Investment Professionals: Are You Earning Your Keep?
CFA Institute sees a long road ahead in terms of restoring investor confidence. Poll after poll reflects poorly on the financial industry. It is a function of not only the deep-cutting financial crisis still unfolding but a constant barrage of news about the latest fraud or Ponzi scheme. The phrase “Wall Street,” it seems, has become shorthand for an industry out for itself. So, as part of our “Challenging Industry Norms” series examining long-held notions about issues facing the investment industry, CFA Institute recently took on its most controversial topic yet — whether investment managers are delivering value for their clients (view the webcast).
That’s because the status quo will not likely move us towards rebuilding trust. Progress will require honest assessments of our industry and a more introspective approach. The discussion comes at a critical time, amid reports that the industry is underperforming and overpaid for the privilege.
In response, the “Challenging Industry Norms” discussion raised the following crucial questions:
- Are fee levels appropriate and aligned with client interests?
- Are these fees contributing to distrust and a growing restlessness with investment managers?
- What steps can CFA Institute take to improve investor trust?
Suzanne Duncan, global head of research for State Street’s Center for Applied Research, moderated the panel discussion, which featured Paul Haaga, board chairman of Capital Research and Management Company; former U.S. Securities and Exchange Commission (SEC) Chief Accountant Lynn Turner; Rosalind Tyson, regional director of the SEC; and Wall Street Journal columnist and author Jason Zweig.
Duncan kicked things off with a sobering statistic: While 85 percent of the equity managers studied underperformed the market in nearly all relevant time periods, the amount of fees extracted globally for this and other financial-intermediation services is in the range of $1.5 trillion annually.
The panelists weighed in on compensation in the investment management business, stressing the importance of defining and instituting more credible, long-term-focused compensation that rewards performance, not just asset accumulation by managers. Often investors pay management performance fees for short-term gains despite longer-term investment horizons. The notion of asset managers paying a negative performance fee for poor results also was raised during the panel discussion. Paying money back to clients from fees collected, when you as manager do not beat your benchmark, sent an air of unease across the audience of mainly investment professionals.
Other topics included how performance should be measured to determine whether value has been delivered to investors. One money manager noted that time-weighted returns reflected in Duncan’s statistics may not always reflect the true experience of a client who has been investing periodically, through market highs and lows over the long term. The panel discussed other aspects of the value proposition offered by the investment management industry, generally acknowledging that much needs to be done to educate and inform the average investor on products and services, as many are significantly unprepared for approaching retirement.
CFA Institute was complimented for taking an active role in both investigating industry challenges and setting examples for behavior and practice in an effort to restore trust and confidence. The panel encouraged our voice and message on ethical practice to remain loud and clear.
Where do you stand on this issue? Are investment professionals delivering value for their clients?
With the level of management fees on many investment products exceeding what can be defined as the risk-free rate, the question as to whether professionals are earning their keep is very valid.
We live in a world of low absolute levels of interest rates (tax on savers) where commoditized “Beta” is available at a low cost to most savers. It is not unreasonable to view this industry backdrop as one where the professional investment management industry must face up to earning less than it has historically (by charging less). Other industries faced with such challenges (e.g. oil industry in late 1980s) survived through a difficult operating environment by earning less, therefore its understandable for industry outsiders to view the investment industry as one that deserves to earn less going forward.
Management fees need to reflect the costs of doing business–research, trading, publication, etc.–and base level compensation for managers’ skills. However bonus compensation should only come if there is an increase in long term assets under management due to manager decision-making in the products for which he/she have responsibility. Excess compensation based on company wide results or short trade trading should not be passed on to investors. But as assets grow, management fees need to be reduced as relatively fixed costs are now spread over more assets.
Most institutional management fees do appear reasonable. Mutual fund management fees can be excessive, especially for passively managed funds. However, the payment of 12b-1 and other advisor fees are often excess relative to the value the advisor brings to the investor. These fees need to be lowered returned to “original intent”. Then let the investor compensate the “advisors” similar to management firms, based on costs and the ability of the advisor to guide the investors portfolio along the track the investor needs to meet financial goals.
Please see the “Financial Analysts Journal”, “Reflections” Section, Sept-Oct, 2005, pp 44-51. The article is “Are Active Management Fees Too High?”, by Richard M Ennis, CFA.
At the time, I sent the article to several friends with this short cover note:
Skimming a recent copy of the Financial Analysts Journal, I found something rare in that magazine – an article that is both relatively easy to read/understand as well as really interesting. The attached pdf of an 8 page article about fees for active portfolio management is terrific reading if you have anything to do with active management — including simply being a client!
If anyone who reads this would like a copy of the article, just email me at:
[email protected]
I wonder if performance fees are set to be the next big financial scandal.
Performance fees are sold on the basis that they help to align the interests of investor and manager. Although intuitively this seems to be true it is rarely the case. The asymmetric bargain implicit in performance fees means that investors entering into such an arrangement are effectively writing an option to the asset manager. This leads to all sorts of anomalies. For example, a manager earning performance fees would be well advised to ensure that the benchmark is as unrelated as possible to his/her actual investment style, increasing the volatility and hence the value of the option. Taking on incraesed risk can have the same effect. A manager whose performance is never likely to recover to a high watermark can simply close the fund and open another.
Performance fees which were originally largely the province of very long-term investors such as family offices have now been extended to pooled portfolios such as mutual funds. In the former case, with a single investor, alignment of interests is feasible. In pooled portfolios with investors investing and disinvesting daily it is well-nigh impossible to ensure that individual investors pay only for the performance they have earned.
Perhaps surprisingly, this is one area in which much-maligned hedge funds with their infrequent entry points and equalisation schemes manage rather better than their mainstream counterparts.
The critical problem is that most investment professionals do not add value to society as a whole.
In the case where we add value to a client we still may be harming society overall. With active management there is a zero-sum game where this year’s losers cancel out this year’s winners and then we take our extra fees and our investors face taxes for the turnover, disbursements, and income we generated playing the game. Practices like high-frequency trading, most structured product, market-neutral hedge funds, etc are almost strictly wealth transfer activities leaching off of civilization. All such investing activities destroy value in the aggregate; as an investment prospect our industry seems to have a negative expected return.
[To be fair, there is an argument that we add aggregate value by making capital allocation more efficient. But the reason for that is that we’re out here trying to eat everyone else’s lunch. So it’s not exactly a great PR angle. When Lloyd Blankfein says Goldman Sachs is doing God’s work everyone balks — for good reason. The public image of the enfranchised professional investing community is not George Bailey or even Warren Buffet. It’s Gordon Gecko.]
We should be focusing our energy on those activities which add value to both the client and society at large. Primary market investing, developing an IPS, implementing the IPS, creating new markets, developing inexpensive vehicles to gain passive exposure to certain assets, tax-efficient investing, liability-matching, etc are the sorts of activities we should be putting front-and-center. Those of us in active management, financial engineering, black box hedge funds, and the like need to start thinking seriously and creatively about how we can do what we do and still add value to the whole pie. Then we need to tell people about it.
This whole train of thought seems misleading. The fees charged by advisors reflect the cost of communicating with clients, not the cost of managing the assets. We should be concerning our selves with the quality of this communication, a value not particularly well measured by the underlying investment performance. Remarkably, why do people buy several mutual funds, and hire an advisor to help them chose which ones to buy. Why not just buy the Vanguard Wellington Fund and forget about hiring a separate advisor?
Where the investment manager is in relatively close proximity to the client (either deals with the client or with the relationship manager who is the primary client contact), my impression is that fees begin to resemble the true economics of the service. (I am refering to discretionary management, not farming things out to outside managers in SMA programs etc).
That said, there are probably marketplace ineffeciencies with respect to mutual funds and hedge funds where fees are not as visible and harder for the client to ascertain at first glance. Sometimes great performance can establish a fund in short order that grows before fees and subsequent performance become an issue. Then the fund has some momentum and continues to exist despite its fees and ongoing performance. Anecdotal, but I have seen patterns that suggest this.
As a young investment professional, working bottom-up through the industry, I would say the lack of integrity and value is most prevalent at the lower retail (Mom & Pop) levels. In short, the ugly truth and age-old problem is the lack of sophistication of average investors coupled with aggressive sales targets and compensation schedules of advisors results in conflicts. It is commendable that professional organizations like CFAI actively address these issues but the general apathy of advisors prevails when clients are blissfully unaware of their options.