How do investment fund managers make money?
There is an old saying that goes, “in every gold rush the people who make the most money are the merchants who sell the picks, pans, and shovels to the miners”. The same is true in the investment fund industry. The guys who manage the funds make more money than their clients because they charge fees on all the transactions. There may also be a monthly “service fee” that investors pay.
So why would anyone want to invest in these funds? Well, the answer to that question is complicated. It depends on who you are and what your long-time financial goals may be. It also depends on how much experience you have at investing.
An investment fund is a way for a lot of people to pool their assets together. With the right fund manager those assets can pay off handsomely in the future as the value of stocks rise, dividends increase, or asset sales turn profits. That is what the savvy investors are waiting for. That is what people are looking for all around.
Three Types of Investors Who Rely on Expensive Funds
You have three classes of investors who do very well by paying the exorbitant fees that investment funds charge. By “very well” I mean they do okay over time. If you look at their day-to-day valuations you might think they are losing money.
Large Buy-and-Hold investors can afford to pay these fees. Anyone who makes a big investment once every few months is going to hang on to that investment for a while, probably for several years. They are looking for long-term growth in asset value and perhaps some dividend income. They eat the transaction fee for buying into the fund and take the monthly maintenance fee into account. If they can, they invest in a fund where the dividends cover the maintenance and produce some extra income.
Institutional investors need to diversify their holdings. When you are managing hundreds or millions or even billions of dollars in capital you have to put that money to work in as many places as possible. You will buy a lot of CDs, to be sure, but you’ll also invest in stocks, bonds, and commodities. The best ways to make such investments at scale are to buy into large funds. The large funds may waive some fees for large investors, or they may have graduated pricing scales that make larger investments more attractive.
Either way, institutional investors don’t dare put all their eggs into one basket. It is quite common for them to invest in 5-10 different types of funds and to rely on those fund managers to grow asset value over time. This strategy sometimes hurts the institutional investors, who may become rancorous and demand changes in fund management if after a few years they have not realized the growth they were looking for.
Naive investors who hope to beat the market buy into expensive funds. There is a false logic behind this strategy which assumes that if the fund is really that expensive the guy running it must know what he is doing. He knows he is charging you exorbitant fees and, to be honest, that is really all he needs to know once you give him your money.
Those fees may pay the commissions for lowly stock brokers who work for the fund owners. So when you call your broker and ask him where to put that $50,000 you just inherited, he may push you toward one of his company’s own expensive funds. That way he’ll make a commission and you’ll feel like you got some good investment advice. Always ask your broker (if you deal with one) to disclose his financial interest in whatever funds he recommends.
Are There Cheap Investment Funds That Grow Asset Value?
Oh yes, there are plenty. And you don’t have to look hard to find some good ones.
The best cheap investment funds that grow asset value are called “index funds” or “exchange traded funds”. These are automated funds set up by most brokerages that track major indexes. The most popular, of course, is the Standard & Poor 500 index and many of the most popular index funds track this index.
Exchange traded funds have become popular over the last ten years for two reasons. First, Warren Buffett famously said that he would advise his wife to put 90% of her money into such a fund if he died before she did. Second, anyone who can do the math eventually sees that the ETFs are more profitable than the typical managed funds.
But there are other cheap funds out there. Sometimes a famous fund manager leaves his old company and starts a new fund. To attract investors he’ll offer very low fees. So the best time to get into such a fund is when it’s starting up, but you need to understand the risks of the marketplace. Is that good a industry with viable long-term growth?
Some funds are cheap because they don’t attract large investors. To raise the capital they need from small investors they have to keep their fees low. The fund managers still get rich but they are not taking as big a cut from your income as their super-wealthy competitors.
Investment Fund Managers Sometimes Make Money from Investing
Yes, it’s true. Every now and then you’ll find an investment fund manager who actually invests his own money in whatever he is selling. There is no law requiring the fund managers to do this but they are required to disclose when they do and do not have an investment in the asset.
Just because the fund manager is staking his own money on the fund doesn’t mean it’s a good fund but it does indicate he thinks he is going to make money from the investment. If his expectations are realistic then his investors should make some money, too.
Sometimes you get a guy with a little too much ego. You don’t hear about failed investment fund managers very often, except when they go to jail, but if they come off a lucky streak with a hundred million dollars in their pockets they might decide it’s time for them to ride the market to billionaire success. Most often they start or join a private capital firm where they collaborate with other wealthy investors to make smarter decisions. But a few investment fund managers thought if they could do it once they could do it again and they started new funds that failed.
For the most part, the money to be made in managing an investment fund is through fees and commissions. Don’t confuse the investment fund manager’s portfolio with an investor’s portfolio. No one pays you to invest in your portfolio. You have to pay yourself from making smart investment decisions. You have a better chance of making money from your portfolio by avoiding the high fee investment funds, at least until you are in the category of institutional investor who needs to work with those kinds of funds.