Don't forget costs when evaluating fund performance
Don’t forget costs when evaluating fund performance
Investors whose fund’s performance exceeds that of market benchmarks can congratulate themselves on having done well, particularly in times of enormous volatility – right?
“Wrong”, says Steve Roberts, joint MD of Taquanta Asset Managers and head of the group’s Quants asset management operation. “There’s the important matter of costs - management fees, trading costs and tax - that should also be taken into consideration.”
Roberts maintains that costs matter more than is generally appreciated. He cites a 2005 article published in the Financial Analysts Journal in which Jack Bogle, one of Fortune Magazine’s four “investment giants” of the 20th century, noted that from 1983 – 2003, while index funds returned 12,8% and the average mutual fund 10%, the average investor received only 6,3%.
“This is the result of two phenomena. One is a function of behavioural biases: the majority of investors seem hard-wired to make poor investment decisions, often getting in at the top and selling out at the bottom. The other is more predictable – the reality of costs which are seldom fully taken into account,” he adds.
According to Roberts, it’s a mathematical certainty that the average investor will earn the average market return – the benchmark or index. However, once management fees and transaction charges are taken into account, the average asset owner can reasonably expect to earn negative active returns against market cap benchmarks.
It’s therefore clear that investors incurring lower transactions costs and with lower investment management fees will be at a significant advantage.
Roberts believes that asset managers have an obligation to improve the probability that their clients meet their investment objectives and this, he says, demands getting the product offering right in terms of risk, return consistency – and costs.
“It’s not much comfort for clients to know that their fund has beaten the index if costs push their returns into negative territory,” he says and adds that it’s Taquanta’s belief that investment management fees in general imply a much higher level of certainty in expected excess returns than can be justified in reality.
In other words, he explains, fees are generally calculated to take account of the returns fund managers expect to earn, rather than what they actually earn. In addition, many performance structures allow investment managers to earn fees based simply on the portfolio’s volatility against a benchmark rather than any measure of long-term outperformance.
It’s also not unusual for some managers to earn performance fees on recoveries from relative losses or for some clients to pay for performance accruing to other clients.
“At Taquanta, in addition to actively pursuing a low-fee structure, we implement an expanding cap on performance fees. This minimises the possibility that the client pays performance fees on positive active returns that turn out to be impermanent and noise rather than signal.
“This mechanism creates a delayed gratification mechanism – not one that is simply a form of delayed payment. Rather, it’s delayed payment on condition that the alpha has not disappeared by the time the payment falls due,” he concludes.
