Money Managers Aren’t Dead
(Bloomberg Businessweek) -- “Many academics have concluded that the value of investment advice is virtually zero,” Princeton economists William Baumol and Burton Malkiel wrote in 1968. “There seems to be no evidence that the selections of professional investment men are superior to selections that are made by throwing darts at the Wall Street Journal.”
This was at the time a fringe belief outside the ivory tower. The booming U.S. mutual fund industry, led by Fidelity Investments, had quintupled in size over the previous decade on the promise of market-beating returns and the reality of a long bull market. While the bear market that followed shrank the industry by a third, most were dismissive in 1976 when John Bogle’s Vanguard Group Inc. launched the first fund for retail investors that took the academic skepticism about investment management to heart and simply aimed to track the performance of the Standard & Poor’s 500-stock index. “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns,” said Ned Johnson, then near the start of his long run as Fidelity’s chief executive officer, to the Boston Globe.
He was wrong about that. About 45 percent of U.S. equity fund assets are now passively managed, according to Morningstar Inc., with the share expected to pass 50 percent in the next few years. Vanguard’s Total Stock Market Index Fund is the largest mutual fund in the U.S., and Fidelity’s own 500 Index Fund is the largest fund at Fidelity. And now, in a twist, Fidelity has decided to charge exactly nothing for a couple of its index funds. Baumol and Malkiel were right! The value of investing advice is zero!
Yet Fidelity is bigger and more profitable than ever, as is the asset management industry in general: If you include pension funds and insurance companies, Federal reserve data show, it now has more than $51 trillion under management in the U.S., or about 250 percent of gross domestic product. In 1968 that ratio was 80 percent. Meanwhile, Malkiel—a former Vanguard board member and author of the investing classic A Random Walk Down Wall Street—is receiving nonzero remuneration as chief investment officer at robo-investor Wealthfront Corp.
How is it that asset managers are still such a prominent, profitable part of the landscape? One explanation is that a lot of money managers are still selling investors on the idea that they can beat the market. In big U.S. stocks this has gotten to be quite a suspect claim—according to S&P Dow Jones Indices, only 15.7 percent of large-cap managers outperformed the S&P 500 in the five years ended last December. But as AQR Capital Management LLC, a firm that straddles the line between active and passive, found when it sorted through two decades of performance data earlier this year, the professionals did appear to beat the indexes “outside the United States and more generally in ‘dusty corners’ of financial markets.”
Another, perhaps more important answer is that asset managers have an economic role to play even if they can’t assemble market-beating portfolios. “There are lots of services that can be provided that aren’t stockpicking,” says Malkiel. At Wealthfront, a 0.25 percent annual fee pays for diversification among index funds and exchange-traded funds covering different asset classes, portfolio rebalancing as periods of outperformance or underperformance push allocations out of whack, and tax-loss harvesting to minimize capital-gains taxes. “An individual could certainly do all that,” Malkiel says, “but most of them don’t know the difference between a stock and a bond.” Are these services worth the price? That’s hard to say, but they definitely weren’t available that cheap 50 years ago. In the words of index pioneer Bogle, “there are certainly a lot better choices” available for individual investors now.
I’d called Bogle because he’s the author of perhaps the clearest outline of the economic role of the asset manager that I’ve ever read: his 1951 Princeton senior thesis, “The Economic Role of the Investment Company.” It focused on mutual funds—which under the U.S. law that governs their behavior are called investment companies—but its description of their three main economic roles applies to all asset managers:
1. Providing useful services to individual investors, which in the view of the ahead-of-his-time Bogle were less about beating the market (“The funds can make no claim to superiority over the market averages”) than diversification and steady-handedness;
2. Influencing corporate management to make better decisions; and
3. Stabilizing markets.
I’ve already devoted a lot of attention to No. 1, but it’s actually the other two roles of the asset manager that have come in for the most questioning as indexing has risen in popularity.
One way professional asset managers influence corporate managers is by bidding share prices up and down. In an influential 1976 paper, economists Michael Jensen and William Meckling proposed that these efforts were “socially productive” even if they didn’t result in market-beating returns. If index funds’ market share rose to 100 percent, it would put an end to this monitoring and setting of stock prices, which would be a bad thing. But it would likely have to rise a lot higher than 45 percent—Malkiel says he thinks the threshold is 95 percent—before starting to cause problems.
What Bogle had in mind in 1951, meanwhile, was direct monitoring by voting in corporate elections and nudging management, and he says he’s been encouraged by the increasing focus on corporate governance at Vanguard and its fellow index giant BlackRock Inc. “What I predicted in my thesis all those years ago is coming true,” he says.
There is a catch. In an article published this year in the Journal of Finance that’s been making waves since it was first circulated in draft form in 2014, economists José Azar, Martin Schmalz, and Isabel Tecu showed a statistical relationship between the high percentage of airline shares held by indexers Vanguard, BlackRock, and State Street and the less-than-competitive nature of the airline industry. Why try to steamroll your rivals if you all report to the same handful of shareholders?
Bogle is well-versed in this research and thinks that so far it’s too dependent on evidence from one industry to draw strong conclusions. But he does believe that if the share of U.S. equities held by the three biggest passive investing firms keeps rising from its current 20 percent, some sort of regulatory reaction will be inevitable. “Think of a single firm possibly owning 50 percent of every stock in America,” he says. “I can’t tell you why it’s not going to happen, but it’s not going to happen.”
Lastly, there’s the role of the asset manager in stabilizing markets. Economist John Maynard Keynes wrote famously of professional investors spending their days “anticipating what average opinion expects average opinion to be” and thus driving financial markets to repeated excess. Bogle argued hopefully in 1951 that, as their size and impact grew, responsibly managed mutual funds would “stabilize rather than unstabilize the market,” thus invalidating “Lord Keynes’ dismal and socialistic conclusions.”
Bogle later decided he’d been wrong—“Keynes 1, Bogle nothing,” he told me 15 years ago—and that professional investors failed to stabilize markets for pretty much the same herd-behavior reasons that Keynes had outlined. In recent years, some have argued that because they have no choice but to buy securities that are going up in price and sell the ones that are going down, index-based funds could exacerbate market swings more than actively managed ones. But there’s really not much evidence of that happening. There is ample evidence, though, that the asset management industry has gotten bigger and more concentrated, which has led to proposals that some asset managers be regulated as “too-big-to-fail” financial institutions. There’s been no action along those lines yet.
The near-zero-cost investment era, then, has brought us interesting questions about the role of asset managers in the broader economy, for which we don’t have conclusive answers. It has also brought a lot more low-cost choices for individual investors. The average equity mutual fund expense ratio in the U.S. has fallen from 1.04 percent of assets in 1996 to 0.59 percent in 2017, according to the Investment Company Institute. Interestingly, though, the share of American families with direct or indirect stock holdings fell from 53 percent in 2001 to 51.9 percent in 2016, according to the Federal Reserve. Near-zero-cost investing hasn’t succeeded in luring more people into the market.
Justin Fox is a columnist for Bloomberg Opinion.
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