The Mutual Fund Game Is Rigged In The Managers Favour

I have alluded to fees being an antithesis to performance many times over the past few years. Fees are the main reason why index funds outperforms actively managed funds. The following from famed venture capitalist Chris Sacca further cements why fees are an investors worse nightmare and that mutual funds are rigged in the managers favour.

Although the comments below are to do with venture capital but it could as well be applied to mutual funds. Have a read and see whether or not you are still comfortable holding your money in a mutual fund.

Chris Sacca on Fees:

“This is a rigged game, right? And I’m just looking to make it even more rigged. For those who don’t know, venture capital is totally unfair. I mean, people give me their money; I draw a management fee off it, so they pay me to take their money and invest it for them. If I make money, then I pay them back the management fee and then after that we split the profits and I get a really big chunk of the profits.

And if I lose money, that’s fine. It doesn’t come out of my pocket. I keep my fee and my investors lose money. That’s how this industry works. That’s bananas. And at some point, it’s gonna break. It’s just an unforgivably unfair, rigged game that’s in favour of the venture capitalist. You’re cash flow positive from day one when you start a venture fund and your downside is incredibly limited by the structure of the fund.”

Sacca goes on to say that this type of fund structure allows him to take some risks that he likely would be unable to take if the deck wasn’t so stacked in his favour. He states that he can take more binary, all or nothing, bets on certain companies with the hopes of hitting it big, but the possibility of crashing and burning (although this is generally the premise of venture capital investing — many failures and a few home runs).”

What Sacca is talking about here is the power of incentives on people’s actions, something that most people fail to appreciate. It’s obvious that people don’t always act in the most rational manner, but if you’re looking for the main reason why things are the way they are in the world of business you should always start with the incentive structure. This is especially relevant within the finance industry where incentives shape the way nearly every business and individual functions to some extent.

Essentially Sacca is saying that he is incentivised to swing for the fences because he doesn’t participate in any of the downside. Luckily, for him and his investors, this strategy has paid off handsomely for his funds. By his own admission, his current fund is probably the most successful venture capital fund in history from a return standpoint because of the early stage investments mentioned above.

It makes you wonder what’s going to have to happen to see changes in this incentive structure and make it break, as Sacca forecasts. I imagine it will probably involve the downside of swinging for the fences as many of these funds will strike out the further along we get in the cycle.