By Paul Bouchey, chief investment officer
Of the approximately 8,000 mutual funds and 11,000 hedge funds available in the marketplace, most are completely inappropriate for the majority of investors. A large portion of an investor's return, which they bore the risk for, will go to the investment industry (given the high trading turnover, commissions and fees of a typical investment strategy) and the government (in the form of taxes).
The traditional investment manager business model--"I'm smart, I've developed a mysterious black box that magically generates free money, you should trust me, my high fees mean that my strategy is a good one"--is starting to break down. It is being disrupted by systematic strategies that are simple, low cost, and transparent. If the approach is easy to understand and fully disclosed, investors can be more informed and rely less on "trusting" their investment manager. Importantly, these systematic approaches are often lower turnover and lower fee. For taxable investors, that also translates into a lower tax bill.
The key disrupter for the investment industry is the democratization of investing. An investor can now get active strategies, with a chance of beating the market over long periods of time or reducing risk relative to the market--delivered in a low cost, transparent, and tax-efficient format. Anyone can access the capital markets in a flexible way, customized to their views, without being beholden to a Wall Street black box.
It started with passive index investing, but has expanded, through the smart beta and factor investing movement, to include the active side. Trillions of dollars have moved into passive indexes. Trillions more will move into active and factor indexes.
Why have so many bad, expensive products survived and created such confusion among consumers? A lack of transparency. Sure, mutual funds disclose their holdings, but there's a level of uncertainty in returns. As a result, it is hard to measure whether a fund is good or bad, whether the manager is truly skilled or just lucky. The lack of good metrics means that storytelling wins the day. This doesn't work in other industries. If I develop a smart phone that is slow and has fewer features than rivals, it won't sell and will quickly get swept into the dustbin of product development history. However, a manager can launch a new mutual fund and if they are lucky enough to outperform the market over a three-year period, they can raise billions of dollars. It all depends on if their story is interesting enough-regardless of whether the strategy is sound or simply trades on noise.
Investors, and even professionals, sometimes forget that the capital markets were not invented to provide them with returns. The markets were created to provide business and entrepreneurs with capital, while at the same time allowing them to offload the risk of the venture onto the backs of investors. This is a harsh environment with the investor bearing the risk, the transaction costs, and the tax bill. And maybe, just maybe, they get a positive return for their troubles.
Consider an investment that earns 8% per annum. If the fee is 1% and the taxes 2% per year, only 5% is left for the investor. Compounded over 40 years, $1 grows to over $7 at a 5% return, but grows to over $21 at an 8% return. In other words, over a long horizon only one-third of the potential wealth generated by the investment is retained by the investor (the one putting their capital at risk!).
Given these odds, investors need to focus more on surviving the game and less on trying to be the winner. Diversification is obviously important, but so is being low cost and tax efficient. These basic principles are the key to long-term success. Investors are starting to wake up to this fact and ask for better, much to the chagrin of investment managers playing the same old game.
Paul Bouchey is chief investment officer at Parametric and can be reached a firstname.lastname@example.org