Did you know that in a given year, anywhere between 60% to 75% of managers fail to beat a buy-and-hold strategy of holding the index?

When you extend the time factor over a longer period to about 5–10 years, this percentage increases further.

Which means less only about 2 in 10 managers will meet or beat benchmarks at best over a time horizon!

Want to see some facts and figures to back this?

Well, in an empirical study of ~2,000 Zurich hedge funds with their performance marked out from January 1995–November 2000, it was found that the average returns (both absolute and risk adjusted) are “significantly lower in the presence of incentive fees”. When the study accounted for investment style differences, the average hedge fund failed to make back fees, which averaged 2 + 20.

Here are reasons why they cannot beat a buy-and-hold strategy.

Firstly, on average, the market remains fully invested.

They are not making any market-timing moves nor paying commissions for stock changes.

Secondly, mistakes from haste.

The haste of mutual funds trying to catch up with the index puts them at a disadvantage in that the attempt itself to get ahead puts them in a place to make mistakes as they shift in and out of stocks.  

Thirdly, after accounting for mediocre performance, the fees themselves get in the way and bring the performance percentages lower.

To keep clients, window dressing is done when they are reporting to clients. All in all, clients are putting money in a mutual fund that is managed in a manner that produces results that could have been done by themselves. Period.

Fourthly, the agency-principal problem.

The fund manager wants to maximise his returns. Funds have run on a 2 and 20 rule. 2% management fee and 20% on top of that for market beating performance. The temptation to deviate from or display behaviour that takes excessive risks at the expense of clients will be present.

Fifthly, copycat syndrome.

Some funds simply follow the strategies of better performing ones, sometimes at a high cost to them because they are unable to turn quickly as the market makes sharp, volatile downwards moves. And because they did not have a proper thesis as to the initial investments, they will end up closing the move at a loss.

What could possibly be a mover for you to invest in a fund?

It has been found that when fund managers invest their own money into the fund, they moderate risk taking. By using the “eat what you cook” approach, you can have a certain level of assurance that the fund manager will be “forced” in a way to align his investment approach so that he too can gain when investors gain and lose when investors lose. The higher the percentage of his own amount in the fund, the closer the alignment of investment motivation to investors’ objectives.

Yours,

Chief Editor

BBA Market Perspectives

*Not investment advice. Do your own due diligence before you invest!

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