Investing in a Rigged Market

The asset management business as we know it today got started in the mid-19th century. The impetus for investment management firms separate from banks arose out of the awkward fact that banks often fail, while asset management firms hardly ever do.

According to Nigel Edward Morecroft, who has studied the history of asset management, firms such as The Foreign and Colonial Government Trust were not only separate from banks, but also pooled their clients’ investments, thus appealing to middle income people, not just the wealthy.

Over the many decades since those days, asset management has become a highly skilled profession. Today there are several hundred thousand investment advisors in the U.S., and of course many thousands more elsewhere in the world. At the top of the profession are folks like Warren Buffett, and at the bottom are guys like that fellow who lives next door to you and has a little sign in his yard.

From the mid-19th century up until about a decade ago, investment managers plied their trade in a world in which, for the most part, markets moved for what we might call “organic” reasons. In other words, the prices of securities reflected basically three things: matters peculiar to the securities themselves and the issuing firms; broad economic conditions; and investor behavior. Of course, all three of those phenomena are mind-bogglingly complex, which is why there has always been a great deal of difference between the best and the worst managers.

Before we take a look at what went wrong with the asset management business, let’s have a few definitions. Some asset managers are like Warren Buffett, people I will call “money managers.” They buy and sell securities and engage in a wide variety of strategies. Even passive investors, like the Vanguard 500 Index Fund, are money managers, but their strategy is to mimic the performance of an index.

In the 1970s, another kind of asset manager arose, firms I’ll call “asset allocators.” The demand for these investment firms arose out of the increasing complexity of the investment business. There are vast numbers of securities that can be bought or sold or sold short, there are vast numbers of money managers (including mutual funds and exchange traded funds), there is a huge variety of market sectors that can be invested in, and there are almost unlimited strategies that can be employed. People needed help designing the right portfolio for their needs, they needed help sorting out money managers and hiring the best of them, and they needed help understanding how their portfolios were performing.

In addition to complexity, there was a legal issue: many large pools of capital were “fiduciary” portfolios, that is, capital that was managed on behalf of someone else. University endowments, pension funds, foundations, and private trusts faced all the complexities mentioned above, but, in addition, if the money was mismanaged the trustees could be surcharged, possibly for very large sums. The most prudent approach was to hire an asset allocator.

Some of the large capital pools could afford to hire internal asset allocators, people usually called chief investment officers. These are the David Swensens (Yale), the Jack Myers (Harvard, though now a money manager), the Scott Malpasses (Notre Dame) of the world. But most pools of capital hired firms called investment consultants (if they advised institutions), wealth managers (if they advised wealthy families), or financial planners (if they advised the so-called “mass affluent”).

The job of money managers is to outperform a benchmark that is selected depending on what the managers are doing. If they are buying small cap stocks their benchmark will be something like the Russell 2000 Index. If they are hedge funds, the benchmark will likely be more complicated, but the manager will still be expected to beat it.

The job of a wealth management firm is, first and foremost, to maximize the risk-adjusted after-tax returns of the client’s total portfolio. Longer term, the goal is to design an investment strategy that will outpace inflation over the very long run, hopefully with a safety margin. Many investors eke out positive returns net of all fees, costs and taxes, but if those returns trail inflation the investor is getting a little poorer every year.

Like money managers, asset allocators are expected to outperform certain benchmarks. For example, wealthy family clients will expect their wealth manager to beat a “naïve” portfolio, that is, a simple stock/bond/cash portfolio that has the same risk as the vastly more complex portfolio the manager has probably designed for the clients. (After all, the clients could simply call up Vanguard and buy the naïve portfolio very cheaply.) Clients will also look at a “custom benchmark,” that is, a benchmark made up of indices in the exact proportion as the clients’ strategic portfolio allocations.

Note that as far as the U.S. regulators are concerned, asset allocators and money managers are both “investment advisors” and, if large enough to be registered with Securities and Exchange Commission, are Registered Investment Advisors (RIAs). However, as noted, the work these two kinds of investment professionals do is fundamentally very different. These apples and oranges fall under the exact same regulatory framework for the simple reason that Congress hasn’t a clue about asset management.

So far, so good. From 1868—the founding of The Foreign and Colonial Government Trust—until 2008, that is, for 14 decades, asset allocators designed client portfolios and money managers bought and sold securities and all this happened on a level playing field. If you were extremely smart and you worked very hard and you controlled your fear and greed and you possessed good insight into the behavior of your fellow humans (i.e., if you were a borderline genius), you did very well. If you were lazy, didn’t know what you were doing, and simply followed the crowd, you brought up the rear. Most asset managers fell in-between, of course.

But this happy world was turned violently on its head in 2008 and it stayed turned on its head for the best part of a decade. This event, which has shaken the asset management world to its foundations, was brought to us courtesy of the world’s central bankers—another group of folks who have no clue about asset management.

Next week we’ll take a look at what the Fed and its clones around the world did, why they did it, and how those actions affected the world of asset management—the very world in which Your Humble Blogger earns his Humble Bread.

Next up: Investing In a Rigged Market, Part II