(October 29, 2008) Everyone Wants Kool Aid: Pruning the Money Management Tree |
October 29, 2008
(This article by Edward Siedle is included as a chapter in "Investment Management: Meeting the Noble Challenges of Funding Pensions, Deficits and Growth, Edited by Wayne Wagner and Ralph Rieves, published by John Wiley & Sons in 2009.)
Some Make the Kool Aid; Some Sell the Kool Aid; Some Drink the Kool Aid. Everyone Wants Kool Aid.What's in the Kool Aid? It is the hope, myth, or dream that there are money managers out there who can outperform the market year after year, never giving back their superior results or reverting to the mean. The truth is few, if any, such managers exist. It is that simple. However, as long as everyone wants to believe it can be done, selling the dream will be a lucrative business. The Kool Aid will continue to briskly sell.
The money management profession is one of the few in the world where virtually everyone involved fails to deliver the service that is being sold. Almost all money managers do not perform up to the benchmark standards they have established for themselves. Only Las Vega gambling casinos enjoy the same customer loyalty. In Vegas too there are few winners but the players keep coming back hoping to beat the odds. Are most investors are, in reality, gamblers?
Perhaps its human nature to be competitive and seek performance that's better than the next guy's or entrance into an exclusive investment club, such as a hedge fund. Some might call it greed. Whatever the reason, it is clear that the allure of outperformance is strong.
The High Cost of Dreaming
Here's a paradox: Investors willingly pay dearly to chase the improbable dream of getting rich riding on the coattails of a super-talented money manager who can beat the market. On the other hand, investors are reluctant to pay very little for the certainty that they can receive a market rate of return, nothing more and nothing less.
These marketplace realities are not lost on the money management industry. The industry knows the easy big money is to be made selling the dream. The prospect of earning small fees marketing a reality-based product that is difficult to sell to investors is far less attractive.
Perhaps it takes a far more mature, disciplined mind to accept that dreams of beating the market or getting rich quick almost always end in disappointment. Perhaps it takes a far more ethical mindset on the part of money management firms to decline to offer financial products that will result in vast assets under management and high fees (but poorer performance), in favor of less assets and fees but improved investor returns.
"You get what you may for," it is often said.
It is indisputable that frequently, even generally, paying more does get you more. But there are many notable exceptions to this bit of conventional wisdom. It may be counterintuitive but sometimes paying less nets the same result and sometimes paying less gets you more. For example, costly Rolls Royce automobiles and Rolex watches do not outperform lower-priced Toyotas or Seikos. Paying less gets you more in these instances.
For most investors, perhaps the single most important decision they face is who to trust to manage their hard-earned savings. Therefore, investors need to know whether paying more will increase the likelihood of superior performance. The answer to this question is well-documented. The highest cost investment products, such as hedge funds, are far less likely to consistently produce net returns at or above the market; the lowest cost funds, i.e., index funds, can virtually guarantee a market rate of return.
Selling the Dream
Central to the money management business is convincing clients that they will beat the odds despite the fact that decades of data show it is virtually impossible to consistently do so. This means that people in the profession have learned to live with an element of fraud or deceit. Every manager knows in his heart of hearts that it is highly unlikely or indeed impossible that the client will receive the performance he or she is led to believe is possible. Of course few money managers promise superior results. That will get them sued. Indeed every discussion of past performance is likely to be accompanied with the warning, consistent with SEC requirements, that "past performance is not indicative of future results." But the profession knows that in investors' minds past performance, at a minimum, suggests future results.
Even regulators, such as the Securities Exchange Commission, know investors are routinely misled by past performance figures. It is well known to them that investors chase past returns. Regulators allow the game of advertising past performance with cautionary footnotes to go on, as well as other marketing schemes, despite the countless lives that are ruined annually, because they perceive their mandate to involve a balancing of the interests of the financial institutions against those of investors. Make no mistake about it: regulators are not solely focused upon investor protection. They have equal or even greater concern for, what is benignly referred to as "financial innovation." The money management industry desperately wants to retain the power to market to the public any financial product, however improbable. The industry will agree to limitations that appear to reduce the likelihood that investors will be cheated, such as disclosure in footnotes, as long as marketing effort is unimpeded. After all, investor confidence in the system is required to sustain it. As a result of the tremendous influence the money management industry has over regulators, doomed financial products and unsavory sales practices persist. Again, these products and practices persist, not because the regulators are unaware of them but because they have allowed them to.
Successful money managers learn to sell the dream within the limits of the law. That is, while the investor does not receive what he was led to expect (which, by the way, the manager knew the investor would not), the manager can defend himself by showing he didn't really promise the superior results. The fault generally lies with the investor's expectations, not the manager according to the industry. However, to come full circle, the industry creates and markets products designed to appeal to investor desires, rational and irrational.
Whether the law is complied with or not, honest investment management professionals must admit that all-too-often the investor gets hoodwinked. The investor, with less financial sophistication, is sold a faulted product by a money management insider with greater financial sophistication.
When Dreams Fail To Materialize
Since most financial products do not provide the investor with the sought-after return within the time allotted, successful money management firms must be extremely adept at providing satisfactory explanations for unsatisfactory results. That is, the investor must either be convinced that the performance he has already received is adequate or that if he stays invested his dream of better performance may still materialize sometime in the future. Managers must become skilled at employing whatever devices circumstances require to retain assets under management, in spite of performance.
While in law school in Boston, I worked as a summer intern in the Boston Regional Office of the Securities and Exchange Commission. This regional Office, due to the tremendous number of money managers located in the Boston area, had great expertise in inspections and investigations of money managers. My first week of the internship I was allowed to sit in on a deposition of a prominent money manager who had invested (and lost) a substantial portion of a local college's endowment in a speculative oil and gas deal. He and his white shoe legal counsel argued that in an era of high inflation (1980s), an oil and gas investment which had a projected return of 20% was, in fact, conservative because the return would only keep pace with inflation. The deposition was such a polite, fascinating exchange of investment philosophy that I had to keep reminding myself that the college had been screwed. I found myself wanting to believe the investment adviser. So intoxicating was the rarified air of the money management profession to a new-comer.
When a money manager fails to perform up to the benchmark he has established for himself, the manager might (1) simply acknowledge his poor performance or (2) change the benchmark to one that will make his performance appear better. If performance falters in the short term, managers will likely acknowledge the problem and offer a plausible explanation. For example, "Value investing is out-of favor." If performance continues to be poor, soon the manager will begin the desperate search for a benchmark against which his performance looks good. Investors may endure short-term underperformance but, if the manager can't improve his performance within an acceptable period of time, he must either make bad or mediocre performance look competitive or lose the assets. A scheme for making bad look as if it were good is called for. Changing the benchmark is only one of the many devices available to managers to improve the appearance of performance and, not surprisingly, money manager performance reporting violations are the most commonplace of all violations.
Today, with the proliferation of hedge funds, an alternative course exists when performance falters: simply close up shop and start another firm. Hedge fund "fulcrum" performance fees require poor performing managers to endure lean fee years before hefty performance based fees can once again be enjoyed. That's part of the bargain these managers establish with investors: a sharing of the pain and the gain. But the ethics of this industry apparently do not preclude managers walking away from the disasters they have created. All gain, no pain, seems to be the rule. Hedge fund investors are a very forgiving bunch.
Sometimes managers choose not to go it alone. Managers may enlist others in their battle against bad performance.
A Little Help From Friends
Some managers cultivate distribution channels that involve heavily incentivizing intermediaries, such as stockbrokers, to sell their funds, as their best defense against investor dissatisfaction. The broker, who has a personal relationship with the investor, is most capable of explaining the inevitable disappointment. Ironically, incentivizing sales people to sell financial products by adding substantial additional fees greatly reduces the likelihood the investor will receive superior net performance. Money managers who pursue this business model have given up on delivering performance. They have determined that assets under management are more important than satisfactory results to investors. In other words, the manager's prosperity is more important than his clients. There are some money management firms, particularly variable annuity insurance companies that have pursued this marketing course to a level of absurdity. That is, there are some financial products that are so laden with fees that it is inconceivable (not merely unlikely) that the investor will ever receive an acceptable rate of return. These I refer to as "lethal" financial products.
There was a time when thoughtful money managers considered whether they could deliver competitive returns to investors that entrusted them with hard-earned savings. It was understood throughout the profession that there were limits on firm growth. At some point in time, at some level of assets, every manager acknowledged he no longer would be able to execute his best investment ideas. The thoughtful money manager understood and honored the fiduciary tradition, the standard to which he was held under the law. That is, simply put, to put the clients' interest before your own. The fiduciary tradition required extremely successful managers to turn assets away rather than disappoint. As the number of registered and unregistered money managers has exploded in the last 30 years, the business of money management has lost touch with these ethical principles. There is substantial overcapacity in the industry. There are far too many firms yet finding talented managers with integrity is harder than ever. To bring this (money) tree back to health, a severe pruning will be required.
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