The old fund management economic model is dead. It is being killed off by a mixture of leveraged investments, ETFs and tracker funds, high charges and bad public relations. That does not mark the demise of all fund managers; wealth management retains a role; niche service providers will continue to flourish. But the mass market is either in its death throes or needs a truly revolutionary metamorphosis into a low cost, transparent and digital industry.
The purpose of investing is either to accumulate capital through asset appreciation and compound yield reinvestment or to protect capital whilst optimising income. The selection of investments is a function of the risk profile of the investor. In the late 60s, when I started in this business, a 50% split between equities and government securities was seen to be a reasonable risk profile for UK pension funds. Pension funds now are in private equity, leveraged funds, infrastructure investment and a variety of other esoteric investments; definitely not the counters we would ever have recommended for the “widows and orphans”.
The fund management industry has several serious challenges. Firstly, the cost base, primarily remuneration driven, is totally out of synch with their value added. Secondly. The ETF cult or the tracker product should be a technology product and priced and managed accordingly rather than an asset management one. Thirdly, history, as we can see from the Neil Woodford experience, is a guide to past performance and not a guarantee for the future; moreover, reputations can be trashed overnight for reasons of relatively short-term adverse fund performance. Fourthly, the charging structure of the high-risk sector, basically leveraged assets in hedge or private equity stables, is disproportionate to the risk assumed by the sponsors. Fifthly, liquidity is a problem and one that is misunderstood by clients and often obfuscated by managers. And finally, the dangers of giving advice has led to a serious reduction in the ability of investors to judge the appropriateness of their portfolios to their strategy and especially their risk appetite.
The costs of fund management parallel that of many financial services providers; they are heavily weighted to the cost of headcount. However, the cost per capita range is huge and reflects the traditional perceived star power of managers and analysts as well as, often, high rewards for product sales. In a fund delivering consistent long-term alpha, measured against indices, benchmarks and purchasing power, with perhaps those of Warren Buffett being cases in point at the present time, higher management remuneration is acceptable. But the same is not the case with a tracker fund whose investment strategy is set and then operated automatically. The same is the case with smart beta which adds the delusion of high value-added management to an essentially tracker product. And, where performance is driven by leverage or event driven gambles, the management value added beyond long term luck is dubious. I have seen too many Treasury stars operating proprietary portfolios in banks to be anything other than cynical about their term value added, without taking account of the destructive power of their failures on their company’s reputation.
Tracker funds and ETFs are technology products with the main skilled input going into their structure and the core value added of the managers often being in their distribution network rather than their performance. ETFs are becoming more sophisticated, which is often a euphemism for higher risk. And there is a great danger that the industry could be faced with a regulatory chasm between their perception of their responsibility to inform investors and those of their regulators. Many of the larger fund groups do have deep pockets but a quick tally of the cost of insurance mis-selling in the UK, as an example, shows the possible scale of any material investor adverse performance. And the depositaries have a useful role, if ever this risk crystallises, as proven deep pockets to make good investor losses.
Reputational risk has been highlighted by the Neil Woodford affair. But it also has, in part been self-inflicted. Adverse performance was due to a star manager getting markets and asset selections wrong. The manager is human and capable of errors. But, in the Woodford affair, there appear to me to be three material questions that highlight a further challenge. First, was the risk profile of the funds in line with the assessment implied or made explicit in the fund documentation? And second, did the fund abuse the spirit of regulations by its use of low entry Guernsey listing requirements to ensure technical, but not true, compliance with EU regulation? And third were the rules on suspension of liquidations clear enough in the fund documentation; perhaps both an ESMA regulatory issue as well as one for the fund company and their depositary. But we need to remember that Woodford is not alone in suffering reputational damage. In the USA we had the horrific, and this time fraudulent, Madoff affair, that undermined confidence in the industry. And, although by far not all due to reputational issues, the 2017 top performing EU funds contained just over half the named funds in the similar survey five years earlier. Technology and fund supermarkets provide data to the digitally inclined that focuses on short term performance, perhaps unintentionally creating some of the tensions that lead to excessive risk taking or worse and cause investors to overlook the reality of equity investment being either a high-risk short-term trading activity or a longer terms value seeker.
I have already noted the challenges of the fund management cost base, but that almost pales into insignificance when looking at charging structures. Zero charges are fine, but greater transparency is needed around the risks and rewards of the hidden fees that compensate the fund management world, for they have not become altruistic as they have grown. Fund managers, in my view, should be compensated on long-term performance. Whether this is three or five years is for debate. But the short-term remuneration weighting on salaries is not appropriate other than for funds that market themselves as short term trading vehicles. And longer-term compensation packages would make managers also carry some of their leverage or event positioning risk. Compensation should also be linked to liquidity and special attention is needed for the mechanisms for valuing unquoted investments or illiquid listed counters. I suspect that discounts are needed to allow for fast liquidation of such assets, especially where funds do not have clearly defined redemption gates, side pockets or similar structures.
In today’s world, the millennium investor wants a digital service; the baby boomers still like people. The problem is that advice is dangerous, although many declining to give advice may still do so indirectly through their sales brochures. In my 50 years of City life, the risk profile of the industry has changed, the compensation rates in the industry have soared, regulation has multiplied in scope and ambiguity and the litigious tendency of any investor making losses has risen dramatically. With around a hundred trillion dollars of assets under its belt worldwide, the industry revenue footprint is impressive even on a few basis points. But it is facing an existentialist crisis!