Managed Fund Pitfalls
“Money managers purposely work at manipulating numbers and deceiving investors. They’re selling the fund of fund stuff – it’s really unbelievable, piling on the layers of costs. But if they are good at marketing they don’t need to be good at anything else. The poor guy in the general public is getting a terrible product.” Warren Buffett
Managed funds are also known as managed investments, managed products, in-house funds, pooled investments, equity trusts, mutual funds. They are sold by bank wealth advisors, financial planners and stockbrokers.
Managed funds have numerous pitfalls:
- High opaque fees
There are numerous fees, many opaque, which can include entry-exit fees, management fees, performance fees, buy-sell spreads, transaction costs, administration fees, trustee fees, custodian fees, platform fees, and fund-of-fund fees.
Investors need to be aware that they are paying these underlying managed product fees, in addition to wealth advisor and financial planner fees..
You can easily be paying upwards of 3% or more per annum in total fees, and not know it!
All the investment income, and more, can go in paying fees. The industry circumvents this problem by not being transparent. Fees, income and capital are commingled into a single figure, the unit price. Monthly fees are deducted, but are hidden within the unit price. Markets and the unit price rise over time, so the investor is not aware of the fee deductions.
Because of high fees managed funds, in aggregate, underperform the market.
“You often get investors [managed funds] who are really closet indexers, in which case you are being played for a sucker. These guys have 85 per cent of their assets linked to the index and they charge big fees.” Warren Buffett
- Tax disadvantages
There are serious tax issues. New investors inherit the fund’s unrealised capital gains on the stocks it owns, and will be required to pay tax on these gains when the stocks are sold! New investors dilute unrealised capital losses, which disadvantages existing unitholders. Capital losses cannot be distributed to unit holders to offset against personal capital gains outside the fund.
- Not transparent
Managed funds lack transparency because capital, income and fees are commingled into a single figure, the unit price.
The “investment earnings” managed funds report are not just the income earned, but the combined income and capital growth.
You are literally in the dark and budgeting is impossible. With a directly owned stock portfolio you know separately what your dividend income and capital values are, and can budget accordingly. Similarly if you own an investment property you know exactly what its income is, which is separate to the property’s value.
Transparency is particularly important because, while market price fluctuations are inevitable, the dividend income paid by stocks generally stays stable and increases over time. You can live comfortably with price fluctuations if you know your dividend income is not affected. But this is not possible with managed funds.
- Not secure
The best absolute and ultimate security is always to have the title of the stock, or property, registered directly in your own name.
With managed funds you own units in the fund, but not the actual underlying investments. Incidence of fund manager fraud have cost investors dearly in the past.
- Not efficient
Managed funds must maintain cash reserves to cover redemptions. New money contributed to a managed fund can also take time to invest. Holding part of the fund’s assets in cash means the fund is always under-invested, missing out on the full potential of owning stocks. This is another factor contributing to under-performance.
- Not portable
You can become locked-in to a managed fund because, if you decide to take your money elsewhere, you are forced to redeem your investment and pay any capital gains taxes. No such limitation applies to a directly owned portfolio of stocks.
There can be other problems as well such as income being paid from capital, and excessive brokerage charges subsidising fund manager research.
Amazingly, it doesn’t matter if investors have $1 million or $100 million plus, we find sophisticated people invested in managed funds.
How managed funds are sold is discussed at Investment advice, fees and bias.