Asset management has long had a poor reputation with the investing public. Fees are too often higher than necessary, performance is routinely disappointing, and genuine transparency is rare. How did this happen?
Much of the problem comes down to incentives. Vanguard founder Jack Bogle once called it the “croupier’s take”. Since the overwhelming majority of fee structures in the industry are calculated on an ad valorem basis, managers are entitled to collect a percentage of assets under management irrespective of any value that they deliver.
Of course, that does not mean that individual investment professionals are not trying their best. On the contrary, the industry is full of bright, ambitious, and extremely hardworking people. But this has not been sufficient to overcome the powerful commercial incentives that are inherent in flat fee structures. It is simply much easier for an investment management company to focus on asset growth at the expense of performance.
This can be seen with a simple example. Imagine you own an investment firm and you want to increase your revenue growth rate by 5 per cent per annum. One option is to deliver 5 per cent annualised outperformance. Although this is an achievable objective, it is extremely difficult, even for the best investment decision-makers.
The other option is to aim for 5 per cent growth in assets under management. This can be accomplished by finding new clients, persuading existing clients to invest more money with you, or some combination of both. For a good sales and marketing team, this is relatively easy.
When faced with this choice, it’s not hard to understand why so many managers focus on gathering assets. It is a perfectly rational strategy—up to a point. It becomes problematic when firms lose sight of the real purpose of investment management—to add value for their clients.
The most extreme manifestation of the problem is closet tracking. This approach offers the worst of both worlds—a high price for an undifferentiated product—and is a terrible deal for investors. In almost any other industry, competitive forces would quickly eliminate such a product, yet it remains all too common in fund management. The FCA was right to step in and shine a spotlight on closet tracking in their Asset Management Market Study interim report and we hope they will continue to crack down in future.
But there’s one thing that’s potentially even worse news for closet trackers, active managers who fail to add value and financial advisers. The recent arrival of Vanguard’s low-cost direct platform in the UK will give investors a clear choice between picking funds that track the index at a low cost on one hand and the traditional advised route on the other.
Whether or not individuals ever embrace the direct route remains to be seen. However, such a world increasingly calls into question the need for actively managed funds that are stuck somewhere in between being trackers and being truly active. We believe that can only be good news for investors.
Dan Brocklebank is head of Orbis Investments UK