As a profit-making endeavor, managing other people's money is hard to beat. The business requires very little invested capital. There are no worries about getting paid in full when the bill comes due, since fund managers control their customers' money. And lackluster performance is no bar to hefty profits because fees, based on the dollar value of assets under management, are paid even when returns are abysmal.
Wall Street, it often seems, is exempt from the laws of economics. Most active money managers produce worse returns than an index, such as the Standard & Poor's 500. But making enough money to look respectable to clients has been relatively easy as long as falling interest rates boosted the value of most asset classes.
What's more, new competitors constantly enter the business, yet rarely discount fees to gain market share. Instead, funds rely on investors to chase the latest high-performing manager, like gamblers who ignore their losses while seeking a hot slot machine. This has given the business a pricing umbrella that shelters it from competition.
From the owners' standpoint, all this has been fabulous. They work in a business that produces abnormally high profits and forgives incompetence, a rarity in modern capitalism.
Human Nature
Human nature being what it is, I have never met any money managers who believed their own bad results had anything to do with personal incompetence. Rather, investment firms are keenly aware that the talent they possess costs money; hence managers feel no sense of irony when summing up a laggard year with, “It was a good year for us. I only wish it had been a better year for our clients.”
But after a couple of decades in which asset managers floated along in ease and splendor, economics is now grinding down the business. The easy money is going away. Investment management is in the early stages of a historic transformation. Like most tectonic shifts, it probably will take years to fully develop.
The signs are clear. Stanley Druckenmiller, who had a long record of prescience as the founder and chairman of the $12 billion Duquesne Capital Management LLC, was the first notable figure to act on the new reality. He returned his clients' money in 2011 because managing such a large fund was “having a clear impact” on his performance, he told Bloomberg News in 2010.
Druckenmiller and others who followed his example are already rich. This is not true (in the Wall Street sense of “rich”) for a lot of others who work in the industry, or would like to. Despite deteriorating fundamentals, a near-record number of hedge funds and exchange-traded funds started up last year.
That certainly did not occur because clients faced a dearth of choices. It was driven more by the insouciant attitude of “Apres moi, le deluge,” or “After me, the flood.” (Louis XV or his mistress, Madame de Pompadour, supposedly used the phrase to convey that a coming flood, which turned out to be the French Revolution, would be too late to drown them -- justifying the French royalties' excess and debauchery.)
Poor Performance
The first sign of the investment-management flood was last year's manifestly poor performance, just as it was saturated with competition. The average hedge fund lost 4.9 percent and diversified U.S. equity mutual funds lost 2.2 percent. This came on the heels of three shocks: the 2008 financial crisis, the 2009 market panic and the 2010 “flash crash.”
It also followed an entire lost decade for the equity market. Investors' disenchantment shows in outflows from equity funds. In 2010, stock funds (including mutual funds and exchange traded funds) had a total inflow of $36 billion. But in 2011 investors took back almost all of that money by pulling out $35 billion. The sophisticated and flexible hedge-fund business saw no basic change in its overall assets (including all types of funds).
Within that industry, though, funds are flowing furiously toward the largest managers because people want the tried-and-true, lest they wind up trusting another Bernard Madoff. The assets of the 26 largest hedge funds grew 12.3 percent in the 18 months ended June 30, 2011. Of the total assets added by hedge funds in the first six months of 2011, more than 11 percent went to just one manager, Bridgewater Associates LP.
More assets in the hands of a single manager increase that manager's fees. In the long run, however, fees are linked to performance, and concentration is a drag on performance, as Druckenmiller noted. Huge amounts of money make it harder for managers to stake out unique non- consensus positions. Funds that must deploy huge sums wind up crowded into the same list of assets, overlapping their portfolios.
Diversity of market opinions once meant a wide distribution of fine, granular bets. More and more, a handful of viewpoints dominate the markets. The result is big market swings with small changes in sentiment. Yet most managers are being paid partly to defend their clients from volatility.
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Coincident with financial shocks and poor performance, holes have appeared in the industry's price umbrella. According to the website FINalternatives, new hedge funds' average management fees have been declining and, in the year ending September 2011, were at 1.57 percent of assets versus the standard 2 percent, while performance fees (as a percentage of returns) are running at 17.56 percent (versus the standard 20 percent).
Also telling is the transition of money from mutual funds to exchange-traded funds, which charge lower fees for expenses. Equity mutual funds lost $99 billion of assets in 2011, and $64 billion of that money went right back into exchange traded equity funds. This long-term trend is sucking assets out of mutual funds and jeopardizing their future.
By implication, the whole asset management industry is going to consolidate and shrink; its cost and fee structure will also need to adjust to more competitive levels. Meanwhile, the trend toward lower fees and the preference for larger managers pinch smaller funds even more nastily because of the way these developments interact with the second reason for the industry's fundamental transformation: rising costs.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is one culprit here. It forces more funds to register with regulators; imposes heavy reporting burdens on even small investment advisers; requires compliance officers and programs, and expands asset managers' fraud liability in several areas.
A hedge fund with more than $150 million in assets (small in reality) is considered “large” under Dodd-Frank and is required to have a full-time chief compliance officer and meet other compliance and monitoring obligations. A fund of this size that charged a 2 percent management fee would collect about $3 million to cover all its expenses. Dodd-Frank costs would consume a large and possibly fatal percentage of that.
Dodd-Frank has a lighter impact on large managers. In the big picture, though, the outlook for costs isn't positive for anyone. The pro-regulatory climate suggests rules are more likely to be added than taken away. Meanwhile, the political environment demands austerity, and Congress might respond by imposing transaction taxes, levies on fund managers' performance fees, or other measures designed to be “tough on Wall Street.”
Headwinds
These trends -- too much money concentrated in too few hands, higher costs and downward pressure on fees -- are fundamental enough to reshape the business. But there's yet another factor and its effect is overwhelming.
For more than two decades, the asset management business has enjoyed a tailwind of falling interest rates and growing tolerance for leverage. With the leverage boom that began in the 1980s, falling rates and easier credit standards boosted growth in the global economy. Asset valuations (on which fees are based) increased and new opportunities arose for money managers to devise investment strategies based on leverage. If the passive benefit from falling interest rates and leverage could be backed out of investment returns for the past two decades, a lot of what looked like successful asset management would really be second-rate performance.
We now live in a world where second-rate performers have nowhere to hide. Interest rates are low, but will rise once growth resumes. This is a headwind, not a tailwind.
Consider what it means for money managers to live in a deleveraging world. It may not be universally accepted yet, but in this new era, 4 percent is a good return. This will not justify paying 2 percent of assets as a management fee (to say nothing of 20 percent of returns as performance fees). A similar problem exists for mutual fund companies, most of which have high overhead, including managers who get seven-figure bonuses.
Of course, a really good manager will always be able to earn an honest and lucrative living. They just aren't nearly as numerous as the pretenders. This is why, facing the future, some of the brightest asset managers welcome the thought that the untalented are getting flushed out. For them, the story is, “Apres le deluge, moi.”
--Bloomberg News--
(
Alice Schroeder, the author of “The Snowball: Warren Buffett and the Business of Life” and formerly a top-ranked insurance analyst on Wall Street, is a Bloomberg View columnist. The opinions expressed are her own.)
