Wednesday, June 5th, 2013
useless extraction

An article by Justin Fox appeared on the Harvard Business Review website in May.  It was titled, “Just How Useless is the Asset-Management Industry?”Harvard Business Review | It includes some interesting introductory history.  (Question:  Why was Jack Bogle writing pseudonymously?)  Some months before, I had read a report by a hedge fund allocator who wrote that, as part of their compensation, managers “will extract” a portion of a fund’s profits for themselves.  The imagery stuck with me.

To many observers, the investment industry of today is like a giant extraction machine.  The incredible growth in the industry during the last forty years has resulted in a billionaire’s club made up of the owners of asset management firms, hedge funds, pension consulting organizations, and the like — and tens of thousands of others in the business have gotten plenty rich from the mother load of fees.

That wouldn’t rankle those paying the fees if they felt like the industry had delivered on its promises and helped them meet their goals.  But a spate of recent articles — and the Frontline documentary about people losing “The Retirement Gamble”PBS | The program is available online. — have hammered home two consistent points.

First, active management is a crap shoot for asset owners, a “loser’s game” as Charles Ellis proclaimed in 1975.  An investment manager might do well for a while, but it’s unlikely that the performance will persist and near impossible to call the winners in advance.  Plus, cheap and easy index funds beat the vast majority of active managers over time (despite the hilarious assertion by the head of retirement at Prudential in the Frontline documentary that she wasn’t aware of that fact).

Second, those active managers and the intermediaries who deliver their products to clients charge high and, in some cases, hard-to-understand fees.  Over time, those fees turn into the pot of gold at the end of the rainbow that asset owners thought would be theirs.

In short, useless extraction.

Quite an indictment.  As an investment professional, I have to say that the complaints are mostly justified, although putting that in writing could cost me some business.  That’s OK; I’m interested in making the industry better, not in protecting the status quo.

So, I applaud the CFA Institute’s “Future of Finance” initiative, described as “a long-term global effort to shape a trustworthy, forward-thinking financial industry that better serves society.”CFA Institute | This portal includes a variety of resources related to the project.  In the “Statement of Investor Rights” that is part of the initiative, the third point reads, “I have the right to . . . my financial interests taking precedence over those of the professional and the organization.”CFA Institute | Note that each of the items is a link.  Clicking on them will give you more detail.  But an honest assessment of the business models of many firms would reveal that they fall short of that standard.  Therefore, the Institute needs to not only rally its members in support of reform but to take the message to the investment firms that can make change happen.

Speaking of those firms, in spite of the hand-wringing about active management, there are some that step apart from the crowd enough to improve the odds that an investor will receive real alpha, delivered over a long period of time.  That can only come from doing things differently than others, but money management has become a me-too game where standing apart is risky and sticking with everyone else can be very lucrative.

In order to do right by investors, at times firms need to incur the business risk that comes from ignoring the idiotic short-term performance derbies that are allowed to define excellence in the industry.  And maybe, just maybe, the time has come for firms with visionary leaders to address the fee issue as well.  It would be nice to see some innovation in fee structures, but I’d settle for firms lowering fees as a sign of strength rather than weakness (the old, “They’re not good enough to charge the highest fees.”).  Think of this powerful combination:  A quality firm with differentiated methods that manages for the long-term benefit of its clients and doesn’t charge too much to do so.  Sounds like a winner to me — the assets would roll in.

If that doesn’t happen, maybe asset owners will just get smart and reject what the industry has been offering.  On the retail side, that would mean a continuation of the flows toward passive management (although without the expensive overlays that are starting to pervert it).  Of more long-lasting consequence is the accelerating trend among some institutional investors, in which asset owners are bringing the money management function in-house and collaborating with each other in new ways, cutting out the middlemen in the process.  They have the size and power to alter the industry in profound ways, and are compelled to do so because the managers of assets have lost touch with the needs of the owners of assets.  (If you have an interest in these developments, I highly recommend the work of Ashby Monk.Institutional Investor | The most effective way to follow Monk is by signing up for his daily “Avenue of Giants” email.)

I am an interested party.  This involves the industry in which I work and the profession that I have chosen.  I want them to be better.  And I want them to be known for something other than useless extraction.