A very long time ago (roughly 1985), a colleague handed me a short Brooking paper by Robert Vishny, Josef Lakonishok, and Andrei Shleifer. By then it was a couple of years old. I’ve not been able to find it online, but my recollection of it is pretty good.
It was the first time these well-respected economists had looked at the money management business (remember, it was no where near as important then as it is now) and they were mystified. They concluded the industry added no value and by any standards ought not exist (in fact, the paper might have been slightly stronger on this point). I recall it acknowledged in passing that investors might have non-economic objectives.
Other first class minds have come to similar conclusions. Warren Buffett, in 2006 letter to Berkshire Hathaway shareholders, gave a little parable about the Gotrocks, a family that owns all of Corporate America:
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers– for a fee, of course– obligingly agree to handle these transactions… The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new “beat-my-brother” game. Enter another set of Helpers….The suggested cure: “Hire a manager– yes, us– and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades….Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family’s disappointment grows. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers….
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group– we’ll call them the hyper-Helpers– appears….
The new arrivals offer a breathtakingly simple solution: Pay more money…The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY…
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners– if they all just stayed in their rocking chairs– is now going to a swelling army of Helpers.
Now you would think that by now America would have wised up. But people are deeply optimistic and the vast majority overestimates its capabilities. And there are many stories, some of them actually true, of individuals who made a lot of money in the market. Of course, they were all geniuses, as opposed to merely lucky.
Money managers, particularly the big mutual fund complexes, have skillfully preyed on the willingness of the public to believe. They will promote their best-performing funds, encouraging investors to pile in just as mean reversion is about to take place (McKinsey has repeatedly studied mutual fund performance, and has consistently found that top quartile funds don’t stay there very long). At least momentum stocks don’t run ads in the Wall Street Journal.
While the waning enthusiasm may simply be a function of investors having been whipsawed by volatile markets one too many times, this Financial Times piece suggests that they have been sold one too many fads, although they depict the problem differently. Their characterization, which says the author spent a bit too much time with industry sources, is that the fund managers have failed to come up with tantalizing new products. That unwittingly reveals the fundamental problem (if you care about returns, that is). The industry has come to depend on fashion, not fundamentals.
Per Buffet, the FT story reveals that investors are paying a lot of fees to be closet indexers.
I’d like to think this investor skepticism might be a lasting development, but I suspect the industry is clever enough to find a way to repackage its wares once the markets have calmed down (if conditions continue to be adverse it might take some time to get investors back in the deep end of the pool).
From the Financial Times:
The US mutual fund industry’s best attempts at innovation have fallen flat in recent years due to a hairy mix of factors ranging from changes in how funds are distributed to the simple fact that many new products have failed to deliver their promised returns.
Compounding the lacklustre output is the industry’s maturity level. With all the major asset classes already chock full of choices, there is little room for more products on shelves that are stocked with 7,044 mutual funds.
“The level of creativity could use a steroid injection,” says Jeff Keil, principal of mutual fund consultancy Keil Fiduciary Strategies. He says the innovation drought has a lot to do with the changing nature of how funds are sold.
A big factor in the innovation stagnation is the fact that so-called gatekeepers at the broker/dealers whose financial advisers sell funds have gained much greater influence over what those advisers sell. These gatekeepers are paid to sort through the thousands of funds available. And they want predictability in the funds they recommend.
Specifically, gatekeepers do not want to see more than 3 per cent tracking error, or deviation from the relevant benchmark funds are supposed to track. It is an attempt to manage risk and avoid negative surprises. Their job is on the line if the funds they recommend do not deliver as promised. Innovative products, by definition, are not going to be predictable.
“Innovation is dead – or at least severely constrained – in a third-party distribution world,” says Harold Bradley, chief investment officer at the Ewing Marion Kauffman Foundation and former chief investment officer of growth equity at American Century Investments.
The safe bet for portfolio managers is to stay close to their benchmark. The rub for investors is they end up paying a higher fee for active management when what they are essentially getting is an index fund.
While creativity may be at a low level, pressure to come out with new products is high. But so far the response has been to launch “me-too” products that provide access to a thin slice of the market.
“There’s a tremendous urge to differentiate for the sake of differentiating without much thought to whether it is a viable product or not,” says Burt Greenwald of BJ Greenwald Associates. “What ultimately creates and maintains market share is performance.”
Investor flows follow the top-performers, so fund firms are under pressure to have their products stand out amid a sea of mediocre returns. At the same time, as with most consumer products, there are people who constantly need to have “new and improved” cachet, says Adam Bold, chief investment officer at The Mutual Fund Store. “Brokers need a story to tell their clients,” Mr Bold says. “So there’s a constant struggle between pure fad and giving investors what they want.”
Yet, there is a disincentive for fund firms to innovate. It’s expensive to roll out new products and it takes three to five years to incubate a fund and develop a track record. Being a first mover also carries a lot of risk, something most firms are unwilling to roll the dice on.
For fund shops, one of the only ways to differentiate their new products is to offer access to a particular niche. The trouble with rolling out narrowly focused funds is their limited appeal.
Further, recent history has not been kind to many fund shops that have launched “hot dot” products when times are good and ill conceived ones when times are bad — think tech funds in the late 1990s and principal protection funds in 2002.
Principal protection funds were a product of the market crash and promised exposure to stocks without any downside, which turned out to be too good to be true. The funds often sought to protect investors’ principal with insurance or derivatives. And, if investors stuck it out with the fund for the predetermined amount of time, their investment would be protected from dropping in value.
But, these funds have produced dismal returns over their lifespan, a reality that has been reflected in net sales. They have suffered $3.8bn (£1.9bn, €2.5bn) in outflows in the three years ending December 31, 2007, according to Financial Research Corporation.
While still in their infancy, heavily touted 130/30 funds have not delivered either. Long/short equity funds, a proxy for 130/30 funds, have trailed the S&P 500 since the beginning of 2006.
“130/30 funds are not the answer,” says Rob Isbitts, chief investment officer at Emerald Asset Advisors, a registered investment adviser in Weston, Florida. “It’s being sold as the everyman’s hedge fund and it’s got a lot of marketing muscle behind it. But if that’s product innovation, we’ve got to go back to the drawing board.”
Other new funds that have generated a lot of buzz are specialty or sustainable funds that invest in water, energy or infrastructure. While these narrow slices may have some merit for a small group of investors, they do not make for a good core investment.
Of all “new” funds on the scene, lifecycles have been the most heralded, even though some shops, such as Fidelity, have had them in place for 12 years. An estimated 102 new lifecycle funds were launched last year, FRC says.
But much of the set-it-and-forget-it funds’ success may have more to do with changes in legislation than product innovation. The funds have gained prominence with the passage of the Pension Protection Act of 2006 and their subsequent place on the list of qualified default investment options in 401(k) plans.
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I don’t know if this is what you are thinking of, but in the Brookings Papers on Economic Activity, Microeconomics 1992, there was a paper by Lakonishok, Schleifer and Vishny titled “The Structure and Performance of the Money Management Industry” which covers the topic as you described.
There are simple measures (which means they would be totally unacceptable to the industry) to end the mutual fund industry stronghold on Americans’ investments.
1) 401(k) should be structured like the Canadian RRSP or the Chilean Individual pension Plans. That is, anyone can invest a certain amount tax-free per year in any vehicle they wish. No more “Here, you got 10 mutual funds to invest in and that is that, Buster!”. Employers who wish to contribute just send the monies to registered clearing houses and have no direct or indirect control over the choices of vehicles. Right there, 75% of the MF industry would get a much neeeded kick in the pants.
2) Performances should be reported before all fees and after each and every fee then after all fees are accounted for. A mandatory graph would show projected losses generated by said fees at 10, 15, 20 and 30 years, and included in ANY prospectus. Come on laser brain, show Daddy-O how well you REALLY perform.
3) Every trade performed during last 3 days before end of quarter should be disclosed on every mutual fund web site. Wanna do some window dressing? Sure thing, just add a bit of Windex with that please, pretty please?
I wounder what Buffett would make of such and agenda? *evil grin*
One of the errors in the Buffet analogy is to characterize investors as “Gotrocks.” The sad reality is that many investors are not wealthy at all, but are the 40 million working-class Americans who have 401(k) retirement plans.
Frontline did an investigative report that renders an devastating indictment on 401(k) plans…
http://www.pbs.org/wgbh/pages/frontline/retirement/view/
One economist they interviewed calls them the “next big financial crisis” facing America. Another says the “yield disparity” inherent in 401(k) plans is a “financial cancer” that will “destroy the opportunity for ordinary workers to retire in dignity.”
I think Mr. Buffet et al. give too much credit in assuming that the choice of investment vehicle is a purely rational, economic choice.
People decide on investments the same way they buy clothes and decide on restaurants. Everyone objectively knows that jeans bought from Wal-Mart vs. Barneys are the same quality in the sense of durability, fabric, ability to protect your butt from the elements, etc (heck many luxury brands come off the same factory lines in China as their generic counterparts). But people willingly pay for the brand because when they walk down the street, having a specific insignia on your pocket indicates that you’re rich enough to throw away several hundred dollars on something as inconsequential as jeans.
Financial products are the same. In ancient times (say the 50s/60s) dabbling in the stock market was a sign of wealth and savvy, since (as you’ve rightly pointed out many times, Yves), stocks were considered extremely speculative and only safe for people who could afford big losses. Plus it wasn’t worth the cost of all the research on companies you had to do (or hiring of advisers to do the same) unless you had a lot of money to invest.
Mutual funds were akin to the downmarket brands of the fashion labels, in that they could allow investors who previously didn’t have the wherewithal (both financial and knowledge-wise) to invest in stock markets to now be a part of the equity markets just like the rich guys. Thus, in the 70s/80s/90s, even if you didn’t know a thing about P/E ratios and dividend yields, etc., etc., you could pontificate around the water cooler about “your” stocks while your peers were still stuck in boring money markets and CDs. Thus, mutual funds boomed by marketing the “brand” of being an equity investor (implying you were rich and financially savvy) to a much larger pool of people than the narrow confines of the truly wealthy.
As any marketing specialist will tell you though, the problem with marketing an upper class product to the lower classes is that eventually, the brand becomes seen as lower class, at which point, you have to start competing on commodity factors (e.g. price, quality, etc.) rather than cachet and brand value. That’s what’s happened to the mutual fund industry, as owning mutual funds and playing stocks have become a middle class and even lower class pursuit. Hence, returns are converging on the benchmark indices, and people are starting to pay attention to expense ratios and the such.
So what’s a poor millionaire to do? Be forced to suffer the indignity of putting his money in the same yeoman’s fidelity mutual fund in which his servant parks his IRA? Never!
Enter the hedge funds. An entirely new brand. One limited to rich people by law (how many couture labels can say that?!). I’ve always been of the opinion that the requirement that only high net worth individuals could invest in hedge funds was a blessing in disguise for the industry. It meant that saying you owned a hedge fund automatically implied you were a high net worth individual. Same with private equity (which are just LBO shops by another name, and these days, are neither private, nor have much equity). People who willingly pay several hundred dollars for jeans will willingly pay 2/20 for the ability to advertise their net worth and prevent the hoi polloi from doing the same.
Thus, I assert that choosing an investment vehicle is not an economic decision, but a brand decision. For most Americans who can’t even balance their checkbooks, the idea that they can understand principles such as compound interest, yields, or (god-forbid) reversion to the mean, is doing them too much credit. They don’t know the difference between one mutual fund or the other anyway. So they pick based on which one makes them “feel” like a savvy and rich investor.
Hedge funds have so far done a masterful job of promoting this myth. Who cares that they don’t report their holdings nor their investment strategies? How many people actually read their mutual fund prospectuses?
The main goal of investing in a hedge fund is to advertise to the people around you that you have enough money to invest in a hedge fund. And that you’re hip enough to realize that mutual funds are sooo last year. And you’ll be happy to pay through the teeth for that privilege.
I use index funds and that’s pretty much it for mutual funds, somewhat subdivided (cap level, foreign, etc.)
I never trusted all the fancy systems and the results didn’t seem worth it.