Chapter Two: Three things you should know about the motivation of fund managers

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As you sow, so shall you reap, they say. As you measure, so shall you reap, say the business managers. The fact that the performance pay of fund managers depends on the measure applied, the value of which remains questionable to investors, is a problem evident around the world.

Chapter one emphasised that it is very difficult to find a fund manager with the ability to outsmart the market. It is even more difficult to find a fund manager with the ability to significantly outsmart the market. So much so as to be able to provide investors with a higher-than-market-average yield, even after major expenses incurred in the process.

Nonetheless, let us presume that you get an opportunity to use the services of an investment expert, whose skills and abilities can be considered truly exceptional. Now what?

Let us now consider your objectives. What would you like your expert to do for you? If you are saving up for your pension, you probably want your assets to grow as much as possible until the day you decide to start using the savings. This day could be twenty years or even fifty years away. In all likelihood, it is not any day next year.

1. Standard fund agreements do not motivate fund managers to generate the best yield

Now sign an agreement with the expert – an agreement which would motivate him to strive towards the established objectives. If you are interested in high long-term yield, you should also establish long-term conditions for the agreement. For example, the fund manager should receive performance pay – after every five years (better yet, ten years), the fund manager should receive a portion of the yield generated. This percentage may be quite high – if you are earning well, why shouldn’t the fund manager? For example, a fifth (20%) of the yield generated.

Is your expert willing to sit down and discuss your contractual terms and conditions?

With pension funds and most investment services offered by banks, there are no negotiations. A teller or a staff member referred to as an “investment consultant” simply presents you with a standard agreement. All you can do is give your signature. You cannot even refuse: the second pillar is mandatory.

Swedbank stated in its last year’s newsletter addressed to pension fund customers that Swedbank has taken less than a half of the yield generated by the customers. Naturally, the yield was below market average. Therein lies the problem – the bank would have charged as much in commission fees if the customers’ yield had been negative.

2. Commission fees charged by pension fund management companies depend on asset volumes rather than yield

Why shouldn’t the commission fees of management companies and fund managers depend on how well they perform their duties? Because bank’s have ulterior motives.

The quality of life allowed by your pension assets in the future will only depend on a single measure – yield on your pension fund assets over your lifetime.

The profit to be earned by the owners of Estonian pension fund management companies also depends on a single measure – the fund asset volume.

Second-pillar pension fund asset volume is mainly enhanced by the number of people transferring their mandatory pension payments into the fund.

This is the reason for the horde of pension fund sales agents in our shopping centres, using their charisma and tireless consistency to talk you into changing the fund. Indeed, a bulk of the fee paid to the management company is spent on active sales work. Over a half of the yield of Estonian pension fund management companies is spent on sales and marketing expenses.

Unfortunately, the fund yield does not follow the growth in asset volumes.

I dare to claim that the remuneration of Estonian pension fund managers does not currently depend on whether or not the funds under their management generate a better yield for the customer. Neither is the remuneration of any fund manager dependent on the size of your pension assets in 20, 30 or 40 years. Can any currently operating pension fund manager refute these claims?

3. Pension fund managers avoid short-term fluctuations, sacrificing long-term yield

Obviously, advertising costs money and sales people want remuneration. You have purchased an investment service but are also paying for marketing services. Furthermore, you are also paying for a service you never needed. This service is called short-term management of risks.

Saving up for a pension is simple. Once a month, a fixed amount of money is transferred to your pension fund account. In return, you receive new fund units. When the market is overheated and the prices go up, you will get less units for the same amount of money. When the market is down, you will get more units. You should not be worried about short-term fluctuations. When the market is up, your pension account will hold a bigger amount of money, but you will have to purchase new units at a higher price, and vice versa.

You thus have no need for a fund manager who avoids major short-term fluctuations of fund units. This is only useful for the management company itself. Why?

As mentioned above, the management company’s income depends, above all, on the success of fund sales. It is very difficult to sell a fund, which showed a negative yield last year, in shopping centres and bank offices. A bank teller may conceal a short-term loss but competitors will surely take advantage of it.

I have no doubt that a good fund manager is able to explain their customers why the customer should not worry about short-term fluctuations. Over a long dinner, the fund manager would surely be able to convince people to invest in the fund, even if the fund has been in the red for two years in a row. These people, who have been ordered by the banks to sell pension funds, are not good fund managers however. They sell energy packages or credit cards on one day, and pension funds on another. They are good people, but cannot possibly be proficient in everything.

Nonetheless, at the end of the day, a fund manager’s remuneration depends on how well these people are able to sell the fund. Therefore, fund managers create a product which is seldom in the red and the results of which differ from those of the competitors as little as possible.

Thus, when a representative of a pension fund claims in the media that the fund offers “quality” in addition to costs and yield, the quality mainly consists of services required only by the management company: marketing and short-term risk management.

How to best invest the pension assets?

It is a problem evident not only in Estonia: the conflict between the interests of investors saving up for their pension and the motivation of fund managers is a problem all around the world. It is one of the reasons why index funds are gaining popularity.

As mentioned in Chapter One, Warren Buffet advises its heirs to invest their assets in index funds. David Swensen, the long-term, highly successful head of Yale University, is also on the opinion that an index fund is likely to be the best option. “Unless the investor has access to extremely qualified professionals, they should be investing 100% passively,“ he explains. “This is true for almost all private investors and most institutional investors.”

If you aim at market-average yield, the market should be your expert and the index fund your best option. The rules framework makes the management of index funds more profitable and a lot cheaper. The cheaper the better, remember?

So once again, we have reached full circle and are talking about index funds. But my actual goal is not to sell you an index fund. As one of the founders of Tuleva, my goal is to go beyond.

We aim at creating a management company where the interests of the owners would not contradict those of the investors, i.e. people saving up for their pension. This is an entirely new concept in Estonia. Are we sure that the experiment will be successful? I believe we have fulfilled one of the most important prerequisites for a successful future: Tuleva’s owners are the people themselves.

However, I also know that success depends on whether current and future members of Tuleva are able to establish, for the staff of the management company, measures that help to ensure the best long-term yield for themselves. This is the reason why I am writing this article series.

In Chapter Three, I will discuss why the net asset value of the pension fund unit does not reflect the actual state of your assets, I will also help you measure the actual yield of your pension assets.

In Chapter Four, I will explain why attempts to avoid short-term fluctuations may prove harmful in the long run.

It only takes a few minutes to transfer your pension to Tuleva. You do not have to be a member of Tuleva to transfer your pension, and changing funds doesn’t cost anything, you will be saving money on management fees instead! We have prepared a guide to help you out here:

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