Mutual fund managers make a lot of money. They are deciding where to invest large amounts of other people’s money, so if they’re making a lot of money for those people, you’d imagine they should get paid a lot.
The problem with the pay structure for most mutual fund managers is that it’s often not in line with the needs of their investors.
You might think that mutual fund managers make money when their investors make money and don’t make money when their investors lose money.
Unfortunately, this is rarely the case.
Most mutual fund managers make their money from a base salary and bonuses based on the performance of their funds. These performance bonuses are typically taken as a percentage of the assets they manage.
How Do They Make Their Money?
Very few managed mutual funds have reward structures that are in line with their investors’ best interests. Here is how they make their money.
Management fees are a big part of buying into an actively managed mutual fund. These fees are almost always based on the net amount of money they are managing, not the amount they are making for their investors.
Let’s say a mutual fund has $1,000,000 spread out over 10 investors and it charges a management fee of 1%.
- If the value of the fund goes up to $1,100,000 over the year, then the mutual fund manager would make $11,000.
- If the value of the fund goes down to $900,000 over the year, then the mutual fund manager would make $9,000
At first glance you think “yeah that’s in line with the investors’ best interest.”
The manager makes more money if the investors make more money and the manager makes less money if the investors lose money.
Yes, but there’s a major problem here, too. If the value of the portfolio goes down by 10%, but the fund is able to get 2 new investors to put money into the account then the net value of the fund would actually go up in value, and the manager would make more money.
- 10 investors have their collective investments drop to $900,000, but the fund gets 2 new investors putting in $150,000 each, so the total assets of the fund go up to $1,200,000 and the manager makes $12,000.
Managers want to maximize how much money they manage
The problem here is that mutual fund managers biggest incentive is actually to maximize the amount of money they manage, not boost long term returns for their investors.
Usually this means they do what they can to maximize short term return numbers, not long term numbers.
The average investor picks his mutual fund based on the highest ROI in the past quarter or the past year.
So the mutual fund manager focuses on the short term, since that’s what convinces new investors to come on board and invest their money in the fund.
This is one reason why actively managed mutual funds perform worse than the S&P 500 over long periods of time.
The management fees aren’t completely synonymous with the salaries of the fund managers. There are two main ways that managers are paid.
- Base salary
- Performance bonuses
Most mutual fund managers have a base salary that is not based on performance or on the amount of assets they manage.
The base salary typically makes up a very small percentage of the take home pay of the mutual fund manager. The rest is made up from performance bonuses.
According to a 2018 study of 4,500 U.S. mutual funds, 79% of mutual fund managers get performance bonuses when their fund performs well.
The issue I take with this structure is that I believe it’s somewhat misleading. As far as I can tell, these bonuses are based on the net asset value of the funds.
I read through some brokerage disclosures to try and get a feel for how these fee and bonus structures work, and I regularly ran into verbiage that looked like this:
“This creates a conflict of interest because the different compensation provides Merrill Lynch and/or Merrill Lynch Financial Advisors with an incentive to recommend share classes or funds that pay more compensation over those that pay less”From the Merrill Lynch fund disclosure
This is the root of the problem with these managed funds. There are conflicts of interest everywhere in how they set up their payment structures.
Trust me, this is not unique to Merrill Lynch. It just happens that Merrill Lynch was that only broker I could find that openly admits to their conflicts of interest.
So, back to bonuses. Unfortunately, I couldn’t find any actual disclosure information on how the bonuses work, but it is my belief that the bonuses are taken from the net assets in the fund.
If this is the case, then better performance on the account could mean the manager gets a 1.1% management fee instead of a 1.0% management fee.
What’s The Alternative?
I’m not an expert on the inner workings of Wall Street banks. I’ve never worked for one, and I don’t have any close friends who do.
But based on the information I’ve absorbed from reading and conversing with the members of my mastermind group, I’ve concluded that actively managed investment funds are scams.
The incentives of the fund managers and the companies that employ them have created conflicts of interest that often swing in favor of the banks rather than the investor. These funds exist, not to benefit investors and provide better returns for them, but to scrape something off the top of all that money by providing a false sense of security.
If you interpret the information the same way I do, then I have three options that I believe to be better.
1. Index funds
There are plenty of funds that are not actively managed. Index funds like the S&P 500 keep a relatively static group of stocks and put investors’ money into them. There are practically no fees associated with these funds because they require little to no management.
And again, they typically outperform the actively managed funds anyways.
2. Manage your own portfolio
You don’t necessarily need an expert to decide which stocks you should own. If you don’t have any interest in picking your own stocks, then consider index funds. But if picking your own stocks sounds like fun, then start allocating a portion of your wealth to stocks you choose.
Over time you can allocate a higher and higher percentage of your wealth to self picked stocks.
3. Invest outside the stock market
Real estate and business can consistently see 25-30% returns, which is much better than the vast majority of stock investors. If you don’t want others dipping into your wealth through fees, then consider trying another form of investment altogether.
Brokers that provide managed index funds have created conflicts of interest in the way they pay the managers of those funds. These situations are rarely benefiting the investor, and because of this, I strongly recommend avoiding them and opting for investments that are better aligned with your own self interests.
Index funds historically perform better than managed funds and they avoid the management fees. You can also choose to manage your own portfolio. Last, you can start looking outside the stock market and investing in real estate, business and other types of investments that can outperform stock.
The most important thing is to keep informed about where your money is going. And as always,