The Emperor Wears No Clothes, Part 3: Money Managers Out of the Closet
Interestingly, I have not received any threats due to my last two columns, which raised significant questions about some of the practices underlying the investment consulting industry and the use of style boxes to achieve investment diversification. So, this month I’ll tackle a question that seems to baffle so many in the industry, “Why do so few money managers (aka the stock pickers) seem to be able to consistently outperform their benchmarks, especially after fees and taxes?”
A frequently speculated reason is that markets are efficient, especially in the U.S. It takes an information edge to pick better stocks than your peers. However, since all information is available to everyone (ignoring insider trading and other illegal stuff), no manager has an edge in identifying the best stocks.
Although the theory sounds good, I think there are more practical reasons. Understanding those reasons requires you to recognize that money management is a business out to make money for itself. It does not necessarily operate in your (the investor’s) best interests and it is subject to constraints imposed by you and the consultants.
Making Big Fees
The easiest way for a manager to make big fees is to:
Amass large amounts of money under management on which to charge a percentage fee
Manage all that money in the same way in order to be cost efficient
Generate good investment performance in the early years to raise more money and avoid terrible performance thereafter to hang on to it.
None of these business motivations is good for you – the customer. The substantial marketing focus required to amass large amounts of money distracts the manager’s attention from investing. Managing large amounts of money makes it difficult to be nimble in the market. (Remember Fidelity’s Magellan Fund that performed well for years until it got too big for the managers to handle?) Our experience is that managers who really add value tend to be willing to remain small, limiting their own profits. They close their doors to new customers.
The last bullet point is more complex. Understanding its implications to you requires much of the rest of this article.
Evaluation is Key
How managers are evaluated, rewarded and punished impacts how they act. Consultants and others evaluate managers based upon their investment performance relative to the indexes for their respective style boxes. If a manager owns (on your behalf) all of the stocks in his index in exactly the proportions in which they are reflected in the index, his performance would equal the index. Your net investment return from that manager would be the index return, reduced by the manager’s fee, trading costs and taxes.
There are several ways for a manager to outperform his benchmark. Remember that the consultants will fire the manager if he doesn’t stick with stocks in his style box, so he can’t look elsewhere for better stocks. (Actually, if he takes the risk to stray from his style box and outperforms the benchmark, the consultants won’t fire him until he next underperforms.) He also can’t be defensive by increasing cash when he thinks his style-box stocks are overpriced. If he does, he gets fired because the consultant has already determined the cash component of the overall portfolio, which is held elsewhere.
A manager has two basic ways to deviate from his index that are less risky from his own business perspective. He can bet on specific companies (e.g., buying more of Company A than its percentage of the index and less of Company B relative to its share of the index) and/or specific sectors (e.g., buying more technology stocks than technology’s share of the index and less energy).
Unfortunately, individual stocks and industries tend to move rather randomly in the short term. Here is where the manager’s business objectives enter into the picture. It takes relatively big bets to significantly beat the index. But, if the manager makes big bets and is wrong in the “random” short term, his customers will quickly abandon him. On the other hand, if he makes only little bets and only slightly underperforms in the short term, he’ll keep his customers and continue to make money for himself.
The business risk of short-term underperformance outweighs the business benefit of potential long-term outstanding performance. So, most managers will tend to take only incremental bets relative to the index. In fact, if a manager outperforms in the first part of the year thanks to good short-term luck, he might restructure the portfolio even closer to the index for the rest of the year in order to preserve his performance!
So, now you know the truth…many managers are closet indexers! They stick close to the stocks in their index and do a little better or a little worse. Either way, they keep you as a customer and make money for themselves. However, after fees and taxes, you likely will not do as well as the index.
Now that I’ve “outed” the closet indexers, you might consider just using index funds. You get index returns, with lower costs and less stock turnover with the associated taxes. Not as much fun, perhaps, but inherently logical.
Unfortunately, managers could offer substantial benefits to clients relative to index funds. Through their stock selection/disposition processes, reducing weight in unattractive sectors, holding cash when the market is overvalued, and using options and other techniques, managers can reduce risk relative to the index. In other words, managers actually have the potential to lose less money than an index in down markets. They also could substantially outperform the index over time.
Yet, most managers won’t do these things. Protecting you on the downside and outperforming over the long-term inevitably means that a manager might not capture all of the upside in the short-run. You’ll dump him in boom markets. For example, most managers knew that technology was overpriced by 1999, but anyone who reduced technology exposure was flayed by his customers because performance suffered relative to the benchmark – at least for a little while!
Like an index fund, managers also could be very tax efficient. Indeed, taxable investors should be far more interested in after-tax than pre-tax returns. Unfortunately, most managers ignore tax efficiency. Why? Consultants typically evaluate managers on pre-tax returns. Most customers are pension funds and endowments that don’t care about taxes anyway. And, most importantly from the manager’s business perspective, tax-efficient management is labor intensive (remember the second bullet point). So, why bother if it’s not appreciated?
Consultants and customers force managers into a pretty narrow box, severely punish deviations (by firing the manager) and then wonder why the performance is so mediocre. There’s plenty of blame to go around. But, that is not the end of the story about what goes on inside the investment industry. Stay tuned for the continuing saga. (Note to investment industry participants: Future articles are locked away in a safe place and will be revealed by others if anything mysterious happens to me before next month.)
Ross Nager is Senior Managing
Director of Sentinel Trust Company of
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