In this blog post, we’ll look at the structural reasons why banks recommend funds with fees that outweigh their returns, highlighting examples of fund risks, hidden costs, and pitfalls of return claims, and outline the criteria investors should look for.
Funds are investments, not savings
The first “fund” in Korea dates back to May 1970, when the Korea Investment Development Corporation launched the KRW100 million Stable Growth Securities Investment Trust No. 1. Funds continued to be launched afterward, but it wasn’t until the “By Korea Fund” was launched in March 1999 that the “fund craze” really took off. The fund was heavily advertised and became so popular that it raised 12 trillion won in four months. It was even said that the fund was the best investment method of this century.
However, the “good times” didn’t last long for the domestic fund market. In 2000, the venture craze began to die down, and By Korea’s fund returns plummeted to -70%. The fund market waned in popularity after that, but in 2004, the ‘fund craze’ began again with the introduction of ‘accumulative funds’. While previous funds invested a certain amount of money in a fund at once, accumulative funds invest a certain amount of money continuously at a certain period of time, like a regular savings account. It was possible to invest even if you didn’t have a lot of money, and the risk was low because you didn’t invest a lot of money at once. Even college students were investing in funds, so you can see how popular they were at the time. But it didn’t last long, and the subprime mortgage crisis in the US in October 2007 exacerbated the situation.
While the banker may have explained to you that it’s a fund with good returns, the reality is that not only did you get very little money back, but you often lost your principal. So why is this happening, and what is a fund anyway? First, let’s break down what a fund is.
A fund is a financial instrument that pools money from a group of people, invests it in bonds or stocks, and then shares the profits.
When I buy a fund, the money of people who bought the same product as me is pooled together and sent to a ‘custodian’, which holds the money and decides on investments in consultation with the fund manager at the asset management company. The custodian company then invests the money in stocks, etc. and if it makes a profit, they share the profits in proportion to their investment. But it’s important to be clear at this stage that funds are investments, not savings. The word “investment” means that you can lose all your money.
As an investment, funds also carry risk. Funds are divided into equity, fixed-income, and commingled types depending on what they invest in. Of these, equity funds are categorized as “high-risk” because they have the potential for high returns, but also high risk. The general rule of investing applies here. Higher returns mean higher risk, and lower returns mean lower risk. But is there such a thing as a “high return, low risk product”? Here’s what one famous lawyer had to say
“When I see financial advertisements, I sometimes get tempted and think, ‘Oh, I’ll invest in that,’ but then I start thinking about the risk, and I usually end up not investing. High return and low risk are completely opposite concepts, so if there was such a product, I would be the first to invest in it. As far as I know, there is no such product.”
When choosing a fund, it’s very important to keep in mind that return and risk are directly proportional, and to choose a product that suits your goals and style. If it doesn’t, you’re doomed to lose money. Even the most knowledgeable bankers have invested in funds and lost money. As one well-known lawyer explains
“In many cases, foreign financial institutions sell products to Korean financial institutions that utilize financial engineering called advanced financial techniques, and Korean financial institutions sell them to their customers without knowing what they are.”
The end result is a laughable situation where neither the person recommending the investment nor the person receiving the recommendation knows the details.
You can lose your principal and still pay fees
If there’s one thing you should never forget when buying a fund product, it’s the “fees” part. When a group of people buy a fund, the money is pooled, and the fund is managed, it’s not the bank. The bank merely acts as a “seller” to sell the fund to the customer and a “custodian” to hold the money for a while. The actual fund management is done by the asset management company. It seems like so many professionals are working hard to make my money work for me. And you might even feel grateful. But, as you already know, nothing is free.
First of all, banks and brokerage firms earn commissions from selling funds. If they take a commission when you sell, they take it up front, if they take it later, they take it afterward, and if you want to sell it back before 90 days after you bought it, you’ll have to pay 70% of the proceeds as a redemption fee. According to one financial planning director, this is something many people overlook.
“If I pay $100 to invest in a fund, there’s $99 in the fund account,” he says, “and they think, ‘Why am I short a dollar?’ Some people don’t even realize that there’s a dollar shortfall. The dollar shortfall is the money that the bank takes as a commission on the sale. That’s a dollar that’s missing out on a lien fee.”
Not only that, but you also have to pay the custodian and investment management company a fee every time. That’s fine if the fund is doing well and making at least 50% profit. It’s not a big deal if they’re taking a cut of the profits. But the problem is that not making a profit doesn’t mean you don’t get paid, and it doesn’t mean that the custodian and management company will say, “We’re sorry we didn’t make a profit,” and cut your fee. If they don’t make a profit, they have to pay out of the principal.
Mr. Kim Soo-chul (a pseudonym), who invested in overseas funds, suffered a lot from this.
“They calculated the commission as $10,000, $20,000, etc. without explaining it in advance, and when it came time to return the principal and interest, they unilaterally took the company’s own profits first, and if there were no profits, they unilaterally cut it from the client’s principal.”
A common statistic is that a one percentage point increase in sales compensation reduces investor returns by 0.31 percentage points. At first glance, you might think that 1% doesn’t seem like a lot. But if you do the math, assuming you invest $400 per month, it’s a different story. After 30 years, you’ll have paid a whopping $1.46 million more in fees. This leads to the conclusion that even 0.1% is an expense that should be saved.
So what’s a bank’s number one priority when recommending a product to a customer? Obviously, it’s a product with high compensation and fees. In other words, the product is never in the customer’s favor. And it doesn’t end there. Commissions and fees are just the visible costs, there are other invisible costs.
Every time you buy or sell a stock, you pay a fee
This is the “stock trading commission,” or the cost you pay every time you buy or sell a stock. The term “turnover rate” is used to describe how often a stock is traded. Turnover refers to buying shares with your money and then buying them back with your money. A full turnover is called a 100% turnover rate.
If an asset management firm buys all the stocks we raise with $10 billion and then sells them, it has a 100% turnover rate. If they do two turns, it’s 200%. In the U.S., the average is around 100 percent, but even 200 percent is a surprise to the U.S. fund industry. However, in Korea, it is not uncommon for large funds to have turnover rates of 1400% and 1500%. There was even one that was 6200%. The problem is that the client has to pay the trading fee for each turnover. Higher turnover rates naturally mean higher fees, which are passed on to the investor, so it’s important to look at the turnover rate when buying a fund. As one financial planning director says
“When you buy and sell stocks or bonds, there are transaction costs, and a ‘high turnover rate’ means a lot of buying and selling, so there are a lot of costs that investors don’t realize they’re paying.”
How to pick a good fund
So how do you pick a fund? Your goal is to minimize losses and maximize gains. There are a lot of different types of funds, and the names can be confusing. But that doesn’t mean you can just take the seller’s word for it. You need to be able to recognize the fund. Luckily, there’s a certain format for fund names.
The first part of the name, “M Assets,” refers to the asset manager.
In other words, it says “the money in this fund is managed by M Asset”. This is followed by the word “Discovery”. This refers to the investment strategy. Discovery means, “We will identify promising companies and invest in them. Thirdly, “Equity” indicates the type of investment. In this case, it means you want to invest in stocks. The number 4 after it is the series number of the fund, meaning that if it says 1, it’s the first series of the fund, and if it says 2, it’s the second series. The higher the number, the more popular the fund is in its own right. The next series is only allowed when the total amount raised is over 1 trillion won, so if it says 3, it means that the fund has already raised 2 trillion won in the previous series. And the A at the end indicates the fee structure. If it says A, it’s upfront, if it says B, it’s deferred, and C is neither.
It’s a long and complicated list, but when you sign up for a fund, you need to know who invests in it, where it’s invested, how it’s invested, and what the fees are. As one lawyer explains.
“Usually when you go to a financial institution, you’re going to get a brochure for the product, and it’s going to have a lot of favorable things in it, and the law requires them to list the unfavorable things, so it’s just going to be in small print or gray, low-resolution type, so I’m going to tell you to look at those things carefully, and I’m going to tell you that it’s not going to protect you, and I’m going to tell you that it’s not going to protect you, and I’m going to tell you that you should consult with a professional about the prospectus or whatever.”
If you want to invest in a fund and you don’t understand everything, don’t just go ahead and do it, but make sure to check everything and ask the seller, and if you’re still not sure, you should consider consulting an expert.
Along with being careful about the type of fund you choose, another thing to keep in mind is not to be fooled by the returns. Banks will often quote a specific rate of return when selling a fund. You may have seen ads that say things like “3.5 times the market return”, “top 1% of 3-year returns”, or “1032.27% return”. The thing to keep in mind is that any returns you see when you sign up for a fund are “historical data”. No one knows how the fund will perform in the future, or if it will return the same level of returns as in the past. It’s important to keep in mind that banks and asset managers are not responsible if you lose all your money, unlike in the past. “It’s the best fund right now” could mean that it’s already at the top and is likely to fall. Therefore, it’s never a good idea to make a decision based on yield alone. It’s important to remember that high-yielding products are also high-risk products.
It”s also not a good idea to invest in a fund just because it has a good yield. The best way to invest is to diversify your assets between real estate, savings, and funds, taking into account the characteristics of each. As one financial planning director advises
“Too many products can be confusing. If there are three or four types of ramen noodles, it’s easy to choose, but if there are hundreds of them, it’s very difficult to choose the right one for you. The same is true for funds: too many types, and you end up relying on the recommendations of financial advisors. So I think it’s important for financial consumers to get recommendations, but also to develop the discernment to be able to compare different products and pick a good one, especially if you’re looking for a return with some risk, or if you’re looking for a steady return with some risk, and then to have a good mix of different products, whether they’re funds, deposits, bonds, real estate, or whatever, that’s the true diversification.”
