Five “Deadly Sins” Of Investing In Funds

There’s a fair amount of disillusionment with funds in the market, and some of it for good reasons. Even amongst the still faithful, a frequent question is how one goes about evaluating managers? And at a broader level, how should an investor manage his strategies and emotions?

I myself actively invest in funds. I think it’s the smart thing to do, if you do it in a smart way. I don’t just invest in brand names. When it comes to fund managers, brand names are often asset gatherers who are better at getting your money than they are at managing it. I avoid brand names unless I can meet and interview the specific managers managing the relevant funds.

Meeting and interviewing the managers is a necessary condition for me to invest with any fund. I need to assess for myself if the track record they have achieved is the product of skill or luck. I will only pay management (and very often performance fees) for skill.

I invest in funds for a number of reasons.

  • I can’t get the diversification I need for the amount I’d like to invest. Funds pool investors’ money into a bigger pot which can be deployed in assets which the retail investor may not have the scale to access.

  • I don’t have the time to dedicate to a particular strategy. I only have 24 hrs a day. I cannot engage in arbitraging interest rates, hedging convertible bonds, investing in merger arbitrage, trading credit correlation and structuring regulatory capital relief solutions all by myself.

  • I may not have sufficient skill. This will most often be the case. Understanding an investment strategy and being able to execute it with the requisite skill are two different things. If one doesn’t understand a strategy, the best advice is to not invest. It is irrational to invest in any scheme or strategy that one doesn’t understand. On the other hand, just because you understand a strategy doesn’t mean you can do it. It just means you know how it’s done, that’s all. But with this understanding you can then delegate the investment to a professional who does it for a living.

  • I don’t have the scale for certain strategies. Not every day trader in his basement can obtain the necessary terms to trade the instruments that a strategy may require.

What I never do is invest in funds for reasons such as:

  • A good track record. A good track record is necessary but never enough. One needs to understand how the track record was achieved and if it can be repeated. One also has to know if the track record is real. Disgraced Ponzi schemer Bernie Madoff had an excellent but fake track record, yet so many clever investors invested with him. Due diligence is necessary.

  • A clever trade. A clever trade does not a fund make. There are specialized closed ended private equity funds that take advantage of very specific opportunities but open-ended mutual funds need to be based on more than a single opportunity. I’m fine with those; in fact I think they are very interesting vehicles that are often launched to capture phenomenal opportunities. It worries me when managers launch funds to take advantage of the recovery post-2008.

    What happens when the trade is done? The manager is typically unwilling to return capital and will likely try their luck in another trade, one that you didn’t sign up for, one that the manager may not be experienced at. I would look at strategies that can last at least 7-8 yrs, because that’s how long, at least, I expect to leave my money in their hands.

  • The market is running and I want exposure.If you want market returns, use an ETF, or buy the underlying instruments yourself. Funds are not cheap. You shouldn’t be using them as trading vehicles but as long-term investments. If you want exposure to a particular segment of the market and no ETFs are available, using funds is a legitimate way of buying exposure. Luxury goods companies for example are not represented by an ETF but can be accessed through a fund.

  • A brand name. A brand name is not a bad thing but it shouldn’t be the only thing, and the brand should add no additional comfort. Each fund must be assessed on its merit and this means due diligence. I have never given my trust freely, and I certainly don’t give it to brand names. Trust has to be earned, and it takes time.

    Brands are often good from a due diligence perspective, however, since they provide the basis for the question: how did they build a successful brand? Usually, a high quality product or service is the answer. Due diligence seeks to confirm and verify the answer. There are no assumptions in due diligence, or at least there are very few. I have very strong views about due diligence and how it is to be conducted. You have to identify the manager, meet the manager, his team, his operations team, his service providers, speak to them about what they do.

  • I don’t know the strategy well and I want to outsource it to a professional. This is an excellent way to lose money. If you don’t know the strategy well, how do you know whom to outsource it to? If one doesn’t know a strategy well, the first and best course of action is to learn all about it. The second best course of action is to stay away.

To Sum It Up...

Investing is not easy. Whether one invests in funds or directly in securities, one is responsible for one’s own decisions. Using consultants is one way of delegating the research and due diligence but it means one has to research and perform due diligence on the consultant or intermediary.