Mutual funds allow your money to grow and attract steady returns. You invest your money in a mutual fund of your choice after careful deliberation and allow the fund manager to do the heavy lifting for you.
While many of us trust fund managers to handle our money and make the right decision, it is important to educate yourself about how fund managers work. And how the fund management practices impact the performance of your investment.
Here are some common fund management practices that may have an impact on your returns:
1. The fund management fee (TER) charged from the investors
Total expense ratio (TER) is a fee that an investor needs to pay to make up for the expenses that the fund house incurs. These expenses include operational costs, salaries, compliance costs, administrative costs, among other expenses involved in running an asset management firm.
A percentage of the market value of mutual fund units held is charged to the investor to cover these expenses. The expense ratio is a standard charge which is paid by the investor regardless of the fund’s performance.
Fund houses are currently working on coming up with alternative fee models that resolve this and still cover their expenses.
Currently, many hedge funds follow this model. For instance, the funds following the 2/20 model earn 2% of the fund’s AUM fee as the base fee and 20% of the profits that cross a predefined limit as performance fees.
2. Window dressing practice to create an illusion
Mutual funds may make it look like the fund is performing well despite the fund’s actual performance. This is called the window dressing strategy. Some of the practices under this strategy include exiting investments that haven’t been performing well. This saves them from explaining why these poor investments were made.
Mutual funds may also invest in stocks that have been performing well right before the quarter ends to make it look more promising.
Another trick used is to divert from the fund’s investment style and make short-term investments in IPOs only to create an illusion of good returns.
As a wise investor, you must carefully read performance reports and identify stocks that do not sync with the fund’s general strategy. This helps you assess if the fund manager is using window dressing to elude you.
3. Closet Indexing strategy to minimize the risk of underperformance
Some funds claim that they are actively investing but come up with a portfolio very similar to their benchmark. This way they achieve similar returns and avoid being labeled poor performers. The industry is moving rapidly to passive management. Thus, fund managers indulge in closet indexing because of their underlying fear of being phased out.
The fund managers are incentivized for their stock-picking abilities when they can match up to the results of their benchmark.
However, this strategy may not be in the best interest of investors. You’d have to pay a management fee when all the fund is doing is mirroring an index fund. You could very well save the amount you spend on the fee by just investing in the index fund.
4. Asset acquisition-based incentive models for advisors
One of the most important factors mutual fund houses consider is the assets under management (AUM) for the fund. Thus, to gain more funds, they need to resort to methods like planning promotional events, making presentations, introducing close-ended funds, etc.
While these do not directly affect the performance of the fund, it may not leave much time for the fund manager to do the most important part of the job: analyze, track or research investment options or to improve the performance of current investments. Thus, long-term returns may be impacted.
Portfolio management services companies are thus coming up with different incentive models for fund managers that can resolve this issue. These include incentives paid based on client portfolio performance.
As an investor, you can also choose to invest in passively managed index funds or small beta funds that do not follow the asset acquisition-based incentive model.