Saturday, January 29, 2011

The Fee Delusion

Fees are perhaps the most frequently discussed, and least well understood, factor in financial product marketing. Financial organizations that serve professional groups often focus on low fees to obscure the fact that their investment arm is understaffed, under qualified, and generally delivers poor service and performance. The simple reality is that in the field of investments, as in many complex fields, differentiated value isn't free, but mediocrity can come very cheap.

To illustrate, consider the following 3 proposed investments:

Advisor A proposes an investment in a fund with a history of performing in-line with stock markets. The manager performs slightly better during really poor periods in the market, slightly worse in really good markets, and averages returns of 1% better than stocks over the last 10 years, after accounting for fees and costs. Note that this performance would place the fund in the top 95% of all funds, as most funds don't come close to this track record. This fund has dropped by more than 35% from its peak twice in the past ten years. This fund charges a fee of 1%.

Advisor B proposes an investment in a systematic strategy, with a history of performing very differently than stock markets over time. The performance of this fund is largely independent of the direction of stock markets, and the fund has never been down more than 25% from its peak. It has performed about 10% better than stocks over the last 3 years, after fees and expenses. This manager charges a fee of 2%.

Advisor C proposes an investment in a fund with a history of exactly tracking the performance of stocks over the very long-term. This fund does well when markets to well, and poorly when markets do poorly. This fund has also been down more than 35% from its peak twice in the past 10 years. This fund charges 0.4% in fees.

All other things equal, which Advisor's proposal would you go with?

Mutual Funds: A Low Probability Bet

Before answering, I urge you to consider the following chart, which illustrates the probability that a fund which ranks in the top 25% of its category will even be ranked in the top half of its category four years later. Remember that funds selected at random would, on average, be in the top half of their category about 50% of the time. However, we see that top funds in one year have, on average, only about a 40% chance of being in the top half 4 years later. That is worse than random chance.

Source: Gene Hochachka, February 2008

The Passive Option

Given the chart above, one could be forgiven for believing that it is not possible to deliver differentiated performance, and in fact there is a very large and credible contingent of the investment community that operates on that basis. This way of thinking is called 'passive investing', and I am willing to concede that for the majority of investors, this is probably the way to go. I concede this for most investors because it is actually very hard to find an Advisor or a fund manager who actually does add value over time, especially after fees and commission. Hard, but certainly not impossible, and potentially highly rewarding for those who do.

If you embrace a passive approach, the only logical strategy is indexing. This is a low-cost strategy which involves purchasing a diversified basket of broad-market Exchange-Traded Funds and holding them forever, with periodic rebalancing. A buy and hold strategy that emphasizes a diversified basket of global asset classes is almost certain to outperform cash in the bank over periods longer than 10 years. However, investors are vulnerable to behavioral biases that will make it hard for them to stick with this strategy when things inevitably turn ugly. Further, the unpredictable path of returns may have a substantial negative impact on your ability to achieve, or maintain, financial independence.

For investors that choose this route, we would be delighted to provide guidance on how to construct a well diversified portfolio of ETFs that will benefit from the ebb and flow of capital and opportunity in global stocks, commodities, real estate and bonds. Under IIROC guidelines, I am not allowed to provide specific investment advice here without first knowing your long-term objectives and risk tolerance. A fairly quick phone call can establish these basic parameters (believe it or not), and we will provide this quick advice at no cost, and with no further obligation.

One final thing on passive investing: there is no conceivable reason to use mutual funds for a passive approach. If you embrace this philosophy, you acknowledge, quite legitimately, the low probability that a manager will add value over time. So why are you investing in mutual funds which charge you 1% or more for the slim chance that the manager will do just that, when you can open an account at a discount broker and purchase Exchange Traded Funds or index mutual funds for as low as 0.25%? It's madness!

Where an Active Approach Can Add Value

I made the case in the previous section for most investors to apply a passive approach to their investments. This means taking your money out of mutual funds and putting them into a basket of very low cost Exchange Traded Funds. However, while a passive approach is likely the best option for most investors, who lack the time, motivation, or acumen to find quality active managers, smart, motivated and open-minded investors who take the time to learn the nuances of different active styles can realize tremendous value. This task is difficult, but certainly not impossible.

Managers that deliver consistent returns over time generally possess some combination of the following 4  qualities:

  • Insider information - yes, this happens all the time, and is quite illegal. No, your mutual fund manager doesn't have any. If he did, he would be making 2% plus 20% of the fund's profit at a hedge fund.
  • A systematic approach with very little qualitative interference based on manager ‘intuition’
  • A focus on asset allocation, not stock-picking
  • A rigorous strategy for risk management
There are some superb talents in the investment industry who have demonstrated incredible performance persistence through time: George Soros, Steve Cohen, John Paulson, and a few others. So far as I know, these managers do not use any specific system to manage money, but instead are able to see into the future via a black box in their heads. Notably, none of these managers is available for average investors, though they charge extremely high fees (5% plus a percent of total portfolio growth). Further, I could count the number of consistently successful investors of this type on two hands. I don't include Warren Buffet because he is not an investor in the contemporary sense. Rather, he is a business man who purchases companies and then adds value through extraordinary management. This is an important distinction!

Thankfully, there are far more examples of true systematic approaches with very long track records of adding extraordinary value to investors. Here is a list of some of these funds, along with their December 2010, and calendar year 2010 returns, and total assets under management, courtesy of Jez Liberty of Au.Tra.Sy blog:

Organisation / FundReturnYTD *AUM **
Abraham Trading1
Altis Partners2
Aspect Capital3
Campbell & Company5
Chesapeake Capital6
Clarke Capital7
Drury Capital8
Dunn Capital9
Eckhardt Trading10
EMC Capital11
Hawksbill Capital12
Hyman Beck & Co.13
JWH & Co.14
Man AHL Diversified15
Millburn Ridgefield16
Rabar Market Research17
Saxon Investment18
Tactical Investment Mgt20
Winton Capital22

Many of these systematic managers charge hefty fees, but have delivered remarkable long-term performance. For example, Jim Simons’ Renaissance Medallion Fund (not shown) charges 5% management fees and a 44% (!!) performance fee. Despite these burdensome costs, Medallion has consistently returned 35% per year in performance after deducting all fees. Unfortunately, Medallion fund has been closed to new investors since 1993. MAN Group’s AHL Diversified Fund has been open to new investors since its inception in 1990. This fund has returned 15.4% per year for investors after charging a 3% management fee and a 20% performance fee. It has reported fund losses over a calendar year only once: in 2009.

There are several Canadian systematic funds, most notably Acorn Diversified in Oakville, and Auspice Capital out of Calgary. Of course, Butler|Philbrick & Associates applies a systematic approach for its clients as well.


Unfortunately, high fees do not necessarily guarantee superior service or investment performance. You are, however, unlikely to receive superior service or performance for low fees. Investment advisors and funds who rely on low fees to capture and keep clients generally fall into 3 categories:
  1. They are in the early stages of building their businesses, and with few qualifications
  2. They have a focus on client volume instead of performance and/or superb service
  3. They do not offer differentiated value
Highly qualified professionals that deliver differentiated value to their clients are confident charging a reasonable fee for their services. For other professionals, this should not come as a surprise.

Perhaps the main point of this essay is to demonstrate that there is no logical basis for investing in traditional actively managed mutual funds, no matter how low their fees are. Given that your probability of choosing a strong traditional mutual fund which will remain in the top half of its category just 4 years from now is worse than random, an average investor should ALWAYS prefer a diversified basket of passive Exchange Traded Funds.

Investors with the acumen, motivation and perseverance to investigate active managers will discover that there are phenomenal managers and strategies out there that have the potential to fundamentally alter the trajectory of their investments, and the landscape of their retirements. These managers do not compete on price - but smart investors won't care.

* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. Altis Partners started trading in 2001 and now manage over a $1B with their Altis Global Futures Portfolio. The figures referenced in the performance table are not provided by Altis Partners and no reliance should be taken as to their accuracy, and as a consequence the figures may not be in accordance with any CFTC / NFA performance reporting requirements.
3. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck).
4. BlueTrend, from BlueCrest Capital, is one of the largest Trend Following funds – headed by Ms. Leda Braga
5. Campbell & Company is one of the oldest Trend Following firms, operating for around 4 decades.
6. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
7. Clarke Capital was founded by Michael Clarke in 1993. The programme tracked here is Millenium.
8. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
9. Dunn Capital was founded by Bill Dunn.
10. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
11. EMC Capital was founded by Liz Cheval, a former Turtle.
12. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
13. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
14. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
15. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
16. Millburn Ridgefield have been trading Trend Following models since the early 1970’s.
17. Rabar Market Research is the company of Paul Rabar, a former Turtle.
18. Saxon Investment was founded by Howard Seidler, a former Turtle.
19. Superfund founder and CEO: Christian Baha.
20. Tactical Investment Management was founded by David Druz, a student of Ed Seykota.
21. Transtrend is a Trend follower CTA based in Netherlands
22. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).