Saturday, December 3, 2011

It's Not Rocket Science: Part VII

Tom Bradley is a founder of Steadyhand, a different kind of mutual fund company that focuses on low-fee, low-turnover portfolios where managers are encouraged to seek value wherever it can be found. Bradley summarizes his thoughts on how to beat the market in his book It's Not Rocket Science, summarized below

In the investment industry, there are several conflicts between the profession and the business. As far as the profession is concerned, it makes sense for money managers to have a multi-year horizon for client money. But investment firms are often publicly traded companies with short-term earnings concerns. As such, in many companies, short-term business concerns outweigh the long-term benefits to clients.

One way this occurs has to do with how far away from an index the manager is willing to stray. Being relatively in-sync with the market won't cause the firm much trouble, but being out-of-sync with the market and in the fourth quartile leaves the investment firm's marketing department with a lot of ground to make up. One example of this occurred during the tech bubble when technology stocks were pushing the market higher. Funds were incentivized to get exposure to this sector or risk losing clients, even though these stocks were overvalued. Even firms or funds that were vindicated when the bubble eventually crashed had lost clients along the way.

Another way this problem emanates itself is related to client pressure depending on the type of security. When a fund owns a respected company whose stock then falters, clients hardly complain. But a controversial name that isn't performing can induce a lot of client questions, and this pushes managers away from what might be undervalued securities.

Finally, scale also highlights the conflict between the business and the profession. The business is better off with larger scale, allowing manager compensation to grow as assets grow. But a large size and/or the acceptance of more fickle clients can result in poorer performance for existing clients.

In this section, Bradley also discusses the backlash against mutual fund fees. Fee averages are somewhat useless, as different classes of investors have different needs. Certainly, some investors are paying too much, particularly those that don't need investment advice (DIYers) or those who aren't getting the advice they're paying for.

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