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Things to be aware of with Managed Funds

Managed funds can be a good way for investors, new and old, to get access to the skill and expertise of a professional to select stocks that they may not otherwise be able to access or invest in themselves. There are a number of things to be cautious of with investing in a managed fund.

No two managed funds are created equally. In actively managed fund, the fund managers are focused on beating a benchmark, whether its a broad based benchmark like the S&P 500, or something more niche like a small cap index benchmark. In any case, an interesting thing about managed funds is that only 30% of managed funds happen to beat the S&P 500 index benchmark (according to the S&P Managers Index).

So while the odds may be against you actually outperforming an index to begin with, many of us still have significant investments in managed funds (I certainly used to, till I sold everything many years ago). What are some of the things you should be aware of investing in a managed fund?

Chasing short term performance - Fund managers chase short term performance. Fund management is a short term game. Their bonuses depend on beating a quarterly benchmark, a yearly benchmark. The ridiculous thing about this is that a business takes years to grow and exhibit any sustained value. A 3 month or 6 month time horizon is really just about timing the market, not really growing any meaningful value.

Huge churn in positions - Because active fund managers are so focused on needing to beat short term benchmarks, they buy and sell companies every few days like they are going out of style. This is not only a significant cost in trading costs, but it also creates many capital gain and capital loss events which you need to record for tax purposes. So while your fund may have delivered you nothing in performance for a given year, you have a tax administration headache to deal with all these positions that your fund has divested, not to mention a smaller return because of all the trading costs you have to bear.

Even worse still, trading so often doesn't allow the time for any investments to compound. Time is an investors best friend (well, time and dividends!). Its how you grow significant total return in the long run. Buying and selling every few months is more of a tactical trading advantage rather than setting you up for long term investment success.

Expense ratios - My biggest gripe with actively managed funds is the expense ratios that they charge. These expenses are taken out before returns are paid to you as an investor. So that 1.5% gross return that you happen to eke out? That may have just disappeared once the manager takes their fee. Sometimes its easy to overlook the impact of just how big an impact these expenses can have on your long term performance.

To put this in some perspective, on a $100k portfolio, you could be looking at $2000 annually in terms of fees. Over the course of 40 years those annual fees and expenses could easily be the cost of your initial $100k investment!

Compared to this, many index funds have expense ratio that are a fraction of what you would pay in an actively managed funds, which is why I prefer index funds over their actively managed counterparts.

Window dressing - At the end of each quarter, many fund managers scramble around to dump their losers and buy the winners that their respective funds benchmark. So if Apple was the hot stock for the quarter, and a fund manager didn't hold that stock, they will be running around at the end of the quarter to make sure the stock appears as one of their holdings.

While this is not only potentially misleading as it gives investors the impression that this has been an active holding for the entire performance period, its actually much worse from a more fundamental point of view. By looking to purchase a "hot stock" at the end of a quarter and dump a "loser", your managed fund is doing exactly what you don't want them to as an investor which is to buy high and sell low.

If there are good reasons for a stocks poor performance that's one thing, however fund managers often dump poor performing stocks purely on the basis that they are the worst performers. If the business is a high quality one, its highly likely to rebound at some point in time, even if it underperformed in a give period. Unfortunately window dressing doesn't allow you the opportunity to see that improved growth because the stock has been dumped.

Performance Records - The presentation of performance records can certainly be a dubious practice. While you may have periods of outperformance from a fund manager for 1-2 years, its very difficult for a fund manager to consistently perform for an extended period of time, greater than 5 or 10 years. Performance tends to revert back to a mean benchmark over a period of time, either as fund size grows or the manager trades closer to the index (given they have to hold progressively larger companies). Ensuring that you look at a long term view or performance of a fund manager can save you from making a negative investment decision based on 1-2 years of selectively presented data.

Managed funds can be a valuable addition to your portfolio if you are looking for exposure to asset classes that are otherwise difficult to access. But you need to be aware of some of the pitfalls, tactics and selective marketing that are used to highlight fund success.

What are your thoughts on using managed funds to achieve your investment goals?

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