I’ve been writing Practical Stock Investing for something over five years now. I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time. I’m going to re-post ten over the next two weeks. This will give you a chance to see some of my earlier work that you may have missed. And I’ll have time for home repairs I’ve been putting off. I may just see a couple of baseball games and watch the basketball playoffs, though.
Talk about ugly.
In the April 4th issue of FTfm, its review of the fund management industry, the Financial Times outlines the conclusions of an as yet unpublished study by IBM of the investment management industry, Financial Markets 2020.
FM2000’s bottom line? …the worldwide investment management industry loses US$1.3 trillion of its clients’ money every year. That’s over $100 million during the time it takes a fast reader to reach this point in the post. Wow!!
The main offenders? Here they are, in order of the magnitude of client losses:
—$459 billion credit rating agencies and sell-side research, because the analysis is weak
—$300 billion fees paid to underperforming portfolio managers
—$250 billion fees paid for advisory services that underachieve
—$213 billion excess expenses caused by investment managers’ organizational inefficiency
—$51 billion fees paid to underperforming hedge funds.
IBM argues that clients are gradually waking up and smelling the coffee …and firing the offending service providers, as they work out how bad the performance has been. The computer giant thinks upward of a third of the people involved in today’s fund management industry will be gone before clients are through with their housecleaning. Among sell-side researchers and credit rating agency analysts, the winnowing will remove closer to half.
First of all, I haven’t seen the study. I’m assuming that it’s being accurately portrayed in the FT.
In the nitpicking department, the data seem to have come from an internet survey. If so, its conclusions represent the input of the respondents, and may not be representative of the views of clients as a whole. In addition, the numbers are overly (maybe “ludicrously” would be a better word) precise, suggesting inexperience on the part of the IBM Institute for Business Value, which wrote the report. The assertion that credit rating agencies et al lose their clients $459 billion a year implies the figure is not $458 billion or $460 billion. How could IBM possibly be confident that this is right?
The general direction of the report is doubtless correct, though. Early in my career as an investor, I remember reading the famous comment by Charles Ellis, the founder of Greenwich Associates, a pension consulting firm, that the average portfolio manager is just that–average. At the time, I was offended. Thirty years later, I’d be tempted to amend it to read that the average portfolio manager is just that–a little below average. The credit rating agencies have been notorious for as long as I’ve been in the business for being behind the curve. And everyone knows, or should know, that brokers make their money by having you trade with them, not by having you achieve superior returns.
I think IBM’s idea that clients will quickly take the axe to many of their investment service providers is much too simplistic. Yes, chronic underperformance is a big issue. But there seem to me to be three factors IBM overlooks:
1. The head of virtually every investment management organization is a highly polished marketer, not an investor. A big reason for this is that investment firms are not only in the business of selling performance, they also sell intangibles–like feelings of prestige, exclusivity, reliability, safety–especially to individuals. Some people will hire a hedge fund manager instead of buying a Vanguard index fund (which will likely provide superior returns) for the same reason they buy an $8,000 Hermès leather handbag instead of a $50 nylon equivalent, or a $150,000 Porsche instead of a $30,000 Subaru Impreza. It’s to exhibit their wealth. Having your yearly performance review in a major city, with dinner and a show and your favorite flowers in the hotel suite your manager provides may be just as important as the performance figures–maybe more so.
2. Companies typically don’t want to manage their employees pension money in-house for legal reasons. Hiring a pension consultant and a series of specialist third-party managers transfers responsibility to them. Doing so acts as a form of insurance.
3. Suppose you go ahead and fire all your investment advisors. What do you do then? What do you substitute for them? Maybe losing a trillion dollars a year is good in comparison with the alternatives.