10% net (12% – 2% fees) or 15% net (30% – 15% fees).

  35. Steve Austin says

    Guess it depends on what you mean by lately, but you sure you know what you talkin’ bout, Andy?

    I calculate:
    * Mr. W. E. Buffett as giving you ~85% cumulative over 1999-2006
    * risk-free rate (10-yr bond yield) giving you ~45% over same period
    * S&P 500 w/ divs giving you ~30% over same period

    * avg. large cap stock mutual fund not calculated, but likely less than 30%

  36. There are several concepts which people are using interchangeably. Are we talking about my “portfolio” beating the “market”, if so, which “market”? Or are we talking about a fund beating it’s index, if it tracks an index, or it beating its “like funds”? Those are all very different things.

    My portfolio has beaten most indices/markets ever since I started taking it seriously: 15%, 48%, 20%, 15% 21%, and 7% YTD (annual returns since ’02). Although, in the broader context, considering the bull market we’ve been in since the end of ’02, a monkey could have done as well as I have.

    I’ll take up your challenge Jonathon if we can compare the results to the S&P 500….

  37. Steve Austin says

    I just recalculated based upon Wes’ returns (better go with Wes):

    * Wes 180%+
    * Buffett still around ~85% (guess first 3 yrs were flat)
    * S&P500 w/ divs ~35%
    * risk-free rate

  38. Steve Austin says

    Above post got clipped. Risk-free rate of return was

  39. If you use symbols like < or > in the comments it will parse it as html; trying using “&lt;” and “&gt;” instead.

    & = “&amp;”

  40. enonymous – I don’t think we have anything to worry about. As you can see by reading some of these comments, hope springs eternal. I’m really not on a mission to “convert” everyone either, I just think that managers should be paid based on them adding value. If they don’t add value, then what am I paying for?

    BackOfficeMonkey – If you cover my relative losses, sure! But I shouldn’t have any with this strategy, right? r

    Wes – As I stated above, “Instead of a flat fee, you choose the investments, and you get to keep 80% of how much you beat a benchmark portfolio where I try to match your level of risk using index funds”. It’ll only be the S&P 500 if that’s the risk profile of your portfolio.

    Hedge funds have a great deal. You play with other people’s money, and get to keep a huge chunk of profits. If you lose, you just disappear into the night and join another hedge fund. Sooner or later you’ll hit it big and be set for life.

  41. As pointed out above, you can’t guarantee any particular results as an investment advisor. It is strictly prohibited in the Investment Advisor’s Act of 1940, so that rules out that option. They can however pay themselves nothing.

    As far as active management as a skill, yes it is – no doubt in my mind. This is particularly true in inefficient markets. In my job I meet with some of the largest institutional investors in the world and there are certainly people out there who consistently kill the indexes. One thing all these managers typically have in common though is that, like Warren Buffett, they tend to hold very concentrated portfolios.

    A great book to read on the subject is Pioneering Portfolio Management by David Swensen – CIO of the Yale Endowment. He has a chapter on selecting active managers and he has consistently outperformed the benchmarks for almost two decades by investing with skillful managers such as Chieftan capital and Longleaf Partners. People talk about Peter Lynch, being this great investor, but as Bernstein points out, he was probably a lucky coin flipper. Joel Greenblat, Bill Ruane, Lou Simpson, Mason Hawkins, Bill Nygren and others have proven to be much more deft at running portfolios and you will find the largest universities and foundations in the U.S. investing with them instead of index products. I liked Bernstein’s book (four pillars) but his chapter refuting active management by using Lynch as an example would be like saying all Rock & Roll sucks because a band like In Sync isn’t really that talented.

    So can active management be better… Yes. Are you going to personally interview 100 managers a year like Yale does… not likely.

    The argument shouldn’t be that managers can’t beat the indexes, the argument should be that the average investor can’t identify managers who can consistently beat the indexes.

  42. Interesting points, thanks for the comment. I remember Swensen saying that individual investors should use index funds, and Googled up some more stuff.

    This interview clarifies his points. He basically says the whole mutual fund setup is against investors (again, the way they are paid!). Yale’s endowment can negotiate the fees and terms of active management advice. Unfortunately, I’m not Yale’s endowment πŸ™ But I am interested in reading Mr. Swensen’s book.

  43. I think none of you are speaking from a solid fundamental background of investment theories. Thats why you have such haphazard views of the market. You only tend to look at the results – that is use hindsight – and then evaluate the risk of future investment. One basic way to look at the results is to notice the alpha. “Modern Portfolio Theory states that Alpha measures the relative value-added provided by an asset manager compared to a market index, given a portfolio?s market risk. A positive alpha is the extra return received by an investor for taking a risk, instead of accepting the market return. For example, an alpha of 1.0 means a portfolio produced a return 1% higher than its beta would predict. An alpha of ?1.0 means a portfolio produced a return 1% lower than would be expected.”

  44. Read Bogle’s book!


  45. Actually a better book for the average investor by Swensen is “Unconventional Success”. Perhaps the best book I’ve read on the logic of choosing asset classes and creating a portfolio.
    Pioneering Portfolio Management is more for institutional investors. (Although written so anyone can understand and enjoy it.)

    Nobody really escapes his magnifying glass in “Unconventional Success”, (Even Vanguard takes a few hits.) That said, he feels Vanguard is the best choice for most people.

    Of particular interest is the fact that he doesn’t recommend corporate bonds for anyone… A very interesting chapter with some great logic to back up his argument.

  46. I generally agree that most people have no reason to be in anything but index funds, and most actively managed funds are just a load of crap. That said I do believe there are good investors, and a good investor can be beat the indexes. The problem is that most funds aren’t aligned with those interests in mind. Since I view good investing as sound fundamental investing, it’s really a basis of recognizing leadership. There are good companies and bad companies because of good and bad management. A good investor like a good manager should have the skills to differetiate talent. The manager does at his company, and the investor does at the top level.

  47. Ted Valentine says

    A guy at Raymond James told me that the fund managers at American Funds are paid based on performance relative to the market. The risk and treasury index is taken into account to measure the performance.

  48. It’s not that beating a particular market index is that difficult, many managers, advisors and the general public do it all the time. The essential problem is doing it as asset base gets larger. This is why many mutual funds tend to lag. Take a look using Morningstar, the larger the fund relative to the market cap invested in, the less favorable the performance. Morningstar has even coined a term for this: bloat. Does this mean to avoid investing in actively managed mutual funds? No, it means invest in smaller funds relative to market cap of companies invested in based on manager track record, NOT stars!

    As for finding an advisor who will manage based on performance, many, many do. However, you must have seven figures to get access to those guys. It just isn’t affordable for most retail brokers/advisors to take on that business model as they are dealing with five and six figure accounts. For a fee based advisor to net a $100k per year income, and frankly why would anybody assume such large liablity for less, would require $20m to $25m in assets under management at 1% (remember, the advisor/broker only makes 30-80% of the total fees, and the higher up on the payout grid has to payout more of the fixed costs of doing business and benefits, i.e. most independents). Getting that kind of money under management isn’t easy. In fact, most advisors are under.

    Here is the essential problem with using Index funds. You are by definition taking 100% of the risk of the market with no benefit of human intelligence. Many many advisors provide index similar returns with much lower risk. How can you tell? Check the cash balances in Advisor managed accounts (or their model portfolios). Virtually any good Advisor keeps 5-15% in cash/money markets. Take advantage of human intelligence in your investments the same way you do with a million other things.

    Re American Funds. Their bonuses are based on performance. They have nice salaries to boot. Also, they have a simple model of trying to mirror the index but subtract the stocks most likely to be skinkers. With their level of assets that is the best they can do. In the past few years they have hugged the indexes tighter and tighter.

  49. I actually know a manager in Milwaukee who beats the market pretty handily over five year rolling periods. This is the time frame he asks for and requires before taking an account. But shhhhh, he only charges up to 1%, and tosses in basic financial planning. I don’t really want him taking the profits.

  50. Question… I have been trading options for myslef but have limited funds. I have been able to do 20% per day consistanly for quite some time. So..My folks want me to manage some of their money by trading full time. My question is… How should I be paid? I would like a % but have no idea what I should get. I was thinking 50% of the profits and maybe a % of the losses I would pay. Anyone who can help me figure this one out will be my hero! Thank you in advance for your reply! Have a great day!

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