This is quite possibly my favorite gym story that just happens to offer us a valuable lessen in finances as well. So let’s set the scene.
My friend and I are just finishing up working out at an LA Fitness in St. Paul, MN. We are just talking to ourselves as we walk into the locker room. When a guy in his early thirties approaches us. We small talk for a bit and exchange what we do for work, he mentions he works at a hedge fund. Let’s call him Chad. (A fitting name).
Basically, for those of you who don’t know, a hedge fund is an actively managed portfolio of pooled money that has less regulation than mutual funds. Usually these funds invest using high risk methods, with high fees, and seek high returns.
Chad, without any prompt from us, begins telling us about what his company does and goes full on sales pitch with us. Chad decides to go with an analogy to describe how much money his company could make us.
Chad: “So you bros know how hedge funds work, right?
Us: “Not really” (wrong answer…)
Chad: Well, you at least know how much money they can make you, right?
Us: Again “Not really”
*Mind you, this is before I had jumped head first into personal finance
Chad: “So our hedge fund operates in a way that no matter what the financial forecast is, we are always making money”
Me: “How so?”
Chad: “So it’s like umbrella’s and sun screen”
Us: *Puzzled looks on our faces
Chad: “So when it’s sunny out, our company sells sun screen and buys umbrellas but when it’s raining we sell umbrellas and buy sun screen. So no matter what, we are always making money”
Me: “So why wouldn’t you just buy umbrellas for shade and the rain?”
Chad: *Puzzled look on his face, walks away
We still reminisce on this story on a regular basis just on the pure boldness of Chad alone, along with the overall defeat he felt as he stormed off after we asked a simple question.
I tell this story because it makes me laugh, but also to lead into explaining some of my fears with actively managed hedge funds or investments in general.
Minus Chad, the people who we hire to manage our money are generally very good at what they do. And it’s less about what they can do with your money, and more about how good they are at communicating and presenting information to you. At the end of the day, it’s about the sale, not your personal finances.
And we all do this everyday to both ourselves and others. Presentation is key.
Which sounds better:
- You received a C on your test or you were 3% away from a B.
- You didn’t get into physical therapy school or you were the last one out
- You scored a 22 on your ACT or you scored/tested better than 63% of students in the United States
- This quarter outperformed last quarter by 20% or last quarter you were negative 19% return on investment
- You failed to match the stock market average return or you made $4,000 dollars passively this year and the market is on the rise.
Again, presentation is key. All of these stats say the exact same thing, but they are presented differently in ways that make us feel better about the outcome. It’s human nature to prefer the sugar coated version.
Actively managed funds or portfolios are great at this. We can all take any information and make it say whatever we want without skewing the actual data. It’s not lying, but it isn’t being transparent either.
Example 1:
You invest $100,000 for a year into the US total stock market. It returns the average 7%. You make $7,000 passively. (slightly under that with the .04 expense ratio).
Example 2:
You invest $100,000 dollars with an active portfolio manager for a year. To make the math simple they invest 25% in 4 different investments.
- Investment 1 doubles and returns 100%.
- Investment 2 returns 10%
- Investment 3 goes under
- Investment 4 loses a modest 3%
This portfolio returns 7% as well. However, in your yearly meeting investment 1 and 2 are raved about, investment 4 is glazed over and investment 3 really isn’t brought up. We walk out of the meeting feeling great, we doubled our money with investment 1. This guy really knows what he is talking about. How did he know that _____ sector was going to explode this year. The future is looking bright.
In reality, we tied the market which I too would say is very good. Because in reality most actively managed portfolio don’t.. According to a report from Standard and Poor, over the last 15 years, 92.2% of large cap funds, 95.4% of mid capped funds, and 93.2% of small capped funds lagged behind the market average.
Meaning, that your chances to beat the market with actively managed funds was roughly 1 out of 20…I don’t love your odds.
I can hear you arguing that investment 3 wouldn’t go under, so that’s an unfair example. Well, according to this same study, in the last 15 years, only 34.11% of the large cap funds that existed are still around today…Sobering I know.
So yes, there is a very real chance one out of your investment tanks on you. Again, human nature, but we always believe it couldn’t possibly happen to us…until it does.
Back to the example: “So what, both example returned the same amount, so who cares”
What we easily forget is that many of these actively managed funds have an ER of over 1% on top of what you might be paying your portfolio manager or financial adviser, usually 1-2 %. We now only returned 4% on our money on a good year when our actively managed funds happened to tie the market.
And hedge funds… Hedge funds are the worst of all with their two and twenty fee structure. Meaning, 2% of your assets annually regardless of how the fund does. And 20% of all financial gains. Look at the car of the next hedge fund manager you see…
Conclusion
Yes, there are pros to actively managed portfolios such as the convenience, the time saved, the explanations, and the chance to beat the market. But as we have shown, investing doesn’t need to be hard or time intensive, the information to learn this stuff is out there, and they rarely beat the market anyways.
I also even understand that most people don’t want to learn about personal finance or money, but my goal is to continue to help simplify personal finance and show the power a few key decisions can have on your long term financial future.
And sometimes, all it takes is just seeing how much money you are losing out on with these decisions and how much you are extending your retirement goals to make a change.
It took me a few hours of my day to learn about about the true cost of actively managed accounts and only a few more hours on top of that to learn about the simplicity and effectiveness of passive index investing from the great Jim Collin’s book “The Simple Path to Wealth”.
Add that to the 5 minutes it takes me per paycheck to place my investments (which I could set up to be automatic) and my hourly return on my time will be in the $50,000 to $100,000 dollars per hour range …Not a bad rate if you ask me.
So before you think about paying someone else to take care of your money, think about paying yourself first.
As always, comment below with any questions or concerns. And if you have specific questions, feel free to message me individually here!
