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The regulation free environment of hedge funds is not without risk even with all of the built in methods of harnessing returns. Chasing the popularity of managers would create a mutual fund "cult of personality", much like the one that currently exists in the hedge fund world. Not only would this be bad for the mutual fund industry, but the average investor would need to rationalize their picks with more than numbers. They would find themselves flipping through the pages of People magazine for managers that suit their taste, a thought I can't bear to entertain. I believe that most investors understand the criteria currently in place is there for the protection of both parties.
So I believe in "style purity". Granted, there are far too many funds to choose from, broken down into far too many categories within each group. But these splinter styles tend to burn themselves out after a period of time. Perhaps a loosening of the rules in each of these "general" groups would open the field to broader investment opportunities. Growth should be able to chase growth wherever they see fit. Value could pursue value in companies of any size. This would only solve part of the problem within the industry. The investor can fix the other part. What the investor and the manager may need instead is a new understanding of their mutual obligation in the agreement when they purchase a fund.
Mutual fund investors are attracted by performance numbers. But these are past results footnoted by no guarantees of future returns, compared to indexes that may not apply. Those numbers are shy of what a manager could do if they were presented with the gift of investor conviction.
I have read many letters to mutual fund shareholders written by well meaning managers. I have, over the course of the last three years, penned a few hypothetical one myself. All of these notes to the investors are apologetic at best, critical of the environment they have to work with, at worst. These managers all come just shy of suggesting that the investor should stand pat, sit tight, and let them find a way to beat this market. I think I have an idea that might work, but will never come to pass.
My suggestion would stem the flow of redemptions by investors, one of the prime causes for poor performance in a down market. Many of those redemptions are done by foolish (bought at the top) and skittish (former believers in dollar cost averaging) investors who are selling at the bottom.
In my opinion, when an investor signs a manager to work for him, the two should enter into a two year long contract. This lock-in period would free those contributions from a reserve pool of money that these managers seem to need to keep for redemptions. Cash on the sidelines is doing nothing for the fund but slowing down the possibility of better returns.
After the first year expired, the investor would renew his contract with the manager with the knowledge that his originally invested principle, secured by his shares, could be borrowed against if needed. This would give the manager the option of selling those shares or holding them in equities.
Once the second year expired, the investor would pay back the principle with interest, renew the account or simply part ways. This gives the manager two years of investor commitment. The ownership would lower turnover within the fund, allow the fund to be fully invested, cut back on trade commissions and lower the cost of taxes, all of which hurt the overall performance.
When the manager and the investor part ways, the manager should be allowed to do one of two things. They should be allowed to borrow against the shares held to pay the investor or simply sell those shares to refund their money. If the manager feels confident in his abilities, seeking returns without worrying about who is looking over their shoulder, or worse, about to bail on his next best idea, they would be free to chase opportunities that would take longer to unfold.
The incentive for the manager will be determined by performance and by the exodus of investors. With the pesky problem of redemptions removed, and the opportunity to earn interest from borrowed funds, style purity would narrow the field of available funds to include those that are the best now, not the best then.
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