“To minimise the cost of investment”

On 18 November 2016 the UK’s Financial Conduct Authority (FCA) released the interim findings of its asset management market study. There is plenty of good stuff in the report and, for consultants, one potential action of seismic proportion – a possible referral to the Competition and Markets Authority. Much has been written, and will be written in reaction to this document. Here, I choose to dwell on one particular phrase that actually comes from the FCA’s press release that accompanied the interim report. I was struck by it on first read and, a month later, it won’t go away. The phrase is the last six words of this sentence from the FCA:

“In today’s world of persistently low interest rates, it is vital that we do everything possible to enable people to accumulate and earn a return on their savings which can meet their lifetime needs. To achieve this, we need to ensure that competition in asset management works effectively to minimise the cost of investment.” [emphasis mine]

This is where my reflections have got me:

  1. This is a poor objective function. To quote Warren Buffett “Price is what you pay. Value is what you get”. While I agree that, starting from current levels, lowering cost (the price to the end saver) is likely to yield better value (for end savers), this will not be true for all cost reductions. A better objective function would be to maximise the value of investment.

  2. Our industry has a composition problem. Alpha is subject to diseconomies of scale – so it is prudent / rational / required to constrain capacity. But, at the aggregate level, there is no alpha – only beta less costs. So society in aggregate has no need for capacity discipline, just a harvesting of economies and passing them on to consumers.

  3. For those asset owners skilled or lucky enough to find asset managers that are skilled or lucky enough to produce consistent alpha, this has phenomenal value. But we know, on an expectations basis, that securing consistent alpha over the long term is an odds-against activity. So why do so many asset owners play this bad-odds game? There must be some expectation of value, even if it isn’t financial value. This list will be incomplete, but I can think of the following:

    1. Comparative advantage: the asset owner believes, reasonably or unreasonably, that they are better able to identify the skilled managers than other asset owners.

    2. Lottery-like value: the asset owners know the game (most of the managers they hire will underperform after costs), but finding the one with consistent alpha would add so much value that it is worth buying an entry ticket (or several) because someone has to win

    3. Long-horizon value: a variation on the above which argues for net financial value. The asset owner hires multiple managers and uses a disciplined process to cut the losers and run the winners with a view to adding money-weighted value over long horizons

    4. Entertainment value: no asset owner would admit to this source of value (nor should they, for legal reasons), but index-tracking and asset allocation is rather dull in comparison to an active manager telling stories about portfolio positions.

I have previously argued that the shuffling of ownership rights adds no value for society (here, if interested). With respect to the existing stock of securities in issue, society needs two things: (1) for the securities to be held and administered securely and cheaply (passive, or buy-and-hold), and (2) for there to be sufficient price discovery so the prices are ‘efficient enough’ (active). We could add a third ‘thing’, namely stewardship, if you don’t feel it will be adequately done under (1) or (2) above.

My problem with the FCA statement is that the logical consequence is to assign all securities to (1), and thereby we lose all price discovery. Instead, I would argue that the end saver is best served by optimising the mix of (1) and (2). In the paper hyperlinked above I suggested 70% passive and 30% active, noting that this is a judgement on my part as the optimal proportion cannot be known, and may not even be constant through time.

Is there another way? This is what I have been mulling – but it would require me to give up my long-standing prejudice against performance fees. My objective is to deliver to end savers (society) both cheapness and price discovery (which is expensive) – so the deal for active managers is to receive an ‘index-like’ base fee and a share of the value they create. To throw some numbers around, let’s say it is reasonable for an active manager to keep 30% of the value they create. If they create a 1% excess return, they make 30bps – which could be 5bps of base fee and a 25% share, or 10bps and a 20% share etc. Clearly, if they produce a 3% excess return then they should have gone for a 0bps base and a 30% share, in order to earn 90bps – under 10bps plus 20% they would only make 70bps in total.

For those managers not earning a positive excess return, they will be running at a loss – the cost of the in-depth research will be greater than the ‘index-like’ base fee – and so they would need to be sufficiently capitalised to survive until they started to collect the performance share. The issue of noise vs signal doesn’t go away of course, so there couldn’t be a full, immediate payout of performance fee, further increasing the importance for an asset manager to have sufficient working capital.

Such a change would bring both intended and unintended consequences. The intended consequence would be more value for the end savers, which would likely be accompanied by far fewer active management businesses as assets accumulated with the active managers able to create value over the longer term. Presumably the business models of active managers would change fairly substantially – more diversification, more technology, fewer employees? Beyond that, I have less clarity. Is this an idea worth debating?