Photo: flickr / Simon Pielow
A new paper recommended as a “required read” to Business Insider by hedge fund legend Cliff Asness charges that America is getting swindled by the investment management industry.The paper, titled Murder on the Orient Express and authored by Charles Ellis, claims that “a ‘crime’ of extensive underperformance has been committed in mutual funds, pension funds, and endowments” – that is, among the institutions where “Main Street” has its money invested.
Ellis gives a few numbers to highlight just how bad the underperformance in these institutional funds is:
New research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs—a number not statistically significantly different from zero.
Everyone has probably heard the saying that “past performance does not predict future results.” And that is a big reason that underperformance is so rampant – institutional funds are notorious for hiring Wall Street managers based on past performance.
But there’s another, even more insidious reason for the terrible underperformance by those funds investing your pensions, 401-Ks, and endowments, according to Ellis: the fees. He writes that “seen correctly, active management may be the only service ever offered that costs more than the value delivered.”
Here is why:
The very small commodity fees charged for index funds that consistently provide market- matching returns at market-matching risk mean that active managers can only hope to deliver real value when they actually beat the market—which, we now know, most do not do, particularly over the long term. As a consequence, for active management, true fees—incremental fees as a percentage of incremental added value—are more than 50% of the value delivered by the more successful active managers and are far higher, even infinitely higher, for the many less successful active managers. Here’s why: The real marginal cost of active management is the incremental fee that active managers charge versus the incremental returns they deliver.
Ellis says across the industry, everyone from investment managers and investment consultants to fund executives and investment committees are complicit in this “crime” of institutional underperformance.
Numbers like these may cause investors to give low-cost, passively-managed index funds another look.
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