A conflict of interest

The investment industry has a problem, at least in Germany. Individual investors do not invest their savings in mutual funds, they prefer cash accounts, high liquidity, a capital guarantee and fixed coupons.

It is understandable that at interest rates of 1-3% people do not like long term investments. And as we know from prospect theory they hate losses and therefore demand capital preservation. Another reason for the reluctance of investors to invest in funds is that fees are very transparent and investors recognize that it may be difficult to realize a net gain for themselves when the fund management company charges up to 2% a year for themselves.

The solution found by the industry is to invent fashion products, each product riding a short-term trend. They hope, that a good story alone convinces investors. In part this strategy works as these fashion products are the only ones with net inflows. Overall the strategy failed.

The fund management industry has to think about its primary goal: to provide asset management that allocates customers resources into a profitable mix of asset classes, behaving as a trustee and trying to preserve customers capital and charging reasonable fees. If a saver wants to invest in bonds and yields are around 2% it is not understable to charge him 1.5% a year. The result of that is that the fund will be loaded with higher yielding and riskier bonds not only because the fund manager is convinced of them as a good investment, but also he need this extra yield for his own fees. That's a conflict of interest.

The industry has to think about fees as percentage of the current yield (in bond management) or to reduce the fixed fees and replacing them with a performance fee. I underscore: reducing fixed fees to implement a performance fee. In the past, most companies add a performance fee on top of too high fixed fees. That's not in investors interest. Much worse, that these performance fees have sometimes no high water mark or hurdle rates, which is a great disadvantage for investors in these funds.