FOOL'S EYE VIEW
Managed Fund Myths

By Stuart Watson (TMFTiger)
December 19, 2001

A version of this article was first published in May.

Carburton Street, London -- Currently I'm working my way through a book called "Common Sense on Mutual Funds" by John Bogle, reviewed earlier this year by TMFDragon. It's an excellent (if occasionally heavy-going) book that looks at the mutual fund industry in the US, the equivalent of unit trusts here in the UK.

Many of the points Bogle makes travel very well. The central messages of keeping things simple and that performance reverts to the average over time are ones well worth stapling to your investment bulletin board. He also demonstrates that, over time, the best performing funds tend to be those with the lowest costs. Before costs, the performance of managed funds and trackers are fairly similar.

He also debunks a number of popular concepts used to sell funds and illustrates some of the inherent conflicts between those who sell funds and our interests as investors. Here is a selection of five popular selling points:

1. Funds of Funds

This concept takes diversification to ludicrous extremes. The argument goes that, rather than chancing your arm with one or two funds, isn't it safer to get a fund manager to select a bundle of funds on your behalf?

No, is the simple answer. Adding in an additional layer of fund managers merely increases the costs with no obvious improvement in performance. And higher costs imply lower performance.

2. Past Performance

Despite a constant barrage of evidence that past performance provides no statistically significant indication of future performance, funds are still sold primarily on the back of how well they have done in recent years. The concept of reversion to the mean should make you think twice about buying a fund that has put in a recent spurt. Gravity is a powerful force in investment.

Many startling performance figures are also massaged by selective presentation of dates. They can hide the fact that much of a fund's past growth took place when it was small and nimble. That leads us neatly to our next point.

3. Size Matters

The bigger the fund, the harder it is to outperform the market. Your universe of investable shares is reduced. When a fund reaches £2b, there is little point in taking a position in smaller companies. It also becomes harder and harder to move in and out of larger companies without affecting the share price.

There is also the conflict between the compensation structure of the fund manager and the interests of investors. With many managers being paid on a flat percentage, there is a great incentive for them to increase the size of the fund by pulling in new money. However, it is hard to continue to invest new money successfully.

4. Global Diversification

Have you ever been advised to put a little money in Europe, the US or the Far East? After all, you don't want to be at the mercy of the UK economy, do you? Not only does this add an extra element of risk in the form of currency risk, many UK companies see a significant part of their earnings from overseas anyway. As a very general rule of thumb, international funds have higher costs and therefore on average will be poorer performers.

5. Churn Those Funds To Beat The Index

With the UK market being broadly flat over the last three years, the popular advice of the moment is to chop and change funds (or indeed shares) in order to gain a decent return. Of course, this does give you the chance of beating the elusive index. But on average, the increased costs you will incur mean that your performance slips even further below the index you are attempting to beat. In particular, your costs will balloon if you attempt to churn with funds that charge up to 5% in initial fees.

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