The basic financial assets (also known as financial instruments) - equities, debt and derivatives - are sold not only singly but also more usually in pooled investments, known as funds - thousands of them! These are managed by a host of providers, including all the big banks, each running several or many separate funds, and each fund investing in various combinations of UK and foreign equities, bonds, and derivatives. Insurance companies also manage funds linked to endowment and life policies. Advantages claimed for pooled funds include diversification over many different investment types so as to reduce risk, management by experts, shared costs, and less work because all the buying, selling and associated administration are done by the provider. The most popular in the UK are unit trusts and open-ended investment companies (OEICs). In the US they are known as mutual funds.
Funds can be actively managed, where a manager is appointed to oversee the fund, select particular investments and buy and sell as he or she sees fit in accordance with the fund policy as specified in its prospectus; or passively managed, where investments are selected automatically so as to match the performance of a particular index such as the FTSE 100. Passive fund charges are lower because they involve much less management than active funds, and passive funds do significantly better than the majority of active funds because of the lower charges.
Fund providers were given a great boost with the migration from defined benefit (you know what you will get) pension schemes to defined contribution (you know what you will pay but not what you will get) schemes. This migration was sold as giving people more choice and control over their own pensions, but the real reason was to transfer risks from employers to employees. Employers lost the risk of suffering future heavy pension liabilities and employees took on the risk of inadequate future pensions. As will be seen, the real winner from the migration was the financial trading sector, and it won massively.
All companies selling pooled investments claim outstanding performance for the funds they want to promote, and carefully worded advertising can give that impression, often by showing how much an investment would now be worth if it had been held from the outset of the fund, by listing yearly growth over the last few years, or by providing growth charts. However what is not said is that many new funds are started every year, and that all funds start with a relatively small amount of capital. Some do well and some do badly, and the bad ones aren't mentioned publicly but are merged into existing bigger funds. What is important to note is that funds with a small amount of capital have much greater scope for doing both well and badly. To understand why this is consider investing in a single lottery ticket; it has a very small chance of winning a very big amount, so if it does win then its investment growth has been phenomenal. Now consider investing in every single lottery ticket for a particular draw. All the prizes are won but the cost has been enormous, and overall the investment won't have grown at all, in fact it will have lost by the amount that is taken for administration and awarded for lottery-funded projects. As badly performing funds are weeded out what are left are the well performing funds, which after several years begin to be advertised and grow substantially in terms of invested capital as new investors buy in - that isn't investment growth, it's growth in fund size. Now, because more is invested the performance begins to match more closely the benchmark for that type of fund, and all funds have benchmarks which represent the overall performance of funds investing in similar asset classes. This is the same as would happen if more and more lottery tickets were bought. Nevertheless, by advertising the (correct but very misleading) outstanding early growth, and by combining the high initial growth with later lower growth or even decline, the impression is given that the fund will continue to deliver outstanding growth, but that becomes increasingly unlikely as the fund size grows. Let's consider an example, originally quoted by Fabrice Taylor for the Globe and Mail[215]:
A manager can wipe out hundreds of millions of dollars of value and still enjoy a sterling investment track record. How? Suppose a company launches a fund with $10-million and the manager returns 100 per cent in the first year, doubling the assets to $20-million. That stellar return attracts $500-million in new investment at the beginning of the second year. But the manager then loses 40 per cent, or just over $200-million. Yet the average annualized return over the two years is still about 9.5 per cent, and the fund can use that number in its marketing, despite having destroyed a massive amount of money.
How can the company claim a two-year performance of 9.5% per year after losing $200 million? It's because only fund performance (growth or decline due to investment skill - or lack of it) is counted, and not fund growth due to new investment. In the first year the fund performance was 100%, in the second year the performance was -40%, so we take a starting value of 1, then double it to 2 after the first year. Then we ignore the fact that massive new investment piled in as a result of the widespread advertising campaign, so at the start of year two the fund is still 2 - for performance analysis purposes. During the second year the fund lost 40% so what was 2 at the start of the year is 1.2 at the end. Now overall growth of 1 to 1.2 in two years is a yearly growth of 9.545% per year, or 9.5% in round terms. However the chances are overwhelmingly likely that if you were an investor in the fund you would have made your investment at the end of year 1 in response to the adverts, and after the second year you would have lost 40% of your investment. Nevertheless the company can still claim and advertise growth of 9.5% per year over two years, which isn’t quite a lie, but very misleading.
If a particular manager's fund does better than the benchmark then they are rewarded more, but if it does significantly worse their reputation suffers, and if poor performance continues they are sacked. Therefore, given such a major difference between good and bad performance in terms of the effects on the manager, a sensible manager tries to match the benchmark as closely as possible so as to avoid being sacked and to retain an exceptionally good income.[216] Note that it is benchmark rather than absolute performance that matters, so if the benchmark drops by 20% in a given year then a manager whose fund also drops by 20% won't suffer a penalty and if the fund drops by only 15% then he or she is rewarded for good performance. Staying close to the benchmark isn't difficult; all a manager has to do is maintain a similar (not identical as that would be too obvious) proportion of investments for the fund as there are in the overall total of investments in the benchmark (Kay 2015 p206). That's not to say that there aren't any exceptionally good fund managers, look at Warren Buffet for example. But for every Warren Buffet there are hundreds or even thousands of mediocre managers. Bear in mind too that they are all fishing in the same pool, so average performance can't be better than the performance of the pool itself; in fact it has to be worse because of all the fees that are taken by the managers and providers.
In 2008 Warren Buffet made a $1 million bet with money management firm Protege Partners.[217] The bet was that Buffet could choose a simple index fund (one that mimics the performance of a financial index, in this case the Standard and Poor 500, being the performance of the largest 500 companies listed on US stock exchanges) that would perform better than a group of five funds chosen by Protege Partners. In May 2016 Buffet's fund was up 65% and Protege's up 22%. Interestingly if all fees are excluded Protege's funds grew by 49%, which is still less than Buffet's but shows quite dramatically the effect that fees have on performance of pooled funds. The bet eventually ran its course with Buffet the clear winner.
Fund managers and providers are all very handsomely rewarded - paid not for the work they do but as a generous proportion of the value of the funds they manage, taken directly from investors in those funds. The incentive that fund managers have is therefore to grow the funds they manage as much as possible, and growth can be fuelled much more reliably by the addition of new investors - tempted in by advertising - than by good performance. What fund managers and providers want therefore is plenty of funds that they can advertise as having done exceptionally well in the past, so as to bring in many new investors and boost their own salaries and bonuses.
The fact that management and related fees are calculated as a proportion of the fund capital rather than of the investment gain means that fund managers and providers don't take risks - their income is assured whether the investments under management do well or badly. The investment risks are taken by the investors who often lose significant amounts. All adverts carry a disclaimer warning investors of the risks, but providers aren't as keen to make clear their own risk-free position:
The value of investments and the income received from them can fall as well as rise. Investors may not get back the amount invested but the providers will be very handsomely rewarded whatever the outcome.
Even worse are hedge funds, which are able to borrow money and have available to them a much wider range of investments, including short selling, because they are only available to wealthier and institutional investors who are deemed to understand the risks. These funds typically charge 2% of the capital under management per year plus 20% of any gains made in the year. If the fund loses value then the 2% is still taken but no contribution is made to the loss. In this way hedge fund managers take a big slice of any winnings, but if there are losses the investors bear them all in addition to the 2% that the managers still take. Hedge funds sometimes produce very high returns, which make the managers seem very skilled, but they do it largely by borrowing money to invest. For example an investment that normally returns 5% can be boosted massively by borrowing ten times the fund's own money and investing all of it. Say £1,000 of the fund's own money is used together with £10,000 of borrowed money at 1% interest. After a normal year the total would be £11,550 (105% of £11,000), but £10,100 would be paid back to the lender (£100 is the interest), so the net value is £1,450. This represents a return of 45% on the original fund stake of £1,000. A return like that makes the manager seem as though he or she is a genius, but not so, what is happening is just gambling. Just as easily the investment might have dropped in value by 3%. In that case the total would be worth £10,670 (97% of £11,000), but £10,100 still has to be repaid to the lender, so the original £1,000 is now worth £570, a loss of 43%. Because of this many hedge funds go bankrupt, but while they exist the manager still pockets 2% of the fund value and 20% of the gains in the winning years - nice! This is why hedge fund managers can and do become fabulously wealthy, but their clients usually don't (Kay 2015 p99).