Choose fund managers with ethical owners and qualified investment teams: Asif Khan

The original write-up appeared on the third issue of 26th anniversary of The Financial Express :

Bangladesh’s capital market is dominated by retail investors who conduct 70 to 80 per cent of average daily trade. In developed countries, the picture is the exact opposite since the market is heavily dominated by institutional investors like asset management companies, insurance companies, endowment funds, etc. The Bangladeshi asset management industry is still tiny with total assets under management of around US$1.4 billion (0.5 per cent of GDP).

For the average retail investor, trying to invest money on their own makes little sense. With full- time jobs, people don’t have the time to track the market and make informed decisions. These investors thus rely on their brokers or friends to guide them regarding investment decisions. Such relationships are characterised by massive conflicts of interest, which usually result in the broker benefiting at the expense of their customers.

The absence of ETFs or Index funds leaves us with the option of relying on asset management companies who have launched mutual funds (a pooled investment vehicle that can either be traded on the market with a fixed maturity or can be open-ended in nature). The mutual fund structure has a lot of benefits such as zero taxes at the fund level and at redemption, tax exemption from dividends up to BDT25,000, allocation in initial public offerings, better bargaining power with banks and NBFIs for fixed deposits, etc.

The challenge, however, is selecting the right asset management companies. The failure to do so can lead to disastrous return performance and is as bad as speculating on broker advice. As very little about this has been discussed in either print or electronic media, I would like to provide some advice to our readers on how to select the best asset managers.

* Follow the fund expenses: Fund return is not completely under the control of the asset manager as all funds are correlated with market performance. Many of the fund expenses, however, are in their control. Mutual fund management fees are fixed and regulated by the Securities and Exchange Commission (SEC) and thus don’t differ from fund to fund. However, some open-ended funds have front and back-end loads (a fee to invest money and a fee to exit), which tend to increase the cost for investors.

A thorny issue is ‘formation cost’. As per current regulation, asset managers can spend up to 5.0 per cent of the proposed fund size as formation cost. This cost is not expensed immediately but rather amortised for around seven years. Imagine a fund with a proposed size of BDT1000 million that ends up raising only BDT300mn. This fund can charge BDT50 million (5,0 per cent of proposed size) as formation fees, which means that the original unit holders have lost 17 per dent of their initial investment on the very first day.

The final cost to check is brokerage commission. This is not explicitly mentioned in any document but investors can ask fund managers about how much they are paying to brokers. Institutions can generally bargain for very low commissions. The choice of broker also conveys meaningful information about the manager.

Summary: Choose the fund manager with the lowest fees (management fee + front/back end loads). Avoid fund managers who spend a lot of money as ‘formation fees’. Formation fee details are available in fund prospectus.

* Skin in the game: Investing others’ money is fraught with conflicts of interest even for asset managers. This is part and parcel of the job. One way to best mitigate this is by ensuring that both fund manager and employees invest their wealth in the fund they manage. This is called ‘skin in the game’, a term made popular by Nassim Taleb. That way, if the fund underperforms, the employees of the asset management company will also lose wealth just like other investors. If the fund performs well, both investors and employees will gain from it. This facilitates the alignment of incentives.

Summary: Check if fund manager and employees have invested significant part of their wealth in their own fund.

* Investment team and ownership: The background of the owners needs to be checked. Are they people with reputation for ethical behaviour? How did they get wealthy? Do they have expertise in this area? Is the asset management company individually owned or institutionally owned?

Similarly, it is important to check the profiles of the investment team, which includes the portfolio manager and the analysts. Do they have good qualifications and relevant experience? Do they have prior experience in fund management? What is their reputation in the market?

Start with the website of the asset manager but also speak to industry insiders and experts to make a judgment.

Summary: Choose fund managers with ethical owners and qualified investment teams.

* Investment philosophy, historical performance and portfolio structure: One needs to understand the investment philosophy of the fund manager. If the fund manager claims to be a value investor but is chasing speculative stocks and churning portfolio aggressively, then there is clear misalignment between stated philosophy and actions. Also watch out for style drift where a manager starts with a stated policy but soon changes strategy to chase short-term performance.

Fund managers are obliged to report weekly NAV performance. One can easily check if the fund has beaten the market over the reporting period or has underperformed. Such analysis, however, is better performed with longer time horizons as short-term performance can easily be linked to luck.

It is more important to look at the quarterly portfolio statements and check which stocks the fund managers invested in and at what price. Is the portfolio too diversified or too concentrated? How aggressive or defensive is the portfolio (for this check cash and bank balances as a per cent of Net Asset Value)?

Summary: Speak to the fund manager to understand investment philosophy. Track historical performance and historical portfolio statements to get useful information on the ability about the manager.

* Dividend policy: For open-ended funds, dividends have little meaning as investors can take back their money at any time. For closed-end mutual funds with finite lives, fund managers giving shares as dividend instead of cash is a red flag.

Summary: Avoid closed-end funds paying stock dividends.

Choosing the right asset manager is extremely important as it will determine whether you meet your long-term investment goals. Making mistakes will not only lead to underperformance but you might also never get your money back. This is a universal problem as the average American spends more time on choosing a television or a restaurant than on planning a retirement fund.

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