| Arete Insights Q314.pdf |
Welcome
As I mentioned in the last quarterly report, a key competitive advantage for Arete has been the strategic integration and implementation of technology. This serves many higher goals not least of which is to keep expenses down for our clients. In addition, the thoughtful application of technology has also vastly improved nearly every aspect of Arete's operations including increasing the efficiency of various administrative processes, reducing error rates, and improving the entire process of building and manufacturing knowledge.
With this as context, it should be no surprise that we are again in the process of leveraging technology to improve our services. As many of you are aware by now, we have created a blog to share much of our commentary with you.
This move is designed to achieve a couple of things. First and foremost, we have heard from a number of readers that while they enjoy the content, there is just too much to comfortably read in one sitting. Not only will the blog format make the content available in more digestible pieces, but it will also enable us to reach a broader audience on a more regular basis.
In addition, we will be building out the “Learn” section of the website to highlight various lessons and insights that we believe can help investors better navigate the landscape for investing as well as that for evaluating investment services. Hopefully this will also provide some useful background as to how we think through various issues and challenges.
As a consequence of these changes, we are discontinuing publication of Arete Insights so this will be the last edition. We will continue to provide all of the content we have normally provided in Insights, as well as all of the content categories, but these pieces will now be distributed through blog posts. We will also retain the Insights archives on the website as reference material
In addition, The Arete Quarterly letter will be significantly abbreviated and will focus much more specifically on numbers and portfolio commentary. Broader commentary about the markets, the investment management business and other content will be shifted to the blog format.
Finally, for everyone who reads our commentary and stays in touch with our work, thanks for your attention, your feedback, and your continued support. We appreciate it!
David Robertson, CFA
CEO, Founder
As I mentioned in the last quarterly report, a key competitive advantage for Arete has been the strategic integration and implementation of technology. This serves many higher goals not least of which is to keep expenses down for our clients. In addition, the thoughtful application of technology has also vastly improved nearly every aspect of Arete's operations including increasing the efficiency of various administrative processes, reducing error rates, and improving the entire process of building and manufacturing knowledge.
With this as context, it should be no surprise that we are again in the process of leveraging technology to improve our services. As many of you are aware by now, we have created a blog to share much of our commentary with you.
This move is designed to achieve a couple of things. First and foremost, we have heard from a number of readers that while they enjoy the content, there is just too much to comfortably read in one sitting. Not only will the blog format make the content available in more digestible pieces, but it will also enable us to reach a broader audience on a more regular basis.
In addition, we will be building out the “Learn” section of the website to highlight various lessons and insights that we believe can help investors better navigate the landscape for investing as well as that for evaluating investment services. Hopefully this will also provide some useful background as to how we think through various issues and challenges.
As a consequence of these changes, we are discontinuing publication of Arete Insights so this will be the last edition. We will continue to provide all of the content we have normally provided in Insights, as well as all of the content categories, but these pieces will now be distributed through blog posts. We will also retain the Insights archives on the website as reference material
In addition, The Arete Quarterly letter will be significantly abbreviated and will focus much more specifically on numbers and portfolio commentary. Broader commentary about the markets, the investment management business and other content will be shifted to the blog format.
Finally, for everyone who reads our commentary and stays in touch with our work, thanks for your attention, your feedback, and your continued support. We appreciate it!
David Robertson, CFA
CEO, Founder
The "system"
If there is just one message I could shout from the mountaintop as advice regarding how to be a good consumer of investment services, it would be to look outside of the “system”. By “system” I mean the eco-system of large banks, brokerage houses, investment firms, mutual fund companies, advisory services, et al. The key word here is large.
There are important caveats to this sweeping statement to be sure, but the important thing to understand is that the “system” is not well designed to efficiently leverage investment expertise for the benefit of clients. There isn’t a dispute about the existence of such expertise; indeed there are a great many smart and talented individuals in the industry.
The bigger questions are: What is the expertise worth? How much do you really benefit from it? Do benefits outweigh the costs? Many firms claim advantages in particular expertise, but they all come with a price tag. While it is very difficult to assess the value of services provided, it is also critical to do so to make sure that you have a fair chance to get ahead with your investing. Unfortunately, the evidence is overwhelming that you don’t get good value.
For example, one of the most egregious trends in the industry is that towards higher fees. Yes, higher. As virtually all of the major costs of managing money have come down dramatically – computing costs, telecom, information and data – the industry as a whole has been raising fees. Charles Ellis provided a nice historical summary in the Financial Analysts Journal in “The Rise and Fall of Performance Investing”.
One of the cost categories for investing that has deviated from prevailing trends in other industries is that for distribution. In a world where consumers are so much better off due to the successes of companies like Walmart, Amazon, Netflix, and Yelp in reducing inefficient and unnecessary distribution costs, such costs in the investment world are actually increasing.
Gillian Tett and Kate Burgess describe in the Financial Times article, “Costly Cogs, misfiring machine”: “Unease is widespread about the very structure of the industry. While in much of the western business world the trend has been to remove middlemen, investing has gone the opposite direction. Not only did the sector expand at a startling rate in recent decades but the ‘investment chain’ that links those supplying capital with the people who ultimately use it has become fiendishly complex, riddled with agents creaming off fees along the way.”
The Economist picks up on the same phenomenon in “Too big for its Gucci boots”: “Every agent takes a cut in the form of a spread or commission. But because financial products are complex or long-term in nature, the client may not realize the worst until it is too late. The finance sector is thus able to earn a high level of ‘rent’ at the expense of its customers.”
While much of the “rent” comes at the expense of investors, some of it also reflects the balance of power within the industry and comes at the expense of other industry participants. This dynamic is described in “Ten trends that will reshape the fund industry”. Robert Huebscher reports, “The distribution channels are demanding more revenue sharing … and in the process they are compressing the earnings that managers make on their funds.” He continues, “If you want access, you have to pay for it.” In other words large distribution platforms are leveraging their market position to extract disproportionate revenues from fund managers.
While these qualitative descriptions tell a disheartening story about structure of the investment industry (aka, the “system”), Sophia Grene at the Financial Times quantifies the costs in the article “BCG predicts 30% wage cut”. According to the work of Andy Maguire, a senior partner at BCG, “industry participants [in asset management] have been used to earning 1.7 times what they might have earned in other professions with similar levels of qualification.”
In short, investment professionals earn more than they can doing just about anything else and those excess earnings come right out of their client’s assets. As such, these excess earnings serve no socially useful purpose but rather serve as a tax which constantly erodes the wealth of their clients.
One might argue that this account is an exaggeration. After all, there is a free market for investment services and people have lots of choices. But this is deceptive and naive. A far more accurate illustration is the one provided by Michael Lewis in Flash Boys which I mentioned in The Arete Quaterly Q114.
In respect to the exchanges Lewis notes, “The deep problem with the system was a kind of moral inertia. So long as it served the narrow interests of everyone inside it, no one on the inside would ever seek to change it.” He adds, “It wasn’t easy … to try to effect some practical change without a great deal of fuss, when the change in question was, when you get right down to it, a radical overhaul of a social order.” Lewis’ conclusion, and one that applies just as well to the financial services industry as a whole, is that the system is rigged.
So what should investors do? To be sure I am not advocating complete avoidance of the industry or of large firms. There are lots of smart and well-intended professionals that provide valuable services. In addition, many commodity services like custody, discount brokerage, and index funds, to name a few, actually do share the cost benefits that accrue to scale with their clients.
Size is far less important, and in many ways detrimental, however, when the nature of the service involves extremely specialized knowledge, good communication, and strong alignment with your goals. In areas such as wealth management and active money management investors would be well served to look outside of the system to smaller and independently owned organizations that have stronger incentives to serve clients than to extract excess fees.
Finally, if a “radical overhaul of the social order” is to take place in investment services, new providers with better value propositions can only do so much. Ultimately, their success or failure will depend on the willingness of investors to look outside of the system for help. Until then, high fees and excess compensation will persist.
If there is just one message I could shout from the mountaintop as advice regarding how to be a good consumer of investment services, it would be to look outside of the “system”. By “system” I mean the eco-system of large banks, brokerage houses, investment firms, mutual fund companies, advisory services, et al. The key word here is large.
There are important caveats to this sweeping statement to be sure, but the important thing to understand is that the “system” is not well designed to efficiently leverage investment expertise for the benefit of clients. There isn’t a dispute about the existence of such expertise; indeed there are a great many smart and talented individuals in the industry.
The bigger questions are: What is the expertise worth? How much do you really benefit from it? Do benefits outweigh the costs? Many firms claim advantages in particular expertise, but they all come with a price tag. While it is very difficult to assess the value of services provided, it is also critical to do so to make sure that you have a fair chance to get ahead with your investing. Unfortunately, the evidence is overwhelming that you don’t get good value.
For example, one of the most egregious trends in the industry is that towards higher fees. Yes, higher. As virtually all of the major costs of managing money have come down dramatically – computing costs, telecom, information and data – the industry as a whole has been raising fees. Charles Ellis provided a nice historical summary in the Financial Analysts Journal in “The Rise and Fall of Performance Investing”.
One of the cost categories for investing that has deviated from prevailing trends in other industries is that for distribution. In a world where consumers are so much better off due to the successes of companies like Walmart, Amazon, Netflix, and Yelp in reducing inefficient and unnecessary distribution costs, such costs in the investment world are actually increasing.
Gillian Tett and Kate Burgess describe in the Financial Times article, “Costly Cogs, misfiring machine”: “Unease is widespread about the very structure of the industry. While in much of the western business world the trend has been to remove middlemen, investing has gone the opposite direction. Not only did the sector expand at a startling rate in recent decades but the ‘investment chain’ that links those supplying capital with the people who ultimately use it has become fiendishly complex, riddled with agents creaming off fees along the way.”
The Economist picks up on the same phenomenon in “Too big for its Gucci boots”: “Every agent takes a cut in the form of a spread or commission. But because financial products are complex or long-term in nature, the client may not realize the worst until it is too late. The finance sector is thus able to earn a high level of ‘rent’ at the expense of its customers.”
While much of the “rent” comes at the expense of investors, some of it also reflects the balance of power within the industry and comes at the expense of other industry participants. This dynamic is described in “Ten trends that will reshape the fund industry”. Robert Huebscher reports, “The distribution channels are demanding more revenue sharing … and in the process they are compressing the earnings that managers make on their funds.” He continues, “If you want access, you have to pay for it.” In other words large distribution platforms are leveraging their market position to extract disproportionate revenues from fund managers.
While these qualitative descriptions tell a disheartening story about structure of the investment industry (aka, the “system”), Sophia Grene at the Financial Times quantifies the costs in the article “BCG predicts 30% wage cut”. According to the work of Andy Maguire, a senior partner at BCG, “industry participants [in asset management] have been used to earning 1.7 times what they might have earned in other professions with similar levels of qualification.”
In short, investment professionals earn more than they can doing just about anything else and those excess earnings come right out of their client’s assets. As such, these excess earnings serve no socially useful purpose but rather serve as a tax which constantly erodes the wealth of their clients.
One might argue that this account is an exaggeration. After all, there is a free market for investment services and people have lots of choices. But this is deceptive and naive. A far more accurate illustration is the one provided by Michael Lewis in Flash Boys which I mentioned in The Arete Quaterly Q114.
In respect to the exchanges Lewis notes, “The deep problem with the system was a kind of moral inertia. So long as it served the narrow interests of everyone inside it, no one on the inside would ever seek to change it.” He adds, “It wasn’t easy … to try to effect some practical change without a great deal of fuss, when the change in question was, when you get right down to it, a radical overhaul of a social order.” Lewis’ conclusion, and one that applies just as well to the financial services industry as a whole, is that the system is rigged.
So what should investors do? To be sure I am not advocating complete avoidance of the industry or of large firms. There are lots of smart and well-intended professionals that provide valuable services. In addition, many commodity services like custody, discount brokerage, and index funds, to name a few, actually do share the cost benefits that accrue to scale with their clients.
Size is far less important, and in many ways detrimental, however, when the nature of the service involves extremely specialized knowledge, good communication, and strong alignment with your goals. In areas such as wealth management and active money management investors would be well served to look outside of the system to smaller and independently owned organizations that have stronger incentives to serve clients than to extract excess fees.
Finally, if a “radical overhaul of the social order” is to take place in investment services, new providers with better value propositions can only do so much. Ultimately, their success or failure will depend on the willingness of investors to look outside of the system for help. Until then, high fees and excess compensation will persist.
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