ARE MUTUAL FUND MANAGERS WORTH THE MONEY?

Their pay is lush, but their results are middling.

Kelly Rodgers, MoneySense, November 1999

YOU MAY HAVE HEARD MUTUAL FUNDS JUSTIFY THEIR FEES by saying that top investment managers cost money, and investors must be prepared to pay those managers adequately. Is that true or just a marketing pitch?

To answer the question I decided to compare mutual funds with pooled funds, let me explain. These products are intended for wealthy investors. Pooled funds are sold without a prospectus, usually require a minimum investment of more than $150,000 and charge fees that are considerably less than those charged by most mutual funds. You can buy pooled funds from investment counsellors, banks and trust companies.

While pooled funds are interesting in themselves, my primary purpose in making this comparison was to see whether mutual fund managers really deserve their big paycheques. If they are the best money managers in the business, their skill should be evident in their superior performance. They should outperform pooled funds and other types of institutional investors.

I've listed the results in the accompanying chart How Do Mutual Funds Stack Up? (Let me add a note of explanation: mutual funds report their performance after management fees are deducted, while pooled funds report their results before fees are taken off. To make the two categories comparable, I took the raw performance numbers for each category of mutual funds, then added back a figure representing the typical fees for that category. The result approximates what these mutual funds would have achieved if their performance was reported on the same basis as pooled funds.)

The evidence is clear. Mutual fund managers usually perform just about identically to pooled fund managers. The exception is in small cap funds, where the pooled fund managers did a much better job of protecting capital during last summer's market meltdown than mutual fund managers.

If you're an affluent investor, you should take a close look at these numbers. What they suggest is that you're silly to be paying big mutual fund fees. Instead, you should closely examine what's available in pooled funds. Chances are that you'll wind up getting the same gross performance (i.e. performance before fees are deducted) as you would with mutual funds, but because your fees are lower, you'll wind up taking more of the gains home for yourself.

If you're a cautious investor, you should also look at some other numbers. These numbers have to do with the range of performance in each category - in other words, how much top performers tended to vary from bottom performers.

To get a handle on the range of performance, I used surveys of mutual funds and pooled funds from Portfolio Analytics of Toronto. These surveys break down performance according to percentile rankings. The best funds-those that perform better than 99% of their peers-are in the first percentile. The worst funds-those that perform worse than 99% of their peers-are in the 100th percentile.

I decided to ignore the very best and the very worst of the funds so that one or two wildly unusual results wouldn't skew the findings. Instead, I looked at how funds in the fifth percentile compared with funds in the 95th percentile. Those funds in the fifth percentile outperformed 95% of their peer group; they are what most of us would call superstar funds. In contrast, those funds in the 95th percentile underperformed 95% of their peer group. They are the losers in the investment world.

Riding the performance range Mutual funds tend to vary far more in performance than pooled funds CANADIAN EQUITY 1 year 5 year (5th percentile)   Mutual Funds 10.0% 19.7% Pooled Funds 5.5% 17.0%     CANADIAN EQUITY 1 year 5 year (95th percentile)   Mutual Funds -14.3% 4.4% Pooled Funds -10.8% 9.5%

My question was how big the gap was between superstars and losers. As you can see from the table above, Riding the Performance Range, the span between the best and worst mutual funds is considerably larger than the gap between best and worst pooled funds. To put things another way, the best mutual funds tend to be much, much better in the short term than the best pooled funds, while the worst mutual funds tend to be much, much worse in the short term than the worst pooled funds. As a group, pooled funds deliver more consistent results, with less variability from one to another.

The huge range of performance among mutual funds may be the result of the push for short-term performance in the mutual fund industry. Desperate to do well in quarterly and monthly rankings, managers take risks. Those risks look great when they work, but they can be painful for investors when they fail.

While investors aren't necessarily compensated for risks, mutual fund managers definitely are. Greenwich Associates, a consultant in the financial services industry, reports that mutual fund managers are much more lavishly paid than pension fund managers. The typical mutual fund manager took in $336,000 last year, nearly double the typical pension manager. Yet, if you take the pooled fund data as representative, mutual fund managers have no apparent superiority in skill or performance over other institutional money managers.

Why do mutual fund managers make so much? Maybe it's danger pay. With the media closely watching mutual fund performance, a manager has no place to hide after a bad quarter or a bad year. But don't feel sorry for mutual fund managers. They're amply compensated for their ulcers. If you're an investor, remember that many of the best managers toil in relative obscurity so look beyond the advertising campaigns of the coming RRSP season.