Charles Ellis once famously wrote that the average portfolio manager is just that–average.  This is an observation that, however true, still grates with me.  But it really doesn’t explain what is commonly believed that it does, namely, why average performance by experienced professional investors virtually always falls short of benchmark target.

I think there’s another explanation for the latter.

It’s that money management firms assume clients prefer a warm and fuzzy working relationship with a financial adviser over strong investment performance.

In a sense it’s only natural that firms should think that way.  Most are run by the head marketer, with the head investor having the CIO (Chief Investment Officer) title and has little to do with strategy (this is the same jocks vs. nerds issue that has the traders controlling Wall Street firms, not the analysts). And the conclusion was probably also correct until about a decade ago.

In practical terms, the thinking went like this:

–why hire an extra analyst, even if that would mean a higher probability of matching our index vs. falling, say, 50 basis points below it?  Better to hire an extra marketer who can bring in more assets.  After all, we earn our fees based on a percentage of assets under management, not on outperforming, and our clients don’t care anyway.

–similarly, why cap the assets our star managers manage at a level where they’re more certain of outperforming?  If they manage 2x or 3x as much, they may be forced into buying larger-cap stocks than they’re comfortable with, and the chances of their beating their benchmark may be lessened by their lack of maneuverability.  The answer: clients won’t notice that, either.

However, clients have noticed    …and are leaving active managers in droves.

More tomorrow.