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You'd never know it from all the advertising done by mutual funds or the glossy brochures their sponsors create to attract your money. But if you own a fund, you must remember this: You and your fund manager aren't entirely on the same side.
The reason: Fund managers -- with a few exceptions -- want the funds they run to get bigger. That's because they get paid via what's called an "asset-based fee." If the manager charges say, 1% a year, that's $100 a year in his or her pocket from every $10,000 in the fund. Almost always, that percentage is fixed whether the fund does well or poorly.
There's nothing wrong really with that arrangement. But as a mutual fund gets bigger, tons of academic research and years of practical experience show that it will have a harder and harder time beating -- or even meeting -- its goals or benchmarks. And that means the fund manager must make a choice: Close the fund before it gets too big to manage in a winning way. Or keep it open, rake in more money, and let the fund investors suffer worsening performance.
ENEMY OF ALPHA. You can read all about this dilemma and what it might mean for your mutual funds in a neat new book, Searching for Alpha: The Quest for Exceptional Investment Performance, by Ben Warwick (John Wiley & Sons, 202 pages, $29.95). If you have much of your money in funds, the book would be worth your while.
As a principal in Denver-based Bornhoft Group, Warwick is in the business of helping rich people and institutions figure out who should manage their money. That means he has to evaluate whether the money managers are earning their keep. He does that by seeing whether they're delivering what financial economists call "alpha" -- investment returns above and beyond a benchmark after adjusting for the risks the managers took.
Alpha, as you might expect, is like gold -- scarce and valuable. It's also easily destroyed. One of the clearest enemies of alpha is growth in assets under management. In part, that's because a money manager who wants to put a few bucks in the stock of XYZ Corp. is unlikely to push the price of the stock up much by virtue of his order. But if he wants to put $25 million in that stock, he'll almost surely drive prices up. With each new share that he buys, he undermines his investors' eventual return. While he's buying, he helps fuel a rise in XYZ's stock price, paying higher and higher prices to build his position. But once he sells, the price of the stock is likely to fall as he reduces his huge stake, eating away at his gains.
AT A CROSSROADS. Such "market impact costs" plague all big investors, very much including mutual funds. That's why if beating the Standard & Poor's 500 is your goal, I don't suggest you put your money in any of the mega-multibillion-dollar funds or those that are gathering assets rapidly. The companies advising those funds "are left at a crossroads. On one side, they strive to increase the amount of client assets under management to maximize their fee income," Warwick writes. "On the other side, is the interest of the shareholder, who simply wants the best return possible."
Warwick's book puts readers in the shoes of a fictional money manager, Mr. Kilgore Trout, to see how tempting the promise of managing more and more money can be even if it means hurting your clients in the long run. Warwick also creates Mr. Winston Smith, a rich supermarket scion with a family fortune that he's helping to invest. His aim, naturally, is to make as much money at as little risk possible. Warwick traces how Trout and Smith try to work out their divergent interests. One idea: Mr. Smith buys an interest in Mr. Trout's money-management firm.
Few real-life investors -- certainly not I -- have the time or money to do anything like that. But the inherent conflict of interest between you and your mutual-fund manager is something that amid the flurry of mutual-fund marketing materials is easy to miss. Don't.
Barker covers personal finance in his weekly column, The Barker Portfolio, for Business Week from Melbourne Beach, Fla. And he appears every Friday on Business Week Online
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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