Money managers make money for themselves whilst losing money for their clients, This makes neither cents nor sense.

Asinine approach to investing

John Collett

September 22, 2010

There should be an industry overhaul on how fund managers are paid.
Asset bubbles, investing manias and financial crises. In his 25-year career in fund management, Jonathan Pain has just about seen it all. After holding senior positions in funds management, he now runs his own consultancy and has fund managers in his sights for investing in a way that leads to frequent catastrophic results for investors.
There is little alignment of interests between fund managers and their investors, Pain says.
Fund managers earn bonuses even if they lose money for their investors. "The whole thing is a sham, a complete sham," Pain says.
What is needed is a major rethink on how managers are paid and how they measure their performance. As it stands, most fund managers get rewarded for investing in stocks that they do not like and would not put their own money in.
Pain says one of the best examples of this misalignment of interests was with News Corp, when its share price shot up during the last gasp of the technology boom at the end of the 1990s.
In March 2000, News Corp reached $28 and made up 18 per cent of the Australian sharemarket. Pain says that almost every fund manager at the time regarded the stock as very expensive.
Fund managers would never have bought the stock at those prices if it was their own money, yet almost every Australian share fund manager was investing in the stock.
When, in 2004, it became known that News was about to drop out of the Australian sharemarket indices, its share price fell by more than 5 per cent as managers started selling the stock, even though the financial fundamentals of News Corp had not changed.
Holding only the stocks they really believe in would run the risk of their fund's performance falling behind the market and peer funds. A fund manager who loses 15 per cent when the market is down 20 per cent can regard it as a commendable result.

"Money managers make money for themselves whilst losing money for their clients," Pain says. "This makes neither cents nor sense.

"An investor's objective when investing in a share fund is to make a return above what they could earn on the 'risk-free' cash rate available at the bank. Surely that, too, should be the money manager's investment objective."

Having the cash return as a benchmark against which performance is measured would encourage fund managers to invest only in the stocks they believe will be good investments, rather than owning stocks they do not like just because the stocks are a big part of the market.

Many managers are really "closet" indexers but charge their unitholders the higher investment management fees that are paid for "active" management, Pain says. The way most funds manage money has more to do with protecting the managers' fees than with managing the investment risks on behalf of unitholders. Managing money relative to an index exposes unitholders to unwarranted risks, Pain says.
For example, international share funds became heavily exposed to Japanese shares in 1990 when the real estate and equity bubble there meant that Japan comprised almost half of most global equity indices. Almost half of most international equity portfolios were invested in Japanese shares despite clear signs the prices of Japanese shares could not be justified, Pain says.
It was the same story with the tech boom of the late '90s, when tech stocks made up about one-third of the US S&P 500 index. Funds were buying shares in tech companies that were not much more than blue sky.
Pain says we are seeing the same thing now.
He divides the world by debt, not geography. The emerging world includes China, India, other Asian nations such as Vietnam and Indonesia and various South American economies, including Brazil.
Then there are what Pain calls the "submerging" nations, which include most of Europe, Britain and the US, with their indebtedness likely to hold back economic growth for years.
"Australia falls somewhere in the middle - a land with developed potential and infrastructure that, if we play our cards right, will continue to be underwritten by Asian growth and thus enjoy the best of both worlds," he says.
But the "submerging" nations dominate the global equity indices followed by fund managers.
Pain says that while fund administrators manage money relative to benchmarks, they will continue to buy overpriced stocks merely to mirror an increasingly bizarre and unrealistic benchmark.

Index huggers put themselves first

The reason that managers — particularly those owned by the financial institutions — can hold stocks they do not like is that fund managers’ performances are measured relative to the performance of the market indices.
Most have an incentive to keep growing their funds under management because their fees are based on a percentage of the investment pool.
The funds run by institutions also play it safe and stick to the indices, which means they deliver average returns. They generally rely on their big brands, marketing and financial planners to attract investors’ money into the funds.
In recent years, more ‘‘boutique’’ funds (owned by individual managers) have performance fees, which are only paid on reaching certain performance targets.
Boutiques will typically have a low, fixed percentage fee and a performance fee, which is usually 20 per cent of returns above the performance benchmark. They tend to invest in the stocks they like rather than those that will deliver returns that hug the index.

http://www.smh.com.au/money/investing/asinine-approach-to-investing-20100922-15ma9.html