Avoid these 9 managed fund red flags for better returns

Investing in actively managed funds is a core approach for millions of Australian investors both inside and outside of their superannuation. It makes sense for many. Identifying expert managers who are able to outperform over the long term makes investors lives easier and less stressful.

But as with stock investing, there are some red flags to watch out for when selecting your fund managers. They tend to pop up time and time again with underperforming and unethical managers so they are worth being aware of.

The 9 managed fund red flags to watch out for

1. Unrealistically high return expectations

One of the often-quoted truths of investing is if it’s too good to be true, it’s probably isn’t. It’s the same with fund managers.

For example, if a fund manager claims they’re aiming to outperform their benchmark by 20% p.a., or that they’re aiming to generate 50% p.a. absolute returns, that’s plain unrealistic. More importantly, it may indicate that they don’t understand their strategy, or worse, that they aren’t ethical. Either way, unrealistically high expectations are a red flag.

2. Departures of fund managers and key staff

Happy fund management teams tend to stay together over the long term.

Whilst some key staff turnover is to be expected, it’s often a red flag when numerous managers and staff members depart a team. More often than not, it means the manager has management and cultural issues that run deep. It’s an important red flag to watch out for.

3. Fee structures that are hard to understand or too high

High quality fund managers have clear, upfront fee structures that are aligned with market rates.

So if you encounter a fee structure that’s unclear, hard to understand, or well in excess of competitors, you may have stumbled upon another red flag. There’s no good reason for a fund manager to not want their investors to fully understand their fee structure prior to investing.

4. Lack of track record

Track record is important in fund management.

Of course, everyone has to start somewhere and it’s the same with fund managers. But you don’t want to be the one who’s funding your manager’s on-the-job training (read: mistakes). That’s why most investment houses help their managers gain the relevant experience by partnering them with a more experienced manager prior to launching their own fund.

So an insufficient track record is a red flag to lookout for. You should be investing with qualified experts who have the requisite experience.

5. Overly complex strategies

As Warren Buffet once explained: ‘Investing is simple, but not easy.’

If you come across a fund manager who believes the opposite is true: that great returns are generated through complex structures and strategies, it’s almost always a red flag.

The best investment strategies involve simple and understandable stock selection, portfolio construction, risk management, and sell disciplines. For example, the crux of value investing is to buy undervalued stocks. It’s beautifully simple, despite being far from easy.

6. Lack of scale & outflows

Fund managers are generally paid fees based upon their assets under management, so their futures are inextricably connected with this key number.

The problem with a lack of scale is that it makes it challenging for a fund manager to profitably operate their business, and that means they’re unlikely to stick around to manage the fund over the long term. For the same reason, consistent fund outflows could spell trouble for a manager and should be monitored.

So lack of scale and consistent fund outflows are red flags to be aware of. Be careful investing with smaller managers who are managing less than $50 million.

7. Unclear communication

As Einstein once said: ‘If you can’t explain it simply, you don’t understand it well enough.’

Simplicity is a core element of quality investor communication. Successful fund managers should be able to communicate their strategies in a way that’s easy for investors to understand.

Conversely, unclear communication is a red flag to be aware of. If you walk away from a presentation having no idea what a fund manager was talking about, you’re probably best to keep walking.

8. A bad reputation

It’s worth keeping your ears open both offline and online to ensure you’re aware of any reputational risks surrounding prospective fund managers you’re considering investing with. In particular, watch out for regulatory problems, bankruptcy notices, lawsuits, and reviews by upset investors. All of these can be red flags.

9. No skin in the game

The vast majority of successful fund managers are invested in their own funds. Warren Buffet explains why: ‘To be successful in business and investing you’ve got to have skin in the game, a stake in the company.’

It’s all about conviction. If a fund manager chooses to invest a large portion of their wealth into their own fund, it’s a signal that their conviction in the fund’s process, strategy, and future is as high as they say it is during marketing meetings. It’s a case of their words and actions meeting in an authentic alignment with their clients’ best interests.

Equally, not being invested in their own fund is a potential red flag that may indicate a lack of conviction.

Do your managed fund research

Thankfully, we’re blessed in Australia with an abundance of high quality fund managers.

But that doesn’t mean they are all cut from the same cloth. Avoiding the above-mentioned 9 red flags may save you time, money, and the opportunity cost of not investing with higher quality fund managers. It’s all about ensuring you have peace of mind while you step toward achieving your long term investment goals.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.