A Manifesto for Giant (and tiny?) Funds
When we look at mutual funds, hedge funds, and most of the money management industry we see an awful lot of offerings that do not present good value to end investors. Legendary investor Warren Buffett provided a similar, and characteristically folksy, assessment of the industry: “There is so much that’s false and nutty in modern investing practice . . . If you just reduced the nonsense, that’s a goal you should reasonably hope for.”
Interestingly, we recently came across a fascinating article in the Economist which addressed this very issue of “nonsense.” Specifically, the piece described the efforts of Paul Woolley, a former fund manager, to study the dysfunctionality of capital markets. In fact, he set up think tanks at both the London School of Economics and the University of Toulouse to study the issues further.
Woolley presented his findings in a doctrine entitled “A Manifesto for Giant Funds” (http://www.lse.ac.uk/collections/paulWoolleyCentre/). Woolley lists several tenets of a reasonable investment program in his manifesto which include long-term orientation, avoidance of performance fees, and avoidance of alternative assets such as hedge funds and private equity.
His argument is that since very large funds such as pensions, endowments, and others, in aggregate, represent such a large share of global wealth that they are engaged in a zero-sum game for outperformance. As a group, by definition, they cannot outperform the market. To the extent that large plans dole out performance incentives to certain managers to try, these fees simply represent economic rents that accrue to the finance industry at the expense of investment plan beneficiaries.
Some elements of Woolley’s thesis are no doubt controversial, but its main thrust is not: Investment fiduciaries should exercise great care to preserve the wealth of beneficiaries by scrutinizing the fees and costs of their investment management vendors. Anything short of such an effort means wealth is being transferred from beneficiaries to the financial services industry.
Two things strike us about Woolley’s manifesto. First, it provides an eminently sensible foundation for any investment policy — for institutions and individuals. Having a long-term investment horizon, maintaining low turnover, demanding fair fees from managers, and eschewing “alternative” investment vehicles are all actions that can go a long way towards “reducing the nonsense.”
The second thing that strikes us is that the prescriptions Woolley makes are nearly identical to Arete’s value proposition. This is no coincidence. We have no desire to use our knowledge and experience of investing to redistribute others’ wealth to ourselves. If we did, we would have had no need to create Arete; plenty of other shops are quite efficient at redistribution. Rather, we try to provide an honest, valuable service for a fair price — which should fit in very neatly with a lot of well-reasoned investment plans.
Before I founded Arete, I used to marvel at how many mutual funds, hedge funds, and other investment vehicles there were for investors to choose from. I used to marvel even more at how few offered a good value to their investors. I measured value in simple ways. Was it something I would want to invest in? Would I feel comfortable recommending it to a friend or family member?
I still feel the same way, enough so to make the enormous commitment of founding Arete. Arete’s value proposition is to offer a sound investment philosophy and process which can really outperform, to avoid conflicts of interest, to be very transparent in disclosures and communication, and to offer it all at a very fair price. I am very happy to report that this proposition seems to resonate deeply with people who have done their research and who understand the business well.
I believe this proposition is becoming ever more valuable to investors of all types. The reason it is becoming more valuable is because the investment landscape has changed over the last several years and in the process, has changed the relative value of the proposition.
In order to appreciate the change, let’s look at some history. Following the bear market bottom in 1982, equity investing was a land of plenty. Valuations were excessively low and the specter of inflation was high. Over time, globalization provided large pools of cheap labor which kept prices down, concerns about inflation receded, and we entered “the Great Moderation.”
During that time, consistent outsized equity returns rapidly built wealth for many people. Those outsized returns also covered a lot of mistakes, though, and smoothed over a lot of expensive money management fees.
The next seven to ten years looks to be considerably different in what Mohammed El Erian has described as the “New Normal.” This landscape looks to provide very little if any stock market appreciation and will be further complicated by more “bumps in the road” than we are accustomed to.
Insofar as this outlook is reasonable, and I believe it is, it has at least two very serious implications for investors of all types. I don’t believe either of these is fully appreciated.
First, plans which are underfunded, and many are, will not be able to rely on the market to bail them out. They will need to increase contributions, reduce liabilities, or both. If the effort is not made to match assets with liabilities, the plans will fail to provide adequately for beneficiaries and therefore fail their only mission.
Second, just as most of us do when our budget gets squeezed, investors will need to increase scrutiny of costs. Can some investment activities be done more cheaply in-house? Are we getting a good value from our vendors? How much are we even spending? These costs — for management fees, consultants, brokers, financial planners, etc. can easily surpass 2% of assets under management (AUM) and can be even higher for individuals.
The trouble is, if market returns are near zero over the next ten years, and costs are 2% (for sake of argument), all of this “help” is going to eclipse returns and whittle away at assets. Investors will be left worse off than they are now.
This is a key point. As the investment landscape has changed from a “land of plenty” to a “bumpy road”, the importance of the value proposition of investment service providers has increased from a modest curiosity to an economic necessity. I very much appreciate the difficult decisions investors face — so much so, in fact, that I built Arete to help investors navigate the difficult investment terrain.
If you or someone you know is not satisfied with the investment options you are finding, please let me know. I would love to see if Arete can help.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Last quarter we noted that, “While conditions are improving in the US, we are concerned about the complacency the market has exhibited toward a rather large number of risks.” This quarter a number of those risks became more evident to the market and got discounted fairly quickly and severely.
In the US, housing starts sank after tax breaks expired and job growth remained anemic. Regulation continued to be on top of investors’ minds, but this time the target was financial services rather than healthcare. Investors barely got a breather from one set of uncertainty before having to transition to another.
In Europe, sovereign debt issues captured the attention of investors along with the implications for slower growth. As events unfolded, weaknesses in the governance and structure of the European Union were exposed which also increased uncertainty. Further east, China’s economy slowed which oddly may have been the only condition scarier than that of China’s economy overheating.
As if there weren’t enough cross-currents to make investors a bit seasick, trading volumes drifted downward as we entered the summer months. Amid lower volume, many price movements were exaggerated far beyond underlying long-term fundamentals. If nothing else, it is clear that the market is still being driven by “narratives” with the dominant narrative currently being deflation.
Due to low volumes and high volatility, there has been a lot of noise in the market and not a lot of real information content. In that context, one of the most useful insights we have heard came from distinguished value investor, Seth Klarman, at the CFA Annual Conference in May. He described the markets as “Hostess Twinkie markets” based on the key factor that there is such a high level of government intervention in so many critical areas of the economy right now. In his view, the markets are currently comprised almost entirely of artificial ingredients and as such, nobody really knows what things will look like when the intervention ceases.
We believe Mr. Klarman’s comments suggest an appropriate course of action as well as any: Don’t read much into short-term volatility and be sure to plan through the various scenarios of returning to a normal economic “diet”.