The Business of Money Management
Before we look at working with traditional and alternative managers in depth, let's take an overall look at some of the challenges active managers face. We'll start by following a new U.S. large-cap management firm to see how it operates.
Hapless Asset Management
The principals of Hapless Asset Management, having worked extensively in the money management industry, understand all too well the dynamics of the business. They know, for example, that attracting new clients—especially private investors—is a difficult, time-consuming, and expensive activity. But they also know that once a client has signed on, the marginal cost of servicing that client's account will be negligible. After all, Hapless will buy and sell pretty much the same stocks for every client, so it can manage $10 billion almost as easily as it can manage $100 million. Sure, clients sometimes want to meet with Hapless too often (from Hapless's perspective), but most clients soon settle into a routine that is highly cost effective for Hapless. After all, clients are busy people, too.
Thus, the main challenge for Hapless is to keep the clients it gets. Those clients provide an annuity income for Hapless, and given the cost of obtaining new clients, Hapless wants to do everything it can to avoid losing accounts. The main way Hapless is likely to lose accounts is for the firm to generate truly dismal performance numbers. If the numbers are really awful, clients will defect after one year of bad performance. If the numbers are merely bad, clients may wait two years to dump Hapless. But dump they will. Hapless, therefore, wants to avoid really bad performance at any cost.
How does Hapless ensure that it will never experience terrible investment performance relative to the benchmark its clients are measuring it by (in this case, the S&P 500)? The answer is surprisingly simple: Hapless will manage its portfolios as closet index funds. Here's how this works. Let's suppose that General Electric represents 3 percent of the S&P 500 index and that Microsoft represents 2 percent (both about right). Let's suppose, further, that Hapless believes that GE's price will rise faster than Microsoft's. We might imagine that Hapless would load up on GE without any Microsoft at all—but that's because we don't understand how money management actually works.
What Hapless actually does is to modestly overweight GE in its portfolio and modestly underweight Microsoft. If we examine Hapless's portfolio, we might find that it consists of a 3.3 percent exposure to GE and a 1.7 percent exposure to Microsoft. Other stocks that appear in the S&P 500 might also be modestly over- or underweighted, and the rest will be held exactly at their index weighting. If Hapless is right about both its over- and underweightings, Hapless will generate a nice-but-modest outperformance versus the S&P 500. If Hapless is right about some weightings but wrong about others (the most likely case), Hapless will generate modest underperformance roughly equal to its fees and costs. If Hapless is more often wrong than right, it will generate negative-but-modest underperformance versus the S&P 500.
In other words, although Hapless may, in an occasional year, outperform its benchmark, in most years Hapless will experience underperformance, but only modest underperformance. Hapless knows that the same clients who would dump it in a second following really bad performance will stick around for years if Hapless can generate occasional outperformance but overall underperformance. In other words, just when the client's patience has nearly been exhausted by several years of underperformance, Hapless will have a good year, and the client will stick around. From the client's point of view, this behavior is perfectly rational. After all, it is expensive to terminate a manager, and there is no guarantee that a new manager will do any better than Hapless.
And consider what Hapless is actually charging in fees. Its stated fee is 1 percent. But remember that Hapless is actively managing only a tiny portion of the capital it's been entrusted with—the rest is indexed.2 Let's say that Hapless's R-squared to the S&P is .96. In other words, 96 percent of Hapless's investment results are determined by the results of the S&P 500. What Hapless is really doing is charging a 1 percent fee to manage 5 percent of our capital. But it's charging on all our capital. Thus, the sad reality is that Hapless is charging 20 percent per annum to manage our money. And people say hedge funds are expensive!
The net result of all this is that Hapless will build a growing and highly profitable money management business even though it is a fairly poor money manager, and even though it is imposing significant opportunity costs on its clients. In other words, if Hapless's clients had simply earned the return on the S&P 500 index, they would be wealthier. If those clients had been with a best-in-class manager, they would be a lot wealthier.
What is going on at Hapless, and what goes on at most long-only money management firms, is the creation of what is known as portfolio deadweight: Most of Hapless's portfolio looks suspiciously like the S&P 500 index. Hapless is making only modest bets on the stocks it likes and against the stocks it doesn't like. Hapless lacks the courage of its convictions because it can't afford, from a business point of view, to be wildly wrong in any year (and, God help it, in any two consecutive years). Therefore, no matter how confident Hapless may be that Microsoft is going up and GE is going down, Hapless will back that confidence with only modest over- and underweightings in those securities.
I've gone into some length on the subject of hapless Hapless Asset Management because many clients—and, let's face it, some advisors—aren't all that familiar with exactly how it is that money managers work and the various tricks they play.
In many firms, all the manager diligence is done by a special team of analysts who hardly ever interface with the client advisor team. But it's very important for advisors to understand in some detail how good—and, especially, bad—money managers go about their business.
If you work in a firm where client advisors don't work directly with managers, you'll need to spend some serious time on your own getting to know the asset management business. Otherwise, you'll be in the position of regurgitating whatever the manager diligence team passes on to you, rather than exercising the kind of skepticism that your client is expecting of you.
Survivorship Bias
Virtually every study of active management in the U.S. large-cap space shows that 70 percent to 75 percent of all managers will underperform the S&P 500 index over longer periods of time. But the truth is that the dismal performance of active management is actually far worse than it appears. If we were to conduct a study today of 1,000 randomly selected managers, we would, indeed, discover that roughly 75 percent of them have underperformed the S&P 500 over the past 20 years. But our study would have missed many managers, most of which had truly dismal records. We would miss them because they are no longer in business, having been liquidated or absorbed into other management firms that dropped their losing track records. But while those managers were in business they managed billions of dollars of client money, and managed it badly. They are part of the miserable track record of active management, whether their contribution can be measured or not. Thus, the challenge of finding managers who will outperform is even worse than it appears.
Survivorship bias shows up in another way as well. Investors often proudly show me that their portfolios are employing only, or mainly, managers who show long-term outperformance. Indeed, a snapshot of many family portfolios will show such a phenomenon. But if we viewed not the snapshot version of the portfolio, but the full-length movie version, we would see a very different story; namely, manager after manager who is hired after a few good years of performance but who then underperforms, is fired, and thus disappears from the current snapshot. But those managers held those investors' money, and the underperformance they generated has had a permanent negative effect on the investors' wealth.
Fees and Costs
Active managers, especially in the large- and mid-cap sector, but elsewhere as well, are working against a powerful headwind of fees and expenses. Managers charge fees that are stunningly high considering the little value they add to—and more often subtract from—investment portfolios. Most manager fee schedules start at 1 percent, then decline as the size of the account increases. But even very large family accounts are often charged 50 to 75 basis points. (There are 100 basis points in 1%.) According to Morningstar, the average U.S. large-cap mutual fund has an expense ratio (management fees plus 12b-1 fees) of about 150 basis points (1.5%).
But to these costs we must add on the round-trip costs of brokerage commissions (roughly 10–11 cents per share for large managers), the spread between bid and ask prices (slightly higher), the cost of market impact (roughly 25 cents) and opportunity costs (10–12 cents). Given that the average share price of a U.S. large-cap stock is about $27 (mid-2003), this means that, in addition to the manager's fee, we must add more than 2 percent for trading costs. In other words, merely to match the performance of the index, a manager must outperform it by roughly 3 percent per year—a truly Herculean achievement.
As noted, virtually all long-only managers charge asset-based fees. The idea behind this approach—which would be odd, indeed, in most other industries—is that the manager is adding more value in absolute terms to larger accounts than it is adding to smaller accounts. If Hapless Asset Management outperforms the S&P 500 index by 1 percent in any year, it has added $1 million to a $100 million account, but only $10,000 to a $1 million account.
But there are several problems with this justification. The first problem is that the asset-based fee has nothing to do with the actual cost of managing money. It doesn't cost Hapless Asset Management 100 times as much to service its big client as it does to service its small client, even though the big client is 100 times larger. Sure, sensible businesses don't typically price their services on a cost-plus basis, but competition in most industries eventually drives prices down quite close to cost, so that only the most efficient firms can survive. In the money management industry, however, we are such lousy consumers that this hasn't happened.
But it gets worse. Hapless Asset Management, along with most other money managers, is far more likely to subtract value than to add it. Let's say that Hapless underperforms the S&P 500 by 1 percent—a far more likely scenario. If Hapless charges our hypothetical $100 million client 50 basis points (½ of 1%) and charges our $1 million client 1 percent, Hapless has earned $500,000 on the big client and $10,000 on the small client. But the big client has lost $1 million and the small client has lost $10,000. What sort of alignment of interests is this? As noted above, Hapless Asset Management, along with most other asset management firms, has created a very successful and profitable business by subtracting gigantic amounts of money from client portfolios.
What's to be done? Unfortunately, most family investors are too small to wield the clout that would be required to change pricing practices in the money management business. Even investors that one would think of as being large enough to wield such clout—huge endowed institutions and pension plans—have had little success in forcing through radical changes in pricing. However, it is sometimes possible to negotiate incentive fees with managers who are very confident in their ability to add value to client portfolios. Even here, however, we need to proceed with caution, as poorly designed incentive fees can create counterproductive motivations.
Perhaps the most sensible form of incentive fee for a long-only manager takes the form of a fulcrum fee. In such a fee arrangement, we ask the manager how much outperformance he expects to deliver to our portfolio. Let's say that the manager claims to be able to deliver 80 basis points per annum above the benchmark on average. Let's say, further, that we expect the manager to deliver about 30 basis points above the benchmark. We will then create a fee structure that (a) will give the manager approximately his standard fee if he outperforms by 30 basis points, (b) will give him a much higher fee if he outperforms by 80 basis points, and (c) will give him a fee much lower than his standard fee if he delivers less than 30 basis points of outperformance.
Fulcrum fees should have both caps above them and floors under them. The purpose of the floor—which we set at about the manager's break-even operating cost—is to ensure that the manager pays attention to the account. Even during a period when the manager's style is out of favor and its performance is weak, we don't want the manager to ignore us or to terminate our account. (We want the account to be terminated only when we want it to be terminated.) The purpose of the cap is to eliminate any incentive on the part of the manager to take extravagant risks with our money in an attempt to earn a higher fee.
It's not enough just to be right. Suppose that back in the 1970s Hapless (or, more likely, a predecessor firm, because most money management firms don't survive that long) had had the foresight to anticipate the technology boom of the past 30 years and had loaded up on tech stocks. Hapless would have made a killing, right? Wrong. Hapless would have underperformed the broad market by roughly 130 basis points per year (1.3%). The reason is that lots and lots of investors anticipated a technology boom, and as a result much of the future appreciation in that sector had already been priced in. For Hapless to make a killing, it would have had to anticipate a development that very few others anticipated.
With all this background information in mind, let's look at why it is so difficult to identify managers who will outperform in the future—that is, while they have our capital under management—as opposed to in the past—when they didn't.