“Advertising is a valuable economic factor because is the cheapest way of selling goods, especially if the goods are worthless.” - Sinclair Lewis.
The Financial Times briefly meandered into relevance last week (‘UK funds split over disclosing how much ‘skin in the game’ they have’, Joshua Oliver, 11th October) by stirring up debate over whether asset managers should be required to report how much personal capital they maintain in the funds they manage on behalf of their clients:
“A transparency push by Interactive Investor has divided some of the UK’s largest retail fund houses over whether portfolio managers should have to disclose personal stakes in the funds they manage.
“The UK’s second-largest investment platform is pushing the country’s funds industry to match US standards on transparency around so-called “skin in the game”. It is challenging operators of funds on its “best buy” lists to reveal how much money fund managers have invested in their own funds.
“The campaign has split some of the leading firms in UK fund management over whether these disclosures aid good governance and help retail investors to make better fund choices..
“But several major UK funds houses decline to hand over the information to Interactive Investor, and some argue that excessive focus on “skin in the game” can lead retail fund buyers astray..”
Ninety-four per cent of fund managers on Interactive Investors’ best buy lists said that they put their own money into their strategies. But more than half of managers, including funds run by Baillie Gifford, Fidelity International and abrdn [formerly Aberdeen Asset Management before its marketing department committed corporate hara-kiri], refused to reveal the size of managers’ holdings..First, an uncomfortable truth. The main commercial driver of fund management organisations is to generate fee income. Under conventional ad valorem fee structures the more assets fund managers manage, the more they earn. Awkwardly for the industry, a growing library of evidence suggests that the larger fund managers become, the less likelihood they have of delivering superior investment returns. Above a certain level of assets, size is likely to correlate inversely with performance. This is unfortunate for the retail investors who are most easily won over by the power and marketing heft of well-funded brands.
Louis Lowenstein’s book The Investor’s Dilemma serves to remind us of the dangers of size: “There is a profound conflict of interest built into the industry’s structure, one that grows out of the fact that (mutual fund) management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance.”
As Bloomberg’s Chet Currier has observed, asset bloat, as investor capital comes tumbling in on the back of a manager’s hot track record, has a tendency to make superior performance mean-reverting. Fund researchers Morningstar point out that: “The worst effect of the asset bloat phenomenon is simple. The more money a fund has in it, the less nimble it becomes. If a fund’s asset base increases too much, its character necessarily changes.”
Which is something Fidelity have experienced before, in the form of the Magellan Fund, one of the world’s highest-profile actively-managed funds. When storied manager Peter Lynch left Magellan in May 1990 after 13 years with the group, the fund had grown to $13 billion in assets. By the time Morris Smith left in July 1992, the fund was up to $20 billion. On Jeffrey Vinik’s departure in June 1996, assets were up to $50 billion. By the end of the century, Magellan assets had grown to over $100 billion (the fund was closed to new investors in September 1997 and peaked at almost $110 billion in August 2000), only to see them fall back to $52 billion on manager Robert Stansky’s departure in 2005, through a combination of investment losses and investor outflows. Stansky is even believed to have helped coin the phrase closet indexer.
The journalist Dan Gross has pointed out the downside of managing vast pools of capital – which is essentially the law of large numbers that others, including Warren Buffett, have highlighted. Once you get beyond a certain size, any individual investment is just too small to move the needle of the aggregate portfolio. It’s also difficult to trade nimbly, and the manager is inevitably constrained to mega-cap stocks. Gross cites the success of Capital Group’s Growth Fund of America, the assets of which have more than quadrupled over the past decade, from $36 billion in 2002 to over $130 billion today. One thing Capital Group does differently, however, is exercise managerial control: Growth Fund’s assets are divided up among a number of individual managers, each with a separate analyst team, and with a broader investment universe from which to populate portfolios.
For their part, hedge funds seem to have largely reconciled the fees versus asset size quandary (commonly known as greed) by boosting the former but tightly controlling the latter. As Gross says, “they know that to try aggressively to manage $10 billion or $20 billion is to tempt the market gods”.
A second impediment to lasting success is that most fund managers fail to beat their benchmark. Investors who are content to receive the returns of an established market benchmark – the FTSE 100 or the S&P 500 for example – would be better off owning low-cost index-tracking funds instead. Worse still, most investment benchmarks are irrelevant for the investors they are supposed to serve – or actively injurious to their interests.
And the worst impediment of all is that professional fund managers and financial institutions have grown to the point that they have become the market. This is what is referred to as the principal-agent problem.
In a piece of research that questions the City’s sustainability, Legg Mason’s Michael Mauboussin asks a simple-sounding question: whether financial institutions matter to asset pricing. In traditional economics they don’t, which is just one more reason why traditional economics is a waste of time. Franklin Allen, we are told, gave a presidential address to the American Finance Association in 2001 in which he identified a strange dichotomy. In corporate finance, agency theory – and the role of economic agents – has been extensively explored over a period of 75 years. In asset pricing theory, however, agents are almost completely absent. As in traditional economics, the role of institutions within the financial markets has been assumed away to make the equations easier. As Mauboussin points out:
“Several market observers, including Jack Bogle [founder of the Vanguard Group], Charley Ellis [founder of Greenwich Associates], and David Swensen [Chief Investment Officer of the Yale University Endowment] have been vocal in pointing out that the agents – professional money managers – have incentives to behaviour that is not in the interest of investors.”
Mauboussin asks why financial institutions and related agency costs have played so little role in asset pricing theory. One answer, he reveals, is that for a long time there was no principal-agent problem:
“As recently as 1980, individuals owned almost three-quarters of all stocks. Only recently have principals delegated a majority of assets to agents – financial institutions such as pension funds and mutual funds – but principals dominated agents as asset pricing theory developed in the 1950s and 1960s. For instance, in 1950 individuals directly controlled over 90% of corporate equities. Agency theory wasn’t in the models because agents weren’t in the picture.”
Agency theory matters because agents control the market. They control the market in absolute monetary terms, but also in marketing, research and newsflow. They control the chatter about the marketplace too, although it would be nice to believe that the rise and reach of the blogosphere is helping to restore the balance back towards some semblance of independence. “And, not surprisingly, agents have very different incentives than principals do. And this game is close to zero sum: the more the agents extract, the lower the returns for the principals.” When he says principals, he means you, the end investor.
Agency risk is the risk that you, the end investor, may not be well served by an economic agent – your fund manager, for example – who has little or no personal skin in the game. An economic agent isn’t focused on outperforming, just on keeping his job. Faced with the career risk that comes with straying far from the herd peer group, an economic agent will prefer to sit right in the middle of that herd instead. Those in the middle of the herd rarely get fired for generating a herd-like return.
One response to agency risk is to adopt exclusively passive investment products, such as exchange traded funds (ETFs). But this doesn’t solve the agency risk problem entirely: economic agents also administer those funds. Giving them money in a passive form enables them to control the market further.
And it still leaves the problem for the private investor of asset allocation – deciding how to allocate your assets between stocks, bonds, property, cash and anything else. Unless one slavishly follows a rigid rebalancing approach across multiple asset classes that permits no variation or subjective assessment of value, the informed investor still needs to take active asset allocation decisions. These decisions are extraordinarily difficult in an environment of explicit financial repression, declining or negative interest rates, and the artificial manipulation of prices in stock and bond markets.
You may never have heard of Edward G. Leffler. But in the words of the Wall Street Journal columnist Jason Zweig, Leffler is “the most important person in mutual fund history”. Leffler’s claim to fame is that he invented the open-ended fund. He originally sold pots and pans, but he was not slow to appreciate that selling investments might be more lucrative. In March 1924, he helped launch Massachusetts Investors Trust, the first open-ended fund. Its charter stipulated that “investors could present their shares and receive liquidating values at any time.”
Its impact was similar to that of Henry Ford’s development of the assembly line. It turned asset management into an industrial process. Whereas closed-ended funds – in the UK we call them investment trusts – contained a fixed amount of capital, open-ended funds had the potential for unlimited growth. As Zweig fairly observes, like any human innovation, the open-ended fund could be used for good, or ill. At a stroke, the invention of the open-ended fund created a schism in the asset management industry. Institutional investors would thereafter have to make a choice. They could be asset managers, or they could be asset gatherers. But they could not be both.
Zweig describes the split as one between an investment firm and a marketing firm. The difference?
Ultimately all fund managers must make a choice. As Zweig puts it:
“You can be mostly a marketing firm, or you can be mostly an investment firm. But you cannot serve both masters at the same time. Whatever you give to the one priority, you must take away from the other.
“The fund industry is a fiduciary business; I recognize that that’s a two-part term. Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits. And that’s as it should be. In the long run, however, you cannot survive as a business unless you are a fiduciary emphatically first.”
There’s a fairly easy way to tell if a firm is a marketing firm or an investment firm, an asset gatherer or an asset manager. Do you see its advertising on buses, cabs and posters? Do they have a practically limitless range of funds, which can be bought from practically anywhere? This is not to denigrate marketing firms entirely. (Well, it is.) But it may be worthwhile to consider the motives of the people charged with managing your capital. Are they asset managers, or asset gatherers? The answer will have some relevance for the sanctity and stability of your portfolio, and for your own peace of mind.
Speaking of peace of mind, for the avoidance of doubt, the two principals of Price Value Partners own exactly the same investments as our clients do. As for this correspondent, his holding in the VT Price Value Portfolio – the only collective fund we manage – is the largest personal investment he has. We may not always get our investments right, but nobody can accuse us of having any meaningful conflicts of interest, or of putting our own interests before those of our clients. How many of our competitors can say the same ?
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: email@example.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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