Stories
In 2008, a hedge fund analyst called Ted Seides got sick of listening to Warren Buffett slagging off his industry.
So Seides wrote him a letter: “I figured, write an old-fashioned guy an old-fashioned letter. I made it cutesy enough that I thought he would respond.”
Seides suggested a bet: that five fund-of-funds could outperform the overall stock market over 10 years. Buffett replied to his letter, and over a couple of months, they negotiated the deal. The bet, which was for charity, was for a million dollars.
At the heart of the bet was the question of fees. Buffett’s bet was on the S&P 500, an index that tracks the overall stock market. Indexes don’t charge fees. The hedge funds on the other hand were free to pick the most promising opportunities — but they did charge fees.
The question was whether the managers’ asset picking skills justified the fees they were charging. Seides was betting the world’s best asset managers were worth the money.
At the outset, Seides was confident. In 2007, the S&P was nearly as expensive as it had ever been. And over the next two years, in the financial crisis, it dropped more than half.
But it didn’t last. The market rebounded and Seides fell so far behind that he had to concede a couple of years early. After ten years, the S&P had risen 99 per cent but Seides’ funds were up only 24 per cent. It wasn’t even close.
Skill, luck and Davy
Twenty years ago, when Ted Seides got into the hedge fund business, fund managers were on a pedestal. They made a lot, they charged a lot, and clients were happy to pay them.
But at some point, the story flipped — whether because of the global financial crisis, or the gradual global drop in returns, or investors getting more educated. Now fund managers are on the defensive. They’ve had to cut their fees. And still, their clients are leaving them for index funds.
Index funds, also known as passive funds, are cheap funds that are designed to track the market. Money in an index fund isn’t managed by anyone. It’s allocated to a basket of stocks per some pre-determined rule, like market cap.
Putting money in an index means the investor will never pick the next Apple and get to retire early. It also means they’re not hedged when the market tanks. And the index has no clue about their individual needs as an investor. But, it is cheap.
Fees are clearly a big part of the decision of whether to invest in active or passive funds. But it gets to the very nature of financial markets. How efficient are they? So efficient that a highly-trained professional fund manager can’t do better?
Davy is Ireland’s main financial business and Davy Global Fund Management (DGFM) is its fund management arm. DGFM has €1.8 billion of assets under management, along with €20 billion it supervises on behalf of others.
DGFM actively manages 24 funds. The funds cover stocks, bonds and cash; global assets, defensive assets, income, and ethical investing.
I ran the numbers on the 24 DGFM funds. Using information in financial disclosures, I compared each fund’s performance over the life of the fund to its benchmark, calculated assets under management, and total fees and expenses.
What I learned says a lot about investing skill versus luck, efficient markets, and how to build wealth for the long run.
Davy Global Fund Management
DGFM does a couple of different things. First, it actively manages 12 funds. These 12 funds are managed in-house by the DGFM team. The DGFM fund managers pick the assets themselves, whether stocks, bonds, cash or derivatives. In 2019 there was €387 million worth of assets in these funds.
Second, it manages 12 funds which are comprised in turn of other funds – funds-of-funds, in other words. Instead of picking the stocks and bonds in these funds, DGFM picks the fund managers, and the fund manager picks the stocks and bonds. In 2019 there was €1.45 billion worth of assets in these funds-of-funds.
Third, it administers funds for third parties, providing compliance and backroom support. It administers €20 billion worth of such funds.
DGFM sits separately from Davy’s market-leading wealth management business. Davy Wealth Management is aimed at wealthy individuals and families. Davy Wealth Management helps people invest their money, as well as providing estate planning, retirement planning and other financial advice. For this, it charges an annual fee of one per cent of assets.
Davy’s wealth management business manages €14 billion, as we’ve seen. So the DGFM business, with its €1.8 billion of assets, is small by comparison.
What about DGFM clients who are also wealth management clients? They’re treated like any other. They get the same service – and pay the same fees.
The 24 funds all have slightly different objectives. The defensive equity fund, for example, uses options to somewhat hedge against volatility. So when the market goes up the fund goes up less, and when the market goes down it goes down less. The ESG equity fund is limited to ethical, social and environmentally friendly investments. Likewise with the low carbon fund. The global bond fund sticks to bonds. And so on.
Each fund has its own benchmark. Benchmarks are low-cost indexes whose purpose is to show “this is what you could have gotten for free”. They’re designed to fulfil the same goals as the fund. The benchmark for a bond fund will be a global government bond index; for a global brands fund it will be an index of large global companies.
Benchmarks are necessary in fund management because investing is a mix of skill and luck — or alpha and beta, in finance jargon. Alpha is the return the fund manager generates over and above the market using their skill. Beta is the market return, which is basically luck. The benchmarks are an approximation of beta.
So how do the DGFM funds compare to their benchmarks? To answer this, I looked at DGFM’s 24 funds’ audited financials going back to 2014. I calculated the funds’ cumulative track record alongside that of the benchmarks. Of the 24 funds, all but four have been around for a reasonable length of time – four to five years. The other four have been around for two years.
In DGFM’s audited financial statements, there are multiple track records for each fund. The track records refer to different cohorts of investors in the fund. For example one cohort might join in 2017 and another in 2015. Their performance would not be the same. Another distinction is between distributing and withholding funds. Withholding funds roll-up income in the fund; distributing ones periodically distribute income to the investors. Typically, withholding funds will have higher returns for this reason.
In calculating performance I focused on the single oldest withholding cohort for each fund. This shows performance as experienced by the earliest investors in the fund. And it assesses performance over the longest time possible.
The funds’ performance is shown in the following chart. It shows the size of the funds, their performance over the time period relative to their benchmarks, and the annual fees charged. 20 of the 24 funds’ track record is four or five years long; four funds’ track record is two years long. And the performance shown below is net of – that is, after – fees.
The average fund returned a cumulative 96 per cent of its benchmark over its published track record. “A cumulative 96 per cent of its benchmark” means that over the full track record of the fund, whether five, four or two years, the fund returned 96 of what its benchmark did. 96 per cent of benchmark is the average cumulative return of the 24 funds.
The average investment with DGFM didn’t make 96 per cent. As the following chart shows, the biggest DGFM funds dwarf the rest. The horizontal bars represent the amount of assets in each fund. The three biggest DGFM funds of the 24 accounted for €1.08 billion, or 58 per cent of all assets managed by DGFM in 2019. Those three funds returned about 89 per cent of their benchmarks.
There’s no room to go into detail on all the funds, so I’ll focus on the three biggest: balanced growth, cautious growth and long-term growth.
Each is a fund of funds, meaning it is made up of a portfolio of other actively managed funds. These funds are provided by global asset managers like Janus, Baillie Gifford and Acadian.
The funds’ benchmark is comprised of a mix of three low cost indexes: the MSCI world index (an index of global stocks), the JPM Global Sovereign (an index of government bonds) and euribor (an interbank interest rate). The precise mix of stocks, bonds and cash in the benchmark index depends on the goal of the fund. The cautious growth fund’s benchmark has 30 per cent stocks 60 per cent bonds, the balanced growth fund’s benchmark has 60 per cent stocks 35 per cent bonds, the long term growth’s benchmark has 80 per cent stocks fifteen per cent bonds.
The aim of the balanced growth fund is “a balance between capital growth and income generation with lower volatility than a typical long term growth strategy”.
The aim of the cautious growth fund is “long term growth through diversification across major asset classes”.
The aim of the long term growth fund, according to the factsheet, is “total returns with an emphasis on long term growth but with the potential for some degree of income generation”.
There are a few ways of slicing DGFM’s performance relative to its benchmarks over the full published track record.
- 19 of 24 funds don’t beat their benchmarks.
- The 19 funds that failed to beat their benchmark hold 90 per cent of DGFM’s assets under management.
- The average fund returned 96.1 per cent of its benchmark.
- Of the 20 funds with a track record longer than two years, the average return was 94.6 per cent of benchmark.
- Weighting each fund’s return with the amount of money invested in it, the average return on each euro invested with DGFM was 92.8 per cent of the benchmark.
Through a spokesperson, DGFM says “Davy is very comfortable with the performance of the various funds which reflect the risk-adjusted-returns priorities of our clients and their individual goals and financial plans, rather than a standalone generic benchmark.”
It’s not surprising that the worst-performing funds are the fund-of-funds — ie, the ones where DGFM picks asset managers rather than assets. That’s because the extra layer of managers has to be paid. At 1.52 per cent, fees are higher for the fund of funds than for the average DGFM-managed fund, where fees average 0.9 per cent.
Another option is for the funds to charge, not for assets under management, but for performance. If funds were to charge 20 per cent of the alpha they generate – but only that – it would be a fairer way to reward them than a fee on assets under management, irrespective of whether they generate alpha.
Where do the fees go at DGFM? Well, Davy’s 33 staff earned €4.5 million in compensation between them in 2019. Of the 33, 11 were in highly-paid asset management jobs. The rest worked in support functions. It’s impossible to know exactly, but it appears Davy’s asset managers are making in the low six figures. Their compensation is made up of 73 per cent fixed pay, 27 per cent bonuses.
Apart from fees, what else matter? According to Jeffrey Ptak, head of fund research at Morningstar, he likes to see “a manager who eats his or her own cooking.” In other words, a manager who invests significantly in their own strategy. “It’s a defining gesture,” he says. Asked whether DGFM fund managers invest in their own funds, DGFM declined to comment beyond “noting that investment by fund managers in their own funds is in line with market norms and standards”.
Fees are key
So is it the case that nobody can beat the market consistently? The Medallion Fund, the secretive hedge fund that’s been returning 70 per cent per year for decades, would say otherwise. Medallion shows it can be done.
But Medallion is a true one-off. No hedge fund in history comes close. The rest of them — even famous investors you might have heard of, like Buffett or Paulson — struggle to beat the market year after year. Once they get noticed, fund managers’ performance tends to revert to average. Which suggests that, in the past, they were more lucky than good.
(Disclaimer: For four years, I wrote a stock tipping newsletter. Its performance was pretty good. But I’m under no illusion that I’m an investing genius.)
So a fund manager might have the magic touch, and might justify his or her fees. But all the evidence suggests fund managers that consistently beat their benchmarks are exceptionally rare. According to a study by Morningstar, over ten years, only 20 per cent of funds beat their benchmark after fees.
Another Morningstar study showed that, in every category, high-fee funds underperformed low-fee ones. In other words, in not one fund category did fund managers exhibit enough skill to compensate for the fees they charged.
That Morningstar study focused on US mutual funds. But we see the same trends everywhere. A study by the European Securities and Markets Authority, ESMA, looked at the effect of fees and expenses on fund performance between 2013 and 2017. ESMA found fees dragged down fund performance by 20 per cent across the EU (20 per cent in this context means in relative, not absolute terms – it corresponds to returns dropping from five to four per cent in absolute terms, for example). Interestingly, fees for Irish funds dragged performance down by less than the EU average. Though, a 17 per cent relative reduction in performance per year isn’t something to crow about.
For fund managers, lagging the benchmark is an uncomfortable place to be. That’s why some resort to “closet indexing” — copying the benchmark’s portfolio so that at least they won’t underperform it. This is mis-selling. The fund manager is charging clients one per cent per year for active management, but delivering the index’s results which are available free of charge.
A 2015 paper by Cremers, Ferreira, Matos and Starks found 28 per cent of supposedly “actively managed” Irish assets were held in closet indexers. This compared to a global average of 25 per cent. But that’s a story for another day – and to be clear, it doesn’t apply to DGFM.
DGFM’s self-managed funds all have a high “active share”, meaning they pick assets not in the benchmark, and therefore do not closet index. DGFM’s competitors, though, have questions to answer.
Moving out
Investors are gradually coming around to the Warren Buffett view that active fund managers aren’t worth the money. And they’re voting with their feet. The following chart shows how much money has accumulated in indexes (passive funds, as they’re called), and out of actively managed funds, in the US from 2009-2019.
As the following chart shows, more than half of American and Asian assets are now invested passively, in indexes. Europe is about three years behind. But the numbers keep rising.
Why underperformance matters
DGFM is an Irish manifestation of a global issue. The fund managers at DGFM haven’t generated enough alpha to justify their fees.
But generating alpha is easier said than done. As we’ve seen, 80 per cent of US mutual funds don’t generate enough to justify their fees.
The fees funds charge, then, aren’t much to do with “alpha” or performance. They are a clearing price between supply and demand. They’re what investors are willing to pay – no more no less.
Some investors want a tailored investment solution. Others want someone to hold their hand. For them, the fees are worth it. Others just don’t know about the relative performance of passive versus active investing over time.
But as true as it might be that clients have unique goals and needs, it’s less clear why they should pay approximately one per cent of their assets per year for someone to fulfil those needs. There are index products that can achieve those same goals without the fees. And there are financial advisors who can steer investors towards the right products, for a flat fee.
Investors should take this issue seriously. For a manager whose fund isn’t beating its benchmark, fees add up. Over the course of a 30 year investing career, the addition of a one per cent fee can cut returns by about 25 per cent, as the chart below shows. And NerdWallet, a website, calculated that a one per cent fee could cost a saver as much as $590,000 over the course of their investing life.
Another way of thinking of it is that – depending on how much of a person’s net worth is managed by funds – fees to fund managers might end up totalling anything from a tenth to a quarter of a person’s net worth.
How many other services in life do people pay a tenth of their net worth for?
