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Why Fund Managers Risk Too Much



Many investors are reactive and accepting of poor fund management. When they should make an argument, they rarely do - even when things go horribly wrong, as they did between 2000 and 2003 during the dotcom crash. But when investors keep their mouths shut about bad fund management, this opens up the potential for fund managers to take improvement of them. In this article, we'll show you why you should play an dynamic role in understanding and evaluating your portfolio, even if it has been performing well.

Investors Lured by Last Year's Winners

In March 2004 study at the University of Cologne in Germany, "Family Matters: The Performance Flow Relationship in the Mutual Fund Industry", demonstrates the predominance of the unfortunate but common process of investing in last year's winners. According to the study, in spite of the warnings against using the previous year's performance as a predictor of future success, investors remain impressed by past gains, and continue to base their investment decision on this data.

This means that in order to attract new investors each year, fund managers need to show excellent results from the year before. This often leads managers to take on above-average risk, which can be fine in good quality period, but it can also be disastrous in a bear market, as this strategy can go horribly wrong when the market turns for the worse

When evaluating a fund, hence, it is significant that investors remember the adage that "past performances does not dictate future results."

Fund Managers Propelled by Investor Behavior

For the reason that investors tend to be reluctant to switch funds and/or managers - whether because of up-front fees or just plain apathy - fund managers are able to take unwarranted risks with existing investors in order to attract new ones. In other words, fund managers are not punished appropriately for gambling with their clients' money because most investors remain authentic to a fund when it underperforms.

In these cases, investors lose out heavily because they do not get what they required or expected in terms of risk. One of the most fundamental principles of fair play in the industry is that people should never lose money through taking risks they did not agree to. Nevertheless, this is precisely what tends to happen in the mutual fund industry when gaining new investors takes precedence over protecting current fund holders' interests.

The procedure can also work in reverse, causing successful managers becoming too cautious. For instance, once a manager has a strong client base, he may become self-protective and focus on matching the benchmark or index. For investors who are counting on active management and exploiting current market opportunities, this is not the attitude they want in a manager.

Common Problem

How possible is all this to happen? These problems are severe in the U.S., where risky business is particularly beneficial to fund managers. Stefan Ruenzi of the Center for Financial Research in Cologne found apparent evidence that bad funds are not appropriately punished by outflows of money. His research indicates that funds in the top 20% during one year choose up 10% more business than funds in the second 20%. Below that, performance does not seem to make much difference.

When top-performing funds rake in considerably additional new business, it is tempting for fund managers to beat an index by taking on a greater amount of risk. This is not always a bad thing for investors in a fund: by taking on more risk the fund will probable perform much better than an index when the overall market is trending upwards. Of course, the problem is that the fund will also do proportionally inferior than an index in a bear market.

Far too many fund managers rely on indexes and try to beat them, but what should actually matter to investors is whether their fund manager is staying within the bounds of the fund's risk profile (and possibly having some form of explicit loss control). Getting a couple of percentage points more in excellent times is not much of a consolation if the gains of the last five to 10 years get wiped out then the market takes a turn for the worse

Vying to Beat the Index Seldom Pays

Investors should also accept in mind that one of the best-kept secrets in the industry is that few funds succeed in beating an index consistently over time. For this cause, investors are generally better off with products that do not claim to do anything other than match an index, so-called "trackers".

On the other hand, if this does not appeal to you, discover a fund that is deliberately contrarian and does not worry about an index at all. Anything in between possibly will turn out to be a bad and expensive compromise, both in terms of fees and potential losses.

Learn the Level of Risk

To keep away from getting trapped in an underperforming mutual fund, investors also need to check out the risk of specific funds through sites such as Morningstar and Feri Trust. These internet services give information on the risk profiles of funds and even give risk rankings. Alternatively, investors should not be frightened to ask their banks, brokers and advisors exactly how (relatively) risky various investments are. They should also demand meaningful feedback as to whether any gamble is really worthwhile in terms of their risk preferences and personal circumstances.

In addition, the Center for Financial Research stresses that it is imperative for investors to know how fund managers are paid. If this depends on how much business they bring in, over and above dangers will apply. Find out how your fund manager is remunerated and rewarded for success as well as how this success is defined.

Most managers are measured by returns in relation to an index (an average of a large number of shares) or a group of analogous funds. What is stated less often is how much money a fund managed to attract in a given era? Even rarer is the information that may matter most: How did the fund do, not only when return is taken into account, but threat as well?

Both the market and firms reward managers for good quality returns in good times far more than they penalize for losses in bad times. This contributes to the dilemma of fund managers taking on more risk than may be suitable. Few managers are paid for keeping to the right level of risk regardless of the fact that during times of market volatility, this may be the only way to prevent losses that investors were never really enthusiastic to chance. As a result, investors who demand medium- or low-risk investments frequently end up with medium-high or truly aggressive portfolios.

The Center for Financial Research suggests that in the upcoming times, some funds may start paying their managers based not only on a fund's returns, but also on the level of risk mandatory to achieve them. Recent research, nevertheless, suggests that that day may be a long time coming. Consequently, investors must try to familiarize themselves with the risk profiles of their portfolios and make certain that they match the level of risk that they are willing to take on.

Mutual Funds
Mutual Funds