Understanding How Mutual Fund Managers Earn A Living
When you invest in a mutual fund, you might assume that the primary goal of the fund manager is to maximize your returns. While this is certainly a part of their job, the reality is a bit more nuanced.
Actually, scratch that… it’s really quite nuanced. Follow me on this.
The statement “Mutual fund managers don’t make money from making you money… they make money from keeping your money” highlights an important aspect of how mutual fund managers are compensated… and thus tells you all about their motivations.
The Basics of Mutual Fund Management
Mutual funds pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. The fund manager is responsible for making investment decisions and managing the portfolio. Investors pay fees for this service, which can include management fees, administrative fees, and sometimes [rarely] performance fees.
How Fund Managers Are Compensated
Management Fees: The primary source of income for mutual fund managers is the management fee, which is typically a percentage of the total assets under management (AUM). AUM refers to the total market value of the investments that a mutual fund or investment company manages on behalf of its clients. This fee is charged regardless of the fund’s performance. Yes, you read that right… the business charges the fee irrespective of the result. This leads to a fairly perverse outcome, but we’ll return to this a bit further down in this rant. As an example, if a fund has AUM of $2 billion and the management fee is 1%, the fund manager earns $20 million annually, even if the fund’s performance is mediocre, poor, or down right terrible. I know… how can you get that job right?
Administrative Fees: These fees cover the operational costs of running the fund, such as record-keeping, customer service, and regulatory compliance. Like management fees, these are also generally a fixed percentage of the AUM. Now, I know what you’re thinking… since when does a business get to pass all of the operational costs on to the client in order to protect the fees that they charge for doing the job no matter the outcome?
Performance Fees: Some mutual funds charge performance fees, which are additional fees that funds charge based on the returns they generate for investors. Stop laughing… a few mutual funds do tie a small portion of their fee structure to performance. However, these are less common in mutual funds as compared to hedge funds. And again, even when performance fees are present, they’re usually a smaller component of the fund manager’s total compensation.
The Incentive Structure
Given that management and administrative fees are tied to the AUM rather than the fund’s performance, fund managers have a strong incentive to attract and retain investors’ money. This can sometimes lead to a focus on marketing and maintaining a stable asset base through risk avoidance rather than focusing on following a bold [if still pretty conservative] strategy that could potentially yield higher returns.
Implications for Traders
Long-Term Perspective: Investors should be aware that while fund managers aim to achieve good returns, their compensation structure might influence their investment strategies. Managers might prefer safer, more conservative investments to avoid significant losses that could lead to investor withdrawals.
Fee Awareness: Understanding the fee structure is crucial. High fees can erode returns over time, so it’s important to compare the fees of different mutual funds and consider how they impact your overall investment.
Performance Evaluation: Look beyond short-term performance. Evaluate the fund’s performance over multiple market cycles and consider how it aligns with your investment goals.
Conclusion
While mutual fund managers do strive to make money for their investors, their primary source of income comes from keeping your money under management. This doesn’t mean they don’t care about performance, but it does highlight the importance of understanding how their incentives might affect their investment decisions. As an investor, being informed about these dynamics can help you make better choices and align your investments with your financial goals.
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