Choosers Can Make You Beggars

While money managers who actively pick stocks might achieve higher returns, those gains are often eaten by management fees. So why bother?

“The capital market always offers opportunities: You just need to know how to find them.” So claims a commercial plugging a local investment house.

Israel’s investment managers are mainly preoccupied with finding blockbuster investment opportunities that will make their clients a killing. A portfolio’s returns are the result of the chosen investment strategy. So how successful are Israeli investment managers at identifying investment opportunities, given their focus on tactical, rather than strategic, moves?

Protesters outside the Knesset in Jerusalem in September - Olivier Fitoussi
Olivier Fitoussi

To find out, I examined the performance of mutual funds specializing in Israeli stocks. All these funds have identical investment strategies: They invest in shares in Israeli companies traded on the Tel Aviv Stock Exchange. The only difference is how good their managers are at choosing stocks with strong investment potential.

These funds aren’t confined to any particular index, so their managers have maximum flexibility in choosing their stocks. There are 33 such funds for which data on their returns over the past three years is available, from October 1, 2008 to September 30, 2011.

Investing in Israeli stocks during the three-year period has paid off despite the market’s recent setbacks. An exchange-traded note tracking the Tel Aviv-100 Index generated an average 6.2% annual return over this period. Annual returns in the group of funds specializing in Israeli stocks ranged between -5.9% and 12.5%, with a median of 6%.

To test the fund manager’s ability to identify investment opportunities, I split each fund’s return into two components: returns as a result of the fund’s general strategy − i.e., investing in Israeli shares − and return attributed to active management. The contribution from investing in Israeli stocks was 6.2% annually, as noted, while anything beyond that would be due to the fund manager’s ability to identify opportunities.

Fund managers who beat the TASE created value for their clients through successful stock picking, while those who chose poorly earned their clients less than they would have received from investing blindly in the entire stock exchange. The net annual returns − after adjusting for the TASE’s 6.2% annual returns and deducting management fees − ranged from -11.4% to 6%, and the median return was close to 0%. Thus, only 16 of these funds generated investor value through active management.

A look at returns attributable to active management before deducting management fees reveals that most fund managers actually did manage to choose winning stocks. The gross annual returns due to active management, meaning after adjusting for the TASE’s returns but before deducting management fees, were between -9.1% and 9.1%, with a median of 2.9%. Some 20 of the 33 funds − 61% − beat the market, before taking management fees into account.

Focusing on fees

In this case, the investment strategy in general bears no cost, since management fees on exchange-traded notes tracking the TA-100 are zero. Therefore, the entire management fee charged by the funds should be attributed to active management − the selection of specific stocks.
Funds specializing in Israeli stocks charged 2% to 3.8% in management fees annually, and median management fees were 2.8%.

These calculations indicate that for the typical fund specializing in Israeli stocks, management fees eat up all the excess returns from correct stock choices. The client sees none of these returns.

The picture is reminiscent of a satirical piece by Ephraim Kishon about a machine that makes fries but also eats them. Just like Kishon’s machine, mutual funds − with their managers paid the entire excess return from their active management − eat any value they create for their investors.

The disturbing question is why investors consent to such steep management fees while receiving hardly anything in return.

The typical investor bases his choice on the fund’s historical returns. But empirical analysis has shown there is no relation between past and future returns. Investors devote much less time to asking how much they are paying for the service and what they’re getting in return.

There are two steps in investment management: Allocating assets between investment channels, and choosing the specific assets for each channel. It is completely legitimate to charge for each step, but the amount paid should make economic sense. Why should a mutual fund, whose managers only identify and pick stocks and don’t need to deal with asset allocation, charge much higher management fees than, say, a study fund ‏(keren hishtalmut‏) whose managers need to deal with both aspects simultaneously?

To demonstrate how investors could gain by focusing on management fees instead of past performance, I examined returns attributed to active management relative to management fees. The funds specializing in Israeli stocks were split into three groups: those with low management fees of 2.0% to 2.6%, average management fees of 2.8% to 2.9%, and high management fees of 3.0% to 3.8%. I then checked how many funds generated positive returns from active management after adjusting for their fees. It turns out that the group with the lowest fees had the largest proportion of funds − 60% − with positive returns from active management.

Israel’s mutual fund market is competitive, so the key to lowering prices is in consumers’ hands. The recent price cuts on dairy products demonstrate consumers’ power to influence prices in much less competitive sectors. Investors should apply the same rules of intelligent consumerism to financial products and avoid buying products that are unjustifiably expensive.

The writer is an economic consultant and editor of the Inbest website. Nothing in this article should be construed as advice or a recommendation for purchasing any security.