Peculiar Investment Management Industry

The Growing Discontent of Investors

Investor dissatisfaction, a concern present eight decades ago, has reached a fever pitch today. A significant disparity exists, with industry professionals experiencing substantial wealth accumulation while a large number of investors achieve only average returns following the deduction of fees.

The Unique Nature of Asset Management

The asset management sector operates in a manner that is notably atypical and often difficult to comprehend. Several key characteristics contribute to its distinctive and, for some, perplexing nature.

Six Peculiarities of the Asset Management Industry

The following points illustrate some of the unusual aspects of how the asset management industry functions.

• Fee Structures: A primary concern revolves around the fees charged, which can significantly impact overall investment performance.
• Performance Discrepancies: There's a noticeable gap between the returns generated by fund managers and those ultimately realized by investors.
• Lack of Transparency: The intricacies of investment strategies and associated costs are often not fully disclosed to investors.
• Incentive Alignment Issues: The incentives of asset managers may not always be perfectly aligned with the best interests of their clients.
• Marketing Practices: The industry frequently employs marketing tactics that can overstate potential returns or downplay associated risks.
• Regulatory Challenges: Keeping pace with the evolving complexities of the financial markets presents ongoing regulatory hurdles.

These factors collectively contribute to a sense of frustration among investors who feel they are not receiving adequate value for their investment.

Understanding these peculiarities is crucial for investors seeking to navigate the complexities of the asset management landscape and optimize their financial outcomes.

The Challenge of Achieving Alpha in Asset Management

The pursuit of alpha, or returns exceeding benchmark performance, often falls short of expectations within the asset management industry. Ray Dalio, founder of Bridgewater, posits that alpha is inherently a zero-sum endeavor. This contrasts sharply with many other industries where gains don't necessarily equate to losses for others.

An investment’s ultimate value is subject to shifts in both the underlying asset’s worth and prevailing market sentiment. Directly influencing the value of an asset is typically beyond the reach of most investors, with the exception of those engaged in private equity or venture capital employing strategies to accelerate portfolio growth. While influential figures like George Soros can sway market preferences, this capability remains uncommon.

Positive-Sum Opportunities in Asset Management

It’s mathematically improbable for the average investor within a specific sector to outperform a low-cost index of that same sector, once all expenses are considered. However, opportunities for positive-sum gains exist for managers concentrating on sectors lacking readily available indices – such as private companies, frontier markets, or emerging cryptocurrencies – and/or focusing on newly developing asset classes.

Consider the performance of hedge funds. On average, they have failed to deliver net-of-fees returns that surpass those of U.S. equities and bonds since the year 2000. The HFRI Index demonstrated an 18.3% annual return during its first decade (1990-1999), but this declined to just 3.4% annually over the subsequent ten years through 2016.

Further evidence comes from Morningstar’s Active/Passive Barometer. Over the five-year period ending October 2021, a minority of actively managed equity mutual funds outperformed their passive counterparts: 26.4% in U.S. large cap, 22.7% in U.S. small cap, and 24.3% in global large-cap.

Nicolas Rabener, managing director of FactorResearch, notes that advancements in analytical tools have led institutional investors to recognize the limited availability of true alpha, with a significant portion of excess returns attributable to risk premia.

Amit Matta, a specialist in risk management, points out that reported performance figures can be inflated, while associated risks are often underestimated, particularly due to the illiquidity of certain investments. This illiquidity can create opportunities for manipulating pricing to achieve more favorable results.

The Role of Corporate Players

A significant portion of market activity originates from corporate entities. These players account for 50% of primary market sales and are substantial participants in the secondary market through mergers and acquisitions (M&A). This activity collectively transforms the market into a positive-sum environment.

It becomes feasible for all asset managers to profit when they invest in a successful initial public offering (IPO) or divest their holdings to a corporate acquirer.

The Detrimental Impact of Scale on Investment Returns

Traditional fee structures incentivize financial managers to increase their assets under management (AUM). This dynamic fuels a “winner-take-all” scenario, resulting in a continuous consolidation of AUM among the largest investment firms. A common belief suggests that larger hedge funds possess superior resources and expertise, enabling them to outperform the market.

However, empirical evidence often contradicts this assumption.

Following a period of underwhelming performance, several high-profile hedge funds experienced unexpected losses during the 2020 market downturn triggered by the coronavirus pandemic. This occurred precisely when these funds were expected to offer diversification and mitigate downside risk.

Specifically, Renaissance Technologies funds catering to external investors documented losses ranging from 7% to 9% as of April 17th, while Bridgewater Associates reported losses exceeding 20% over the same timeframe.

A significant portion of revenue for alternative investment funds – approximately two-thirds – is derived from management fees rather than performance-based carry. As hedge funds grow in size, they inevitably encounter liquidity constraints.

These constraints can ultimately influence market pricing when they execute trades, diminishing their capacity to capitalize on arbitrage opportunities.

The risk parity strategy provides a compelling illustration of this phenomenon. While reaching a peak of $1 trillion in AUM by the end of 2020, a confluence of losses and investor redemptions swiftly reduced its collective AUM to $400 million within a single quarter.

Ironically, at a time when investors would have benefited most from its diversification benefits in 2020, risk parity strategies failed to deliver returns comparable to a conventional 60%-40% bond-equity allocation.

Challenges Presented by Increasing Fund Size

• Liquidity constraints hinder the ability to exploit arbitrage.
• Increased trading volume can impact market prices.
• Performance may suffer during periods of market stress.

Fund size, therefore, can become a significant impediment to achieving optimal investment outcomes.

The Principal-Agent Conflict in Finance

The conflict arising from the principal-agent relationship can be particularly costly to investors within the financial sector, exceeding the impact observed in many other industries. All organizations grapple with the principal-agent problem to some degree; a common example involves a CEO potentially manipulating financial reporting to boost short-term stock performance, especially when a substantial part of their remuneration is tied to stock options.

Within asset management, this problem is intensified due to the involvement of numerous intermediaries with potentially conflicting interests. An investment allocator, for instance, might prioritize allocations to highly popular funds or investment strategies mirroring their colleagues’ choices, primarily to mitigate career risk.

Employing a well-established investment manager offers a degree of protection against criticism should performance falter, as underperformance is less likely to be attributed to poor judgment. This tendency towards conformity stifles innovation and ultimately results in less-than-optimal investment outcomes.

Understanding the Core Issue

Principal-agent conflict occurs when one party (the "agent") is expected to act in another's best interests (the "principal"), but has incentives to prioritize their own. This misalignment of interests can lead to inefficiencies and reduced returns.

In the context of asset management, the principal is the investor, and the agent is the fund manager or allocator. The agent’s decisions directly impact the principal’s financial well-being.

Examples of Conflicted Intermediaries

• Investment Allocators: May favor popular investments to avoid career repercussions.
• Fund Managers: Could prioritize fees or assets under management over maximizing investor returns.
• Consultants: Might recommend products from which they receive commissions.

These intermediaries, while providing valuable services, introduce layers where self-interest can overshadow fiduciary duty.

Addressing this conflict requires increased transparency, stronger regulatory oversight, and a focus on aligning incentives between all parties involved. Ultimately, a more robust system benefits both investors and the overall financial market.

Investment Professionals and Financial Gains

According to Simon Lack’s analysis in “The Hedge Fund Mirage,” a substantial disparity existed between the earnings of hedge fund managers and their investors between 1998 and 2010.

Specifically, managers accrued $379 billion in fees during this period, while investors realized only $70 billion in net investment gains after accounting for those fees.

Asset Allocation in the Investment Management Sector

A common practice within the asset management industry involves general partners contributing a relatively small percentage – typically 1% to 2% – of the total assets under management.

The majority of their personal wealth is then maintained in a broadly diversified investment portfolio.

This contrasts sharply with the risk profiles observed in other entrepreneurial endeavors.

Diversification Strategies of Hedge Fund Managers

Notably, certain hedge fund managers have proactively established elaborate family offices.

These offices are designed to further diversify their personal holdings, moving assets away from the primary investment products that initially generated their wealth.

This practice highlights a potential misalignment of incentives when compared to entrepreneurs in other sectors.

Incentive Alignment in Entrepreneurship

Entrepreneurs in most other industries generally commit a considerably larger proportion of their own capital to their new ventures.

This greater personal investment fosters a stronger alignment between their interests and the success of the enterprise.

The Capacity to Generate Economic Vulnerability

The realm of financial services, encompassing asset management, possesses an exceptional ability to instigate widespread systemic economic risk. This, in turn, can precipitate the potential for societal disruption. This characteristic is largely exclusive to the financial sector and became strikingly apparent during the 2008 global financial downturn.

A comparable situation unfolded in the late 1990s with the failure of Long-Term Capital Management, a heavily leveraged hedge fund. Sixteen prominent financial entities were compelled to collectively contribute $3.6 billion towards a recapitalization – effectively a bailout – orchestrated by the Federal Reserve.

In contrast, the doubling of oil prices between 2009 and 2011, while creating difficulties for certain sectors, did not raise fears of a complete economic collapse. A similar scenario played out in early 2020. To prevent a market crisis, global governments and central banks collaborated to inject liquidity, constituting the largest bailout in history aimed at supporting investment managers.

The scale of this liquidity provision was substantial, even when measured against the standards of 2008. Following the 2008 crisis, as interest rates neared zero and the Federal Reserve’s conventional tools were exhausted, the Fed initiated the purchase of treasuries at a rate of $85 billion monthly.

However, in 2020, the Fed’s response was considerably more forceful. Within a single week, the Fed supplied the same level of liquidity that had been deployed throughout the entire recovery period following the 2008 crisis.

A significant portion of the newly incurred debt is accruing to governments as they assume the role of the ultimate lender for a broad spectrum of entities. This includes major investment firms, corporations, small businesses, and individual citizens.

A Remarkably Uniform Sector

The investment management industry exhibits a surprising level of uniformity, particularly when contrasted with the diverse needs of the clientele it serves. This is ironic, considering the industry’s strong advocacy for diversification as a fundamental principle. As of March 2021, only 11% of assets under management (AUM) were overseen by women, a figure that has remained stagnant since the year 2000.

Notably, investment funds managed by women have consistently demonstrated superior performance compared to those led by men. This outperformance represents a quantifiable cost associated with biases in capital allocation. Furthermore, the distribution network – comprised largely of registered investment advisors – also displays a disproportionate representation of white men in middle age and beyond.

This lack of diversity generates two primary detrimental effects. Initially, it restricts investors’ comprehensive understanding of evolving global dynamics. Demographic projections indicate that individuals with two white parents will constitute less than half of the U.S. population by approximately 2045.

Consequently, patterns of consumption and behavior are inevitably poised to shift. Secondly, as Carol Morley, CEO of the Imprint Group, points out, “Attracting premier talent becomes challenging when firms limit their search to a narrow segment of the population and its immediate social circles.”

Upon reviewing these six identified peculiarities within our industry, we believe that incorporating a more diverse range of decision-makers represents the most expedient path toward normalization. Addressing diversity and inclusion presents the most readily achievable solutions among the issues highlighted, and the natural attrition of the industry’s historically “pale, male, and stale” leadership will inevitably create opportunities for new perspectives.

Disclosure Information

Disclosures: David Teten holds investments in a number of investment technology companies, including Addepar, Asaak, Clarity (acquired by Goldman Sachs), Drop Technologies (Cardify), Earnest Research, Indiegogo, Republic, Stratifi, Wonder, and Xperiti. He also serves as an Advisor to Bullet Point Network.

Katina Stefanova has invested in AcordIQ and Long Game and previously held a Senior Executive position at Bridgewater.

Acknowledgements

Contributors: The initial draft of this paper was collaboratively authored with Brent Beardsley, formerly a Partner at Boston Consulting Group. This research would not have been feasible without the valuable collaboration and support provided by Brent and the Boston Consulting Group.

We extend our gratitude to the research, technology, and editorial team who provided essential support throughout this study: Greg Durst, Jen McPhillips, Jenny Wong, Charles McLaughlin, Michael Rose, and James Ebert. More recently, Ariel Cohen, Caleb Nuttle, Spencer Haik, and Cormac Ryan of Bullet Point Network also contributed significantly.

These disclosures were appended to this article following its initial publication.