There is no shortage of investment managers who will work, one hopes, tirelessly on behalf of their investors. Finding the one who suits your investment profile requires worthwhile effort.
Consider the importance of a complete alignment of interests between you and your investment manager. After all, this is the person that you will be trusting as your steward of capital. You want this person to treat your money as if it were theirs and to have their money invested alongside yours.
What's your downside?
When investing in securities, most investors will first determine how much they stand to gain. But that only tells half the story. Instead, the first thing to you should find out is how likely you are to suffer a loss of capital.
For instance, the idea of investing in a business such as Countrywide Financial (NYSE: CFC) at $7 just because you think it might get back to its year-ago level of $40 comes from a very meager analysis. Remember, a stock can go from $7 all the way to zero very easily. Temporary market volatility that results in a declining stock price isn't a problem -- but a situation that could impair the economics of a business permanently is a major cause for concern.
Individuals should assess their prospective asset managers in a way that's similar to the investing process. The common approach is to focus solely on a track record, which is very important and becomes more meaningful over the long term. Yet just as important, if not more, are expenses incurred -- because they help you define the long-term downside of owning fund shares.
Keeping costs low
For instance, take a mutual fund manager who has earned 13% annually over 10 years. That manager can boast a fairly impressive track record. Yet if the aggregate expenses of participating in the fund offset those gains by 3%-4% per year, the effect on your portfolio is significant. Granted, high expenses don't negate a fund manager's impressive performance; 13% is a very respectable return. Yet the expenses incurred to deliver those results mean that you're not benefiting as much as you'd hope from the decisions your manager is making.
Over time, the impact is profound. A $100,000 investment that earns 13% annually is worth over $339,000 after 10 years. The same investment earning 10% annually is worth $259,000 over the same period -- $80,000 less. As you can see, a 3% reduction in return due to expenses can cost the investor dearly over time -- and turn an above-average manager into one who's merely average.
Pay for exceptional management
As an investor, you have to be prepared for different fee arrangements. Investment expenses vary widely. Many hedge funds operate with a 2% asset fee and a 20% performance fee. Mutual fund expenses vary across the board, from ultra-low-cost index funds with annual costs of less than 0.1% on up to load funds that charge 5% or more up front.
Before his work with Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), Warren Buffett ran an investment partnership with what was, at the time, a very unusual fee structure that I call a 0-6-25 arrangement. Buffett charged no management fees until he'd earned at least 6% returns in a given year. He'd then take 25% of any excess return above 6%.
For Buffett, that particular fee structure made the most sense. I won't get into the math, but that structure offers a manager benefits that grow quickly as annual returns increase. For instance, if he earned 20% for investors in a given year, he'd take 3.5% -- fairly pricey compared to most mutual funds. Nonetheless, if your manager continues to deliver results, then don't be afraid to pay for it.
Investment management is a business, and investors will have no problems paying expenses as long as they get good value in return. If a hedge fund manager has delivered 20% returns or greater over the long term, then that justifies charging relatively high fees.
For instance, before becoming involved with Sears Holdings (Nasdaq: SHLD), Eddie Lampert was running his hedge fund, ESL Investments (which he still runs today). His phenomenal track record, which included investments such as AutoZone (NYSE: AZO), was worth every bit of the fees incurred. Today, Lampert is attempting the same for his fund investors by buying up shares of auto retailer AutoNation (NYSE: AN).
All about value creation
The longer an investment manager's track record, the more meaningful it is. But in the end, it's all about your bottom line -- and with the abundance of available managers, individual investors should expect nothing less than success.
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