by David Robertson, CFA
August 2017
We can easily see the effects of changing business models in many aspects of our lives. Where we used to hop in the car to go shopping, we now hop on the internet and order from Amazon. Where we used to get news broadcast out at certain times from TV or radio, now we get news in real-time from a variety of online sources. Where we used to wait in line for a cab, we now pull out our phone to order a car from Uber or Lyft.
A common thread underlying all of these trends is the transition of power away from providers and to consumers. This phenomenon was captured nicely by Jeremy Heimans and Henry Timms in a piece entitled "Understanding 'New Power'" in the Harvard Business Review [here]. They noted, "A new set of values and beliefs is being forged. Power is not just flowing differently, people are feeling and thinking differently about it." While this trend is broad-based, it promises to have an especially large impact on the world of investments.
Heimans and Timms explain that, "Old power works like a currency. It is held by few. Once gained, it is jealously guarded, and the powerful have a substantial store of it to spend." They continue, "Old power is enabled by what people or organizations own, or control that nobody else does ..."
In stark contrast to "old power", the authors describe, "New power operates differently, like a current. It is made by many. It is open, participatory, and peer-driven. It uploads and it distributes. Like water or electricity, it is most powerful when it surges. The goal with new power is not to hoard it, but to channel it."
Of the two, the investment industry is characterized better by old power. Traders and money managers "jealously guard" proprietary models. Brokers, advisers, and consultants, who control client relationships, can command substantial fees for intermediating clients with various investments or services. Access to markets and/or certain services are often "held by a few" who charge a premium for it.
Given this context, it is not hard to understand why many investors are less than completely satisfied with the value they receive from their investment services. Active management, in particular, has received special scorn in regards to unnecessarily high fees and the inability of smaller investors to negotiate more constructive relationships. Investors have voted with their feet as the active management industry has suffered outflows of hundreds of billions of dollars per year while passive funds have received a huge chunk of those flows.
While many active managers have deserved this fate by being inattentive to their clients' needs, it is also true that many investors are leaving active funds more out of protest than out of strong advocacy for the alternative. This is consistent with broader trends: "Public polls reflect the shifting attitudes toward established institutions. For example, the 2014 Edelman Trust Barometer shows the largest deficit in trust in business and government since the survey began in 2001." Consumers of all types are feeling increasingly empowered to terminate services that don't work well for them.
In fact, new power works especially well in harnessing the power of large scale dissatisfaction. A prominent global example was the Arab Spring political movement. The movement arose from large numbers of citizens who were frustrated by their inability to participate in closed governmental regimes. Participants were able to coordinate their protests through social media and channel the power of their numbers to great effect.
While new power can be effective in breaking away from old regimes of control, this only gets things half right. The other side of the coin of new power is that it often falls far short of creating something better in its stead. Because the "unaffiliated nature of new power makes it hard to focus", this is a severe shortcoming when it comes to endeavors that require a great deal of attention to detail, such as most professional services. After all, who would want to have a fully participatory appendectomy? Or have their legal defense mounted by a flash mob? Or have their money managed by a random group of people?
These examples are obviously extremes but they highlight the fact that some knowledge and skills really are valuable because they are both scarce and useful. This is a reality that often gets overlooked in regards to active money management. Far more than just providing access to the market, active managers also engage in a wide array of research, manage risk, provide market commentary, and often discuss market insights and their implications for different types of investors. Collectively, these services can be hugely important in ensuring the desired results from investment activity. If power is, as the authors quote Bertrand Russell, "the ability to produce intended effects", and the intended effects from investing require at least some proprietary skills, then there is a place for certain forms of old power.
But what is the right balance between old power and new power? The argument for new power gets weaker as the need for special skills increases and the argument for old power gets weaker as the need for cheap and easy access increases. As a result, the most vulnerable providers are those who have relied on proprietary access. For example, when the main way to get access to a diversified stock portfolio was by hiring an active manager, that manager could charge a "toll" for the access. It didn't matter if the manager added much or any value in security selection or portfolio construction because it would have been even more expensive for most investors to acquire those positions individually. Now, if investors just want diversified stock exposure, it is cheaper and easier to acquire it through an index fund. This poses an existential threat to managers who "closet index" or otherwise fail to distinguish the value they add.
The argument for old power is also weak for providers who charge ongoing fees applied to assets under management (AUM) for what is essentially a one-time investment in knowledge. Although education, knowledge, and experience are all important in developing a strong sense of financial literacy, they do not represent an ongoing effort to research and analyze companies and markets or a risk of capital. As such, the fee structures for much of the work of advisers and consultants (such as providing basic asset allocation formulas) is much more appropriately based on an hourly rate - just as it is for comparable professionals such as accountants and lawyers. This disconnect between price and value is exactly why fintech and roboadvisors have made such substantial inroads into these types of services.
An important factor in progressing towards a better balance between old and new power is likely to be that of collaboration. Heimans and Timms note, "New power models ... reinforce the human instinct to cooperate (rather than compete) by rewarding those who share their own ideas, spread those of others, or build on existing ideas to make them better ..." Because so many old power firms are built around the concept of competition, this is likely to be difficult for many. Conversely, firms with proprietary knowledge and skills that can leverage those by working with others are likely to manage the transition well. Regardless, it is clear that there is a lot of room for improvement across the spectrum of investment services. This is an issue we discuss in much greater detail in a newly published white paper [here].
In conclusion, there are several implications from Heimans and Timms' analysis of power. One is that an important aspect of new power is that it demonstrates "a heightened sense of human agency". In other words, it is really important for people to feel as if they can express their individual power. As the authors note, "Today people increasingly expect to actively shape or create many aspects of their lives." Sometimes this can be manifested by the simple refusal of being dictated to. As a result, incumbent providers who have overreached in leveraging their position of control can be vulnerable even if robust substitutes don't exist.
Another implication is that new power provides a special threat to old power because "once old power models lose that [what they own or control that nobody else does], they lose their advantage". In other words, the damage can be irreversible. Further, the digital economy effectively represents a constant, pounding effort to remove barriers to access by increasing distribution efficiency. Whether items of control are relationships, knowledge, access, or material goods, they will be far harder to protect against these forces. Think of Amazon displacing bookstores as the controllers of local book distribution or Netflix or YouTube disrupting cable companies as local gatekeepers to video content. It is not an overstatement to say this presents an existential threat to much of the investment industry.
Yet another important implication of these trends in relation to investing extends beyond services to the stock market itself. When money moves from an actively managed fund to a passively managed fund, on the margin, it increases demand for bigger stocks that are major components in indexes and reduces demand for prior holdings. This happens automatically, regardless of the prices of the stocks. As a result, the dogmatic movement away from active management and towards passive management merely replaces one shortcoming for another. High fees are replaced by a complete abdication of price discipline and risk management.
This goes a long way in explaining the persistently high valuations in today's markets. We know from Robert Shiller's research that stock prices are affected by factors other than just underlying economic fundamentals. Shiller demonstrated [here] that, "The volatility of the stock market was greater than could be plausibly explained by any rational view of the future." It is also true that most non-rational views are related to behavioral causes such as overreaction to dramatic events.
As such, it distinctly appears as if a major cause of ever-rising market indexes is not economic fundamentals, which are not that strong, but rather a strong enough aversion to active management to override "any rational view of the future." If lofty valuations are more a function of dissatisfaction with active management and less a function of economic fundamentals, as they appear to be, then look out below when the consequences of losses become all too real. It wouldn't be the first time that enthusiastic aversion to a regime of control resulted in something even worse.
Finally, the consumers (and investors) who will fare the best in the struggle between old power and new power will be those who actively participate in rejecting services that don't offer good value and in researching and exploring new ones that do. By way of example, the authors describe what they call the DIO (do it ourselves) movement: "The heroes in new power are 'makers' who produce their own content, grow their own food, or build their own gadgets." While most people can't, and probably shouldn't, manage every aspect of their investments, the trend towards greater participation and greater control since the financial crisis makes perfect sense. For everyone who is willing and able to so, more power to you!
August 2017
We can easily see the effects of changing business models in many aspects of our lives. Where we used to hop in the car to go shopping, we now hop on the internet and order from Amazon. Where we used to get news broadcast out at certain times from TV or radio, now we get news in real-time from a variety of online sources. Where we used to wait in line for a cab, we now pull out our phone to order a car from Uber or Lyft.
A common thread underlying all of these trends is the transition of power away from providers and to consumers. This phenomenon was captured nicely by Jeremy Heimans and Henry Timms in a piece entitled "Understanding 'New Power'" in the Harvard Business Review [here]. They noted, "A new set of values and beliefs is being forged. Power is not just flowing differently, people are feeling and thinking differently about it." While this trend is broad-based, it promises to have an especially large impact on the world of investments.
Heimans and Timms explain that, "Old power works like a currency. It is held by few. Once gained, it is jealously guarded, and the powerful have a substantial store of it to spend." They continue, "Old power is enabled by what people or organizations own, or control that nobody else does ..."
In stark contrast to "old power", the authors describe, "New power operates differently, like a current. It is made by many. It is open, participatory, and peer-driven. It uploads and it distributes. Like water or electricity, it is most powerful when it surges. The goal with new power is not to hoard it, but to channel it."
Of the two, the investment industry is characterized better by old power. Traders and money managers "jealously guard" proprietary models. Brokers, advisers, and consultants, who control client relationships, can command substantial fees for intermediating clients with various investments or services. Access to markets and/or certain services are often "held by a few" who charge a premium for it.
Given this context, it is not hard to understand why many investors are less than completely satisfied with the value they receive from their investment services. Active management, in particular, has received special scorn in regards to unnecessarily high fees and the inability of smaller investors to negotiate more constructive relationships. Investors have voted with their feet as the active management industry has suffered outflows of hundreds of billions of dollars per year while passive funds have received a huge chunk of those flows.
While many active managers have deserved this fate by being inattentive to their clients' needs, it is also true that many investors are leaving active funds more out of protest than out of strong advocacy for the alternative. This is consistent with broader trends: "Public polls reflect the shifting attitudes toward established institutions. For example, the 2014 Edelman Trust Barometer shows the largest deficit in trust in business and government since the survey began in 2001." Consumers of all types are feeling increasingly empowered to terminate services that don't work well for them.
In fact, new power works especially well in harnessing the power of large scale dissatisfaction. A prominent global example was the Arab Spring political movement. The movement arose from large numbers of citizens who were frustrated by their inability to participate in closed governmental regimes. Participants were able to coordinate their protests through social media and channel the power of their numbers to great effect.
While new power can be effective in breaking away from old regimes of control, this only gets things half right. The other side of the coin of new power is that it often falls far short of creating something better in its stead. Because the "unaffiliated nature of new power makes it hard to focus", this is a severe shortcoming when it comes to endeavors that require a great deal of attention to detail, such as most professional services. After all, who would want to have a fully participatory appendectomy? Or have their legal defense mounted by a flash mob? Or have their money managed by a random group of people?
These examples are obviously extremes but they highlight the fact that some knowledge and skills really are valuable because they are both scarce and useful. This is a reality that often gets overlooked in regards to active money management. Far more than just providing access to the market, active managers also engage in a wide array of research, manage risk, provide market commentary, and often discuss market insights and their implications for different types of investors. Collectively, these services can be hugely important in ensuring the desired results from investment activity. If power is, as the authors quote Bertrand Russell, "the ability to produce intended effects", and the intended effects from investing require at least some proprietary skills, then there is a place for certain forms of old power.
But what is the right balance between old power and new power? The argument for new power gets weaker as the need for special skills increases and the argument for old power gets weaker as the need for cheap and easy access increases. As a result, the most vulnerable providers are those who have relied on proprietary access. For example, when the main way to get access to a diversified stock portfolio was by hiring an active manager, that manager could charge a "toll" for the access. It didn't matter if the manager added much or any value in security selection or portfolio construction because it would have been even more expensive for most investors to acquire those positions individually. Now, if investors just want diversified stock exposure, it is cheaper and easier to acquire it through an index fund. This poses an existential threat to managers who "closet index" or otherwise fail to distinguish the value they add.
The argument for old power is also weak for providers who charge ongoing fees applied to assets under management (AUM) for what is essentially a one-time investment in knowledge. Although education, knowledge, and experience are all important in developing a strong sense of financial literacy, they do not represent an ongoing effort to research and analyze companies and markets or a risk of capital. As such, the fee structures for much of the work of advisers and consultants (such as providing basic asset allocation formulas) is much more appropriately based on an hourly rate - just as it is for comparable professionals such as accountants and lawyers. This disconnect between price and value is exactly why fintech and roboadvisors have made such substantial inroads into these types of services.
An important factor in progressing towards a better balance between old and new power is likely to be that of collaboration. Heimans and Timms note, "New power models ... reinforce the human instinct to cooperate (rather than compete) by rewarding those who share their own ideas, spread those of others, or build on existing ideas to make them better ..." Because so many old power firms are built around the concept of competition, this is likely to be difficult for many. Conversely, firms with proprietary knowledge and skills that can leverage those by working with others are likely to manage the transition well. Regardless, it is clear that there is a lot of room for improvement across the spectrum of investment services. This is an issue we discuss in much greater detail in a newly published white paper [here].
In conclusion, there are several implications from Heimans and Timms' analysis of power. One is that an important aspect of new power is that it demonstrates "a heightened sense of human agency". In other words, it is really important for people to feel as if they can express their individual power. As the authors note, "Today people increasingly expect to actively shape or create many aspects of their lives." Sometimes this can be manifested by the simple refusal of being dictated to. As a result, incumbent providers who have overreached in leveraging their position of control can be vulnerable even if robust substitutes don't exist.
Another implication is that new power provides a special threat to old power because "once old power models lose that [what they own or control that nobody else does], they lose their advantage". In other words, the damage can be irreversible. Further, the digital economy effectively represents a constant, pounding effort to remove barriers to access by increasing distribution efficiency. Whether items of control are relationships, knowledge, access, or material goods, they will be far harder to protect against these forces. Think of Amazon displacing bookstores as the controllers of local book distribution or Netflix or YouTube disrupting cable companies as local gatekeepers to video content. It is not an overstatement to say this presents an existential threat to much of the investment industry.
Yet another important implication of these trends in relation to investing extends beyond services to the stock market itself. When money moves from an actively managed fund to a passively managed fund, on the margin, it increases demand for bigger stocks that are major components in indexes and reduces demand for prior holdings. This happens automatically, regardless of the prices of the stocks. As a result, the dogmatic movement away from active management and towards passive management merely replaces one shortcoming for another. High fees are replaced by a complete abdication of price discipline and risk management.
This goes a long way in explaining the persistently high valuations in today's markets. We know from Robert Shiller's research that stock prices are affected by factors other than just underlying economic fundamentals. Shiller demonstrated [here] that, "The volatility of the stock market was greater than could be plausibly explained by any rational view of the future." It is also true that most non-rational views are related to behavioral causes such as overreaction to dramatic events.
As such, it distinctly appears as if a major cause of ever-rising market indexes is not economic fundamentals, which are not that strong, but rather a strong enough aversion to active management to override "any rational view of the future." If lofty valuations are more a function of dissatisfaction with active management and less a function of economic fundamentals, as they appear to be, then look out below when the consequences of losses become all too real. It wouldn't be the first time that enthusiastic aversion to a regime of control resulted in something even worse.
Finally, the consumers (and investors) who will fare the best in the struggle between old power and new power will be those who actively participate in rejecting services that don't offer good value and in researching and exploring new ones that do. By way of example, the authors describe what they call the DIO (do it ourselves) movement: "The heroes in new power are 'makers' who produce their own content, grow their own food, or build their own gadgets." While most people can't, and probably shouldn't, manage every aspect of their investments, the trend towards greater participation and greater control since the financial crisis makes perfect sense. For everyone who is willing and able to so, more power to you!
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