Do investment managers add any value?
This question is clearly of interest to clients of asset managers, but it is also an increasingly important question for industry professionals as well. It’s hard for industry professionals to do good work if they do not believe in the work they do, and for clients, it is dangerous to be invested alongside managers that are distracted.
Part of the challenge of answering that question is that the general dialogue usually conflates two separate questions into one:
- Do asset managers add any value when they do not outperform the benchmark?
- Does the industry add any value when it moves money around trading listed equities/bonds and not directly funding new ventures (e.g. venture capital or IPOs)?
These are very different questions that could lead to very different answers.
Performance as the Primary Value-Add
The argument is seemingly quite simple – most managers don’t beat the index. So asset managers, on average, don’t create value.
The long-term statistics are quite depressing. Depending on the study and timeframe, the proportion of active managers that beat their benchmark can be as high as 1/3 (and that’s on the high end) to as low as 15%. Whatever the actual number, it’s not good…especially when you throw in the exorbitant fees that the public is paying for that underperformance.
However, I don’t think the argument is that simple.
I don’t think it’s that simple because this argument assumes that the alternative for the average investor is to buy and hold the benchmark through thick and thin when there is strong, consistent evidence that the average investor buys high (following strong market performance) and sells low (after painful breaks).
Although indexing is indeed a very sound strategy for most people, the average investor generally does not hang on through thick and thin.
And this is precisely an area where asset managers will increasingly need to focus on in order to make up for the collective shortfall on the performance side: How to impart confidence in clients so that clients will invest through the cycle, or better yet, invest when markets are down.
After all, if an asset manager is able to do just that, clients would likely achieve a better outcome investing through the cycle even if performance is marginally subpar compared with the alternative of indexing but buying high and selling low. This becomes even more apparent when considering the number of studies that show that many clients underperform when invested with managers that outperform because clients invest high and sell low.
Managers that are able to engender confidence and encourage countercyclical investments, create value that is not captured in pure performance comparisons.
It’s also important to consider that an investment manager’s value-add is more than just returns. How that return is generated is also an important consideration: How much risk was required to generate that return? And, how volatile are those returns? Historically, hedge funds also added value by mitigating volatility (hence hedging). Hedge funds have strayed from that orientation, but the argument remains true today.
Value of Trading in the Secondary Markets
The second question is a trickier one: if the secondary markets purely involve exchanging stock/bonds between different investors where one investor’s gain is another’s loss, is there any value creation at all?
It’s tempting to say no, but that ignores the interdependence of the primary markets with the secondary markets. Without strong liquid trading of stocks and bonds in the secondary market, the primary market would also be much weaker. And we know this because when the secondary markets are poor, companies tend to hold off on IPOs leading to a drying-up of the IPO market. Without a strong IPO market, venture funding would likely also be impacted.
At the extreme, you also have many tech companies that pay a significant portion of employee compensation in the form of stock options. For example, Facebook recognized $3.2bn of share-based compensation expense in 2016. Secondary market trading is needed to create the value associated with those shares for employees. And for a (albeit controversial) company like Tesla, which is largely unprofitable at the moment, the ability to divert compensation costs into stock options/grants (>$300mm in 2016 vs net loss of >$200mm) gives the company additional room to continue to operate.
Lately, it’s become quite unfashionable to believe that asset managers create any value (and for good reasons). However, it’s not an untenable situation. Remediating the problem simply requires being more thoughtful about what clients need and how the asset management industry operates within the broader financial sphere.
Disclosure: I am employed by an investment manager.