The peculiar investment management industry

If investors complained about Wall Street 80 years ago, they’re howling now. Industry players get richer and richer, while many investors see mediocre results after fees.

Asset management is a highly unusual and somewhat baffling industry. Here are six main examples of just how peculiar this industry is.

The asset management industry rarely delivers what it promises: Alpha

Alpha is a zero-sum game, according to Bridgewater founder Ray Dalio. By contrast, most industries are positive-sum: If you eat a great steak dinner, it doesn’t imply that others have to eat hot dogs. In asset management, each new money manager who generates alpha (returns above the passive benchmark performance) does so at the expense of other managers who underperform.

Your own investment’s value may change because of a change in the value of the underlying asset and/or market preferences. However, few investors can directly impact the value of the underlying asset, except for private equity and venture capital investors with portfolio acceleration strategies. Celebrity investors like George Soros can influence market preferences, but most of us don’t have that advantage.

Diversity and inclusion are the most readily solvable issues, and the inevitable aging of the “pale, male and stale” leaders of the industry will create room for new entrants.

In fact, it is mathematically impossible for the mean investor in a given sector to beat a low-cost index of that sector after expenses. We’d argue that money managers playing a positive-sum game include those who focus on well-developed sectors for which indices are not readily available (e.g., private companies, frontier markets, cryptocurrencies) and/or nascent asset classes.

For example, hedge funds, on average, have underperformed on a net-of-fees basis in both U.S. equities and bonds since 2000. The HFRI Index returned 18.3% annually during its initial 10 years from 1990 to 1999, but it returned just 3.4% annually over the 10 years to 2016. Similarly, according to Morningstar’s Active/Passive Barometer, in the five years ended October 2021, only 26.4% of U.S. large cap, 22.7% of U.S. small cap and 24.3% of global large-cap active equity mutual funds outperformed their passive competitors.

Rolling ten-year returns have steadily declined across hedge fund strategies

Rolling 10-year returns have steadily declined across hedge fund strategies. Image Credits: David Teten
Blue bar: Hedge-Fund Research Institute (HFRI) Weighted Composite Index (HFRI FWD) Aug. 2018 | (HF Annual Return %).
Green bar: S&P 500 Return (Bloomberg).
Blue line: Barclays Hedge AUM Hedge-Fund Industry; 2017 | (Hedge Fund Industry AUM $TN).

“Given better analytics, institutional investors have realized that there is little alpha and much of the excess returns are explained by risk premia,” Nicolas Rabener, managing director of FactorResearch, said.

Amit Matta, a risk management expert, observed that performance is often overstated (and risk understated) due to the illiquid nature of some of the underlying investments, which allows room to manipulate pricing in favorable ways.

However, a large group has different objectives — corporate players. “They are fully 50% of the primary market (sellers) and are material players in the secondary market (M&A), which cumulatively makes the markets a positive-sum game. It’s possible for all asset managers to make money when they buy a successful IPO or sell their holding to a corporate buyer.”

Size often hurts returns

Standard compensation models motivate money managers to add more assets under management. This contributes to the “winner takes all” trend, where we see a steadily growing concentration of AUM at the largest money managers. The argument is that large hedge funds have the resources and talent to beat markets. The reality is far from that.

After years of lackluster returns, when the market crashed due to the coronavirus pandemic in 2020, a number of prominent hedge funds unexpectedly lost money exactly when they should have been providing diversification and downside protection. Renaissance Technologies funds for external investors reported losses of 7%-9% in the year through April 17, and Bridgewater Associates reported losses of over 20% during the same period.

Alternative investment funds earn on average two-thirds of their compensation from management fees, not carry or performance fees. Large hedge funds hit liquidity limits over time and start impacting market pricing when they trade, losing their ability to exploit arbitrage opportunities.

For example, one of the challenges for the widely popular risk parity strategy has become size and liquidity. Risk parity strategies peaked at $1 trillion at the end of 2020, but a combination of losses and redemptions shrunk its collective AUM to $400 million in less than a quarter. Just when investors most needed its diversifying capabilities in 2020, risk parity strategies underdelivered versus a low-cost, boring 60%-40% bond-equity mix.

The principal-agent conflict

The “broken agency” conflict can cost money holders far more than it does in other industries. All companies face some form of the principal-agent problem: For example, the CEO of a public company may be tempted to manage financial results to optimize the short-term stock price if a significant portion of their compensation comes from company stock options.

In asset management, the principal-agent problem is exacerbated by the presence of many conflicted intermediaries. For example, an individual allocator is often motivated to allocate to the most popular fund or type of investment in which their peers are investing to protect from career risk. If an allocator hires a known player, underperformance will not cause the employee’s judgment to be questioned. The resulting herd mentality hurts innovation and leads to suboptimal returns.

Money managers benefit more

Simon Lack wrote in “The Hedge Fund Mirage” that from 1998 to 2010, hedge fund managers earned $379 billion in fees, while their investors earned only $70 billion in investment gains net of fees. In the asset management industry, the norm is that the general partner puts in just 1%-2% of the total assets under management and keeps the remainder of their personal assets in a diversified portfolio.

Some hedge fund managers have even set up sophisticated family offices to diversify their holdings out of the core product in which they made their wealth. In contrast, entrepreneurs in most other fields risk a more significant portion of their capital in their new venture, better aligning incentives.

Money managers can earn more money at less personal risk than in any other industry

Money managers can earn more money at less personal risk than in any other industry. Image Credits: David Teten
Column 1: Mergers & Inquisitions; Brian DeChasare; “The Hedge Fund Career Path: The Complete Guide”
Column 2: Mergers & Inquisitions; Brian DeChasare; “The Private Equity Career Path: The Complete Guide”
Column 3: Mergers & Inquisitions; Brian DeChasare; “Venture Capital Careers: The Complete Guide”
Column 4: Yale & “Major, Lindsey, & Africa”, Jeffrey A. Lowe; “2016 Partner Compensation Survey”; 2016
Column 5: MGMA, “The 2019 MGMA Physician Compensation and Production Report”, 2019

The power to create economic risk

The financial services industry, including asset management, has disproportionate power to create systemic economic risk, which in turn can create the risk of social instability. This is unique to financial services and was particularly obvious in the 2008 global financial crisis. Similarly, when the highly leveraged Long-Term Capital Management fund collapsed in the late 1990s, 16 leading financial institutions had to agree on a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.

By comparison, when oil prices doubled between 2009 and 2011, it created stress for some industries, but there was no concern that the global economy would collapse. The picture was no different in early 2020. To avoid a market meltdown, governments and central banks around the world jumped in a concerted effort to create liquidity, providing the biggest bailout in history for investment managers.

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The scope of the liquidity infusion has been massive even by the 2008 standard. Post the 2008 financial crisis, when interest rates reached close to 0% and the Fed was running out of ammunition, the Fed started buying treasuries at $85 billion a month. In 2020, the Fed was far more aggressive — in a week the Fed injected the same liquidity that it had injected during the entire post-2008 recovery.

The majority of new debt is being added to governments as they step in to become the lender of last resort for everyone from large investment managers to corporations, small businesses and individuals.

A homogeneous industry

The investment management industry is far more homogeneous than the clients it serves, ironically for an industry that worships “diversification” as the one true free lunch. Only 11% of AUM in funds was managed by women as of March 2021 and the number has not grown since 2000. This is despite the fact that funds run by women outperform funds run by men.

That outperformance equals the cost of money holder bias. Distributors (registered investment advisors) also are disproportionately comprised of white men of middle age and older. The bias has two other main negative effects. First, it limits investors’ understanding of the world. Americans with two white parents are expected to be less than half the U.S. population by approximately 2045. Inevitably, consumption and behavior patterns will evolve accordingly.

Second, as Carol Morley, CEO of the Imprint Group observes, “It is hard to attract top talent if firms are looking at a small slice of the population and their immediate peer group.”

Asset Management Headcount by Gender and Ethnicity

Image Credits: David Teten

In reviewing this list of six ways in which our industry is unusual, we think that it will most quickly normalize in incorporating more diverse decision-makers. Diversity and inclusion are the most readily solvable issues of those we list above, and the inevitable aging of the “pale, male and stale” leaders of the industry will create room for new entrants.

Disclosures:

David Teten is an investor in numerous investment tech companies, including Addepar, Asaak, Clarity (sold to Goldman Sachs), Drop Technologies (Cardify), Earnest Research, Indiegogo, Republic, Stratifi, Wonder, and Xperiti. He is an Advisor to Bullet Point Network.

Katina Stefanova is an investor in AcordIQ and Long Game and is a former Bridgewater Senior Executive.

Contributors:

The first version of this paper was co-written with Brent Beardsley, formerly a Partner with Boston Consulting Group. This study would not have been possible without the collaboration and support from Brent and from the Boston Consulting Group. We also want to thank the research, technology, and editorial team who supported us during this study: Greg Durst, Jen McPhillips, Jenny Wong, Charles McLaughlin, Michael Rose, and James Ebert, plus more recently Ariel Cohen, Caleb Nuttle, Spencer Haik, and Cormac Ryan of Bullet Point Network.

These disclosures were added to this article after it was published.