If you have a financial advisor or a portfolio manager or if you have assets in a mutual fund you are entrusting your funds to a professional for management. You are expecting the advisor to make “good” returns and the advisor is expecting a fee for the services provided.
At the outset, let’s get one thing clear – it is almost impossible to generate superior returns without taking greater risk. It would otherwise be called “collecting” as opposed to “investing”
Three things you need to know when you are investing with help of a financial advisor:
- Your opportunity cost: This is your best investment opportunity that you are comfortable with and the rate of return it generates. For many it is the long term rate of return in a bank, for some it is the index return. You would want your fund manager to generate a return greater than your opportunity cost after taking into account the fund management fee. There is no point in paying the piper if he generates less than your opportunity cost.
- To expect greater returns for greater risk – Different products have different levels of risk and one should expect commensurate returns to compensate for the risk. On an average
- With large cap stocks you can expect to gain or lose about 11% to 13% in a year
- With mid cap stocks you can expect to gain or lose about 10% to 16% in a year
- With small cap stocks you can expect to gain or lose about 8% to 24% in a year
If your fund manager is investing in small caps and generating about 10% return, then you may be better off investing in large or mid cap stocks. But if the return is over 16% then it should be fine. It is not prudent to take higher risk if there is not much opportunity for a higher reward.
*Pl note these are broad thumb rules (hence simplifications) that are valid in an average Indian market.
- Have a clear idea of the level of risk you are comfortable with. Knowing oneself is important for making investment decisions. Taking risks higher than what you are comfortable with might lead to a loss that is not acceptable to you or create anxiety that may lead to sub-optimal decision making in the time of stress. For instance, if you are a person who is comfortable with blue chip companies please ensure that your fund manager does not have too much of your portfolio invested in small cap stocks. If the market moves in an adverse direction you could lose over 20%.This may not be acceptable to you and this portfolio could have intraday fluctuations that may cause anxiety.
Most of us can understand and evaluate the rate of return, but find assessing the risk to be bit difficult. A good grasp of both these is key to get into a win-win agreement with your fund manager. We hope this article helps. You can always write to us in confidence and we will be happy to assist.
Paying the piper: In general the fee for fund managers is 2-20, 2% of the assets under management and 20% of the profits. We believe this does not align the interests of the manager with that of the investor, as the piper gets paid 2% of the assets irrespective of the performance. You can read about impact of fees on returns in our earlier article.
We believe that the right way to pay the piper is not to pay anything (or a very small amount) upfront and pay only for beating your benchmark. Your benchmark should be the higher of your opportunity cost and the expected rate of return for assets selected by the fund manager. Of course, the higher your benchmark you should reasonably expect the manager to charge a higher percentage of the above benchmark returns as fees.