What do investors need to think about when choosing a fund to invest in? Many fund management companies advertise based on past performance, and so this is what retail investors typically focus on. But is this really the factor that investors should be focussing on? In this video, the Financial Times’ ED MOISSON looks at why more people should think seriously about the cost of investing.
TRANSCRIPT
Robin Powell: What are the criteria for choosing a fund to invest in? Well, fund management companies generally want you to focus on how well a fund has performed in the past. Ed Moisson from the Financial Times Group is an expert in how the fund industry works.
Ed Moisson: As a retail investor when you’re looking out for, which funds should I invent in, the one that’s got a good past performance track record is quite appealing. That’s hard to get away from. And a fund management company who wants to attract your business is well aware of that. They want to attract clients. They’re going to advertise using their past performance. Not only that, but that is going to be a key component of demonstrating their credentials and how they think they might be able to perform in the future.
RP: The problem with past performance is that it tells us very little, if anything, about how a fund will perform in the future. A far more reliable predictor of future performance is how much you pay to invest in the fund.
EM: How they’ve done in the past: it is questionable as to how important that is for predicting future returns. The cost is actually a pretty good guide to predicting – not necessarily how good the future returns are but – when you look across a range of funds, of predicting which ones are likely to do better than others because you know those costs are going to impact, they’re going to have a drag on the returns over time.
RP: In his book The Economics of Fund Management, Ed Moisson explains how the interests of fund managers and their consumers are, in a sense, misaligned. What’s good for the fund provider can be bad for the consumer.
EM: Inherently, in the way mutual funds work, there is a tension between the asset manager that is managing the money and wants to make themselves money from the fund. So they charge an annual fee as a percentage of those assets. The higher the assets grow – the pot of money that they’re managing – the fees which you generate (because you’re taking a percentage of it), the fees that you generate rise. The issue is that the higher the fees are, those fees come directly off the money an investor receives. So, as the performance of the fund might go up or down, the fees will continue to come out of the pool of money regardless.
RP: There is an added danger in choosing a fund with strong past performance. A fund that has done well in the past tends to attract more assets. But it’s often the case that as a fund grows in size, its performance deteriorates.
EM: When you’re investing in an actively managed fund; if you’re persuaded by the fund manager that it’s worth taking the risk on him or her, then you’re hoping that they’ll be able to see opportunities, invest at the right time, and to withdraw at the right time as well making a profit. If the fund is too big and too unwieldy, then the ability to have that sort of agility is reduced, compromising the individual fund manager themselves and therefore impacting on the returns. And there’s been research to show that. That outsized funds, on the actively managed side, their performance begins to drop off.
RP: Of course, past performance is far more interesting than cost. But, in the long run, it’s the fees and charges you pay that really make the difference.
ALSO IN THIS SERIES
Compound interest: what every investor needs to know
Beware fund managers with a short term focus
Active vs. passive: which is better?
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