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Why are actively managed funds paid via fees, and not based on performance? If someone (or some company) is claiming to be better than me at using my money to

Why are actively managed funds paid via fees, and not based on performance? If someone (or some company) is claiming to be better than me at using my money to make money, surely they'd agree to put skin in the game, and only profit when I do? If they don't feel confident enough about their choices making money (and hence, ensuring they get compensated), why should I? edit: I was referring to the types of funds typical retail investors are in, not hedge funds.

gnaritas 11y ago
They do both, 2 and 20 is standard, 2% fee yearly and 20% of the profits they make.
- kasey_junk 11y ago
  That's true of hedge funds not mutual funds. The op was imprecise.
  - optimusclimb 11y ago
    > The op was imprecise. True. Edited my comment.
jzwinck 11y ago
> If someone (or some company) is claiming to be better than me at using my money to make money, surely they'd agree to put skin in the game, and only profit when I do? Imagine you believe that mail order companies are poised for rapid growth in coming years. You don't know which ones specifically, and there are thousands. So you buy a mutual fund which holds hundreds of these companies. This gives you some diversification and lets you make your bet with only a single commission to buy and sell. But the fund manager may disagree with your investment thesis. She may be fully convinced that online shopping has already destroyed the mail order business permanently. She would therefore gladly run a fund for you, but she would not bet on its performance herself. For a somewhat more real-life example of this, watch or read "The Big Short." The protagonist wants to buy something that the banks think will lose money.
- optimusclimb 11y ago
  > But the fund manager may disagree with your investment thesis. I'm referring to funds managed for me with the proposition that they will beat the market, i.e. the fund manager has a thesis which they agree with (because it is theirs.) So while what you're referring to of course exists, it's not what I was talking about. Apologies for being too vague in my post, however I thought the underlying assumption of this discussion of actively managed funds being chipped away by passive ones was that we were talking about the types of investment vehicles used by a "normal" person that wants to put their money in something that will grow over time, without having to pick stocks on their own.
  - jzwinck 11y ago
    This normal person who has no strategy at all had better just buy a broad index fund. It's made for them! If a person's only belief in the market is that they want to beat it, they are out of luck before the opening bell.
- rdtsc 11y ago
  That's a good way to put it. Wonder then if most fund managers fundamentally don't believe that they can beat the market. They say they can for marketing purposes, but their fee structure indicates they can't. What about this, a mutual fund that users don't really care about what industry it goes into (as long as it is legal) and then the manager decides? In reality are grandma and grampa really deeply insistent that their money should go into mail order businesses so to speak or are they more interested into getting a certain return and would rather have a fund manager "professional" decide? I see the second choice as more plausable somehow.
  - ktRolster 11y ago
    That's a good way to put it. Wonder then if most fund managers fundamentally don't believe that they can beat the market. The wall street journal interviews fund managers every year or so, and asks them, if someone gave you all their money in return for a fixed, guaranteed annual interest rate, how much would you promise them? Generally the answers are in the 1-2% range
foxylad 11y ago
This is why I don't invest in actively managed funds. I like the argument that if anyone could pick stocks better than average, they'd end owning everything - but I don't pretend to understand the share market well enough to be confident investing everything according to that. But if the very people who know most about the share market charge fixed fees, this seems to me to be an implicit recognition that they can't out-perform the market in any meaningful way. I once engaged a broker in an argument about this, and they ended up admitting that the only value they added was managing the whole shares-bonds-cash mix for people who couldn't or didn't want to do it for themselves. And back to the point of the article, automating that management would not be difficult. I agree that there are hard times ahead for most brokers.
jacobwcarlson 11y ago
Because drawdowns are inevitable and investment companies need operating capital even in (particularly in) down markets. If they were paid solely based on performance then you would also pay points on the spread between what you lost vs. what some benchmark lost that year. I can't imagine many investors wanting to take on that kind of risk.
- optimusclimb 11y ago
  > and investment companies need operating capital even in (particularly in) down markets. Do they though? As far as I know, the premise of the public stock market is that there are companies that feel they have an idea/opportunity to make money, but it needs more capital than they have available to get going. Going even further back to basics - it's like saying, "We all need to eat, and by myself I can't take down this big animal I've spotted to kill, but if we get together as a pack, I think we CAN do it together, and we'll all benefit (i.e. eat.)" Given that view of the market, clearly some of the companies that wish to raise money from the public will succeed, and others will fail. In theoretical simpler times, we could evaluate companies based on the merits of their ideas (their prospectus), and decide whether or not to invest. Perhaps this "lightbulb" concept, or "horseless carriage", "telegram", or "Facebook" concept makes sense to us, and we choose to back the idea with our money. Things are clearly more complicated in this day and age. Because of this complexity, we have a new breed of companies - meta-companies, if you will - that promise to do the evaluation of other companies for us, and tell us which ones to put our money into. The product of these companies is not the actual product itself - the lightbulb, car, or social network - but instead, the return on investment itself. For traditional companies - when the product flops, we stop investing, and the company eventually ceases to exist. Sometimes you get General Electric or Ford, and other times you get Pets.com. To me, one of these meta-companies whose products is returns, that fails to produce said returns - should stop receiving capital. It seems to me that actively managed funds that continually fail to beat the market should not continue to collect people's money in the form or fees - and therein lies the madness of the current situation. (Note - I realize that investments do not provide returns immediately or overnight, and therefore timeframes should be attached to any sort of promises an investment company might offer. If they don't believe they are able to do so, even with a reasonably sized window of time - then I fail to see how they are any better than a roulette table.)
prostoalex 11y ago
> Why are actively managed funds paid via fees, and not based on performance? Pay for performance creates an incentive for outsize risks. Sure, our Subprime Mortgages Fund and Greek Bond Opportunities Fund were down this year, but Powerball Tickets Fund and Vegas Bet Everything On Red Fund more than covered those losses. If you're a risk-averse investor, your most likely match is some variant of slow-growth, growth-at-reasonable-rate or dividend-reinvestment strategy. Paying for assets under management motivates the advisor to at least not lose all your money and keep you as a client.
cm2187 11y ago
How do you pay your staff in bad time? Do you just go bust the first year there is a market sell-off?
- kmonsen 11y ago
  You save some of the profits from good years.
Htsthbjig 11y ago
"Why are actively managed funds paid via fees, and not based on performance?" Simple, As Warren Buffet said when he created an investment firm, he expected to be judged over the general market wave, that is if the market crashes 75%(like in 2008 or the great depression) just maintaining the funds worth(or loosing small) is a great deal and you are a genius. If the market skyrockets 50% per year and you get 10%, you are not so good. Putting it another way, they are already based on performance over the market.

gnaritas 11y ago

They do both, 2 and 20 is standard, 2% fee yearly and 20% of the profits they make.

kasey_junk 11y ago
That's true of hedge funds not mutual funds. The op was imprecise.
- optimusclimb 11y ago
  > The op was imprecise. True. Edited my comment.

jzwinck 11y ago

> If someone (or some company) is claiming to be better than me at using my money to make money, surely they'd agree to put skin in the game, and only profit when I do? Imagine you believe that mail order companies are poised for rapid growth in coming years. You don't know which ones specifically, and there are thousands. So you buy a mutual fund which holds hundreds of these companies. This gives you some diversification and lets you make your bet with only a single commission to buy and sell. But the fund manager may disagree with your investment thesis. She may be fully convinced that online shopping has already destroyed the mail order business permanently. She would therefore gladly run a fund for you, but she would not bet on its performance herself. For a somewhat more real-life example of this, watch or read "The Big Short." The protagonist wants to buy something that the banks think will lose money.

optimusclimb 11y ago
> But the fund manager may disagree with your investment thesis. I'm referring to funds managed for me with the proposition that they will beat the market, i.e. the fund manager has a thesis which they agree with (because it is theirs.) So while what you're referring to of course exists, it's not what I was talking about. Apologies for being too vague in my post, however I thought the underlying assumption of this discussion of actively managed funds being chipped away by passive ones was that we were talking about the types of investment vehicles used by a "normal" person that wants to put their money in something that will grow over time, without having to pick stocks on their own.
- jzwinck 11y ago
  This normal person who has no strategy at all had better just buy a broad index fund. It's made for them! If a person's only belief in the market is that they want to beat it, they are out of luck before the opening bell.
rdtsc 11y ago
That's a good way to put it. Wonder then if most fund managers fundamentally don't believe that they can beat the market. They say they can for marketing purposes, but their fee structure indicates they can't. What about this, a mutual fund that users don't really care about what industry it goes into (as long as it is legal) and then the manager decides? In reality are grandma and grampa really deeply insistent that their money should go into mail order businesses so to speak or are they more interested into getting a certain return and would rather have a fund manager "professional" decide? I see the second choice as more plausable somehow.
- ktRolster 11y ago
  That's a good way to put it. Wonder then if most fund managers fundamentally don't believe that they can beat the market. The wall street journal interviews fund managers every year or so, and asks them, if someone gave you all their money in return for a fixed, guaranteed annual interest rate, how much would you promise them? Generally the answers are in the 1-2% range

foxylad 11y ago

This is why I don't invest in actively managed funds. I like the argument that if anyone could pick stocks better than average, they'd end owning everything - but I don't pretend to understand the share market well enough to be confident investing everything according to that. But if the very people who know most about the share market charge fixed fees, this seems to me to be an implicit recognition that they can't out-perform the market in any meaningful way. I once engaged a broker in an argument about this, and they ended up admitting that the only value they added was managing the whole shares-bonds-cash mix for people who couldn't or didn't want to do it for themselves. And back to the point of the article, automating that management would not be difficult. I agree that there are hard times ahead for most brokers.

jacobwcarlson 11y ago

Because drawdowns are inevitable and investment companies need operating capital even in (particularly in) down markets. If they were paid solely based on performance then you would also pay points on the spread between what you lost vs. what some benchmark lost that year. I can't imagine many investors wanting to take on that kind of risk.

optimusclimb 11y ago
> and investment companies need operating capital even in (particularly in) down markets. Do they though? As far as I know, the premise of the public stock market is that there are companies that feel they have an idea/opportunity to make money, but it needs more capital than they have available to get going. Going even further back to basics - it's like saying, "We all need to eat, and by myself I can't take down this big animal I've spotted to kill, but if we get together as a pack, I think we CAN do it together, and we'll all benefit (i.e. eat.)" Given that view of the market, clearly some of the companies that wish to raise money from the public will succeed, and others will fail. In theoretical simpler times, we could evaluate companies based on the merits of their ideas (their prospectus), and decide whether or not to invest. Perhaps this "lightbulb" concept, or "horseless carriage", "telegram", or "Facebook" concept makes sense to us, and we choose to back the idea with our money. Things are clearly more complicated in this day and age. Because of this complexity, we have a new breed of companies - meta-companies, if you will - that promise to do the evaluation of other companies for us, and tell us which ones to put our money into. The product of these companies is not the actual product itself - the lightbulb, car, or social network - but instead, the return on investment itself. For traditional companies - when the product flops, we stop investing, and the company eventually ceases to exist. Sometimes you get General Electric or Ford, and other times you get Pets.com. To me, one of these meta-companies whose products is returns, that fails to produce said returns - should stop receiving capital. It seems to me that actively managed funds that continually fail to beat the market should not continue to collect people's money in the form or fees - and therein lies the madness of the current situation. (Note - I realize that investments do not provide returns immediately or overnight, and therefore timeframes should be attached to any sort of promises an investment company might offer. If they don't believe they are able to do so, even with a reasonably sized window of time - then I fail to see how they are any better than a roulette table.)

prostoalex 11y ago

> Why are actively managed funds paid via fees, and not based on performance? Pay for performance creates an incentive for outsize risks. Sure, our Subprime Mortgages Fund and Greek Bond Opportunities Fund were down this year, but Powerball Tickets Fund and Vegas Bet Everything On Red Fund more than covered those losses. If you're a risk-averse investor, your most likely match is some variant of slow-growth, growth-at-reasonable-rate or dividend-reinvestment strategy. Paying for assets under management motivates the advisor to at least not lose all your money and keep you as a client.

cm2187 11y ago

How do you pay your staff in bad time? Do you just go bust the first year there is a market sell-off?

kmonsen 11y ago
You save some of the profits from good years.

Htsthbjig 11y ago

"Why are actively managed funds paid via fees, and not based on performance?" Simple, As Warren Buffet said when he created an investment firm, he expected to be judged over the general market wave, that is if the market crashes 75%(like in 2008 or the great depression) just maintaining the funds worth(or loosing small) is a great deal and you are a genius. If the market skyrockets 50% per year and you get 10%, you are not so good. Putting it another way, they are already based on performance over the market.