Beat Fund Managers with One Simple Investment

Investing in the stock market can be very intimidating. It’s natural to want the highest return on your investment, which is exactly what fund managers tell they do, but don’t be fooled. I’ll show you how to outperform 90% of active fund managers, and it’s EASY.

Picture This Situation

Imagine you’re a software security engineer, and you run your own company. Your clients are a solid stream of Fortune 500 companies. They hire your company to protect their data, improve their systems, and save them money – among other things.

Your life is very rewarding. You love programming. You’re very good at it. You’re well paid. You have a meaningful impact on society– your work is important, and companies value it.

But consequently, your life is really busy. You just don’t have a lot of free time. You’re not particularly interested in using your precious free time to read financial statements and do stock research. Cash is stacking up, and you know you need to invest it, but you’re not sure how to begin.

What Are Your Choices?

You have two options: The “passive” option is to invest your money in a diversified, low-cost index fund, such as the Vanguard S&P 500 Index Fund (VOO). The “active” option: hire a fund manager and put your trust in them to invest your money like they would their own (Haha).

With the “active” option, you have to put complete trust – and your money – in the hands of your fund manager. They propose to get you “better than market” returns.

What’s the catch? – they charge additional fees.

Now the question becomes – what will the returns look like after ALL fees are taken out of your account?

Typical Fee Structure For a Fund Manager

Now you’re wondering – how much are the fees? Fund managers use a variety of fee structures, but most of them are comprised of 3 components: a fixed fee (F%), a variable fee (V%), and a hurdle rate (H%) – the amount that they must exceed to earn additional fees.

Here’s how it works:

1. Every year the “fixed” fee (F%) is taken out – this guarantees that the manager earns money regardless of their performance.
2. The remaining amount grows during the year yielding a profit (or even a loss).
3. At the end of the year, the fund manager earns the variable (V%) fee of any earnings in excess of the hurdle rate (H%).

Let’s say you invest with a manager that is using [2, 25, 5]. The fixed fee will be 2% off the top, then the variable fee will be 25% of all profits exceeding the hurdle rate of 5%. This year the manager earned 12% on that portfolio, but in the end, you received 8.045% after fees. The manager picked stocks that outperformed the market average, but you only received about 8%. That seems a bit off, doesn’t it? The remainder was all paid to the manager for their performance.

This year the manager earned 12% on that portfolio, but in the end, you received 8.045% after fees. The manager picked stocks that outperformed the market average, but you only received about 8%. That seems a bit off, doesn’t it? The remainder was all paid to the manager for their performance.

The fund manager received about 4 percent of your money, regardless of how your stocks performed. The reality is that many ‘active’ managers cannot outperform the market over stretches of time. As a matter of fact – over the last 10 years over 90% of fund managers have NOT outperformed the S&P 500.  For more information about this see SPIVA.

The current Wall Street standard is the “2 and 20.” This means a 2% fee off the top each year and a 20% on all profits, without a hurdle rate [2, 20, 0]. Most funds have completely eliminated the hurdle rate, which provides them fees even if they are earning simply based on a rising market.

The Manager Versus Self-Managing

Let’s illustrate how this works by comparing the fund manager’s performance to managing our own portfolio with 1 single passive fund. We’ll use the Vanguard S&P 500 (VOO) ETF. This is my favorite passive fund because it has one of the lowest cost ETFs (.03%), it pays dividends, and the fund is weighted in all the best companies. Let’s say this fund yields 9% over the next 30 years. We have also found this brilliant fund manager, Ryan. Ryan says he can outperform the market by 5% and will yield 14% a year over the next 30 years with a “2 and 20” fee.

We’ll use a $1 million investment to illustrate how even an actively managed 14% return cannot outperform a passive 9% self-managed investment.

As you can see: many fund managers, even if they outperform the market, cannot outperform one single passively managed fund. Their stock picking skills might be superior, but their fees reduce the superior returns to less than market averages. This doesn’t mean that all actively managed funds are bad, but it’s important to understand that their main objective is first to earn money for themselves, and then “possibly” a little extra for you.

Warren Buffett’s Opinion

The most respected investor of our time, Warren Buffett, has been openly critical of the “2 and 20” funds. In his 2006 annual publication from Berkshire Hathaway he commented on the fee structure. He criticized the “2-and-20″ crowd saying “this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” He then pointed out an old adage: “When someone with experience proposes a deal to someone with money, too often the fellow with the money ends up with the experience, and the fellow with experience ends up with the money.” His point is that when you have someone else run your farm, you have to trust they will run the farm profitably enough to make you some money, and not keep too much of the profits.

Buffett’s $500,000 Bet Against Fund Managers

In Buffett’s 2016 annual publication he stated that in his 2005 report he offered a $500,000 challenge for charity to anyone who would pick five funds that would outperform the Vanguard S&P 500. Only one man took the challenge – Ted Seides. Ted was a co-manager of Protégé Partners, an asset manager. He raised the money to form his own managed fund-of-funds. (Funds that invest in multiple hedge funds). Below are the results after 9 years. As you can see, they did not even come close to the S&P.

What Does All of This Mean?

Buffett’s Berkshire Hathaway (BRK.A, BRK.B) are essentially an actively managed portfolio of companies that does not charge fixed and variable fees. Over the past 20 years, it has yielded 10.3% annualized, which is about 1% higher than the S&P 500 index.

This is the greatest investor of my lifetime and even he has only outperformed the market by 1% in the last 20 years.

Conclusion

Let these stories sink in a bit, and let them be a reminder. On the path to financial freedom it’s very important to simplify your life, but also to be financially literate and financially responsible. Listen to one of the greatest investors of all time, Warren Buffett. Unless you’re a market speculator yourself – just follow this one EASY step – do your own investing. It’s simple enough to choose a small basket of Low Fee funds from Vanguard and manage them yourself. The profits from even a single passive fund will exceed the earnings by a fund manager, after you deduct all the fees. Take your financial knowledge and put it to use. You will sleep better at night knowing it’s within your control, and you have conviction to do it on your own without making fund managers rich with your earnings.

Frequently Asked Questions – FAQ