Big Money Managers Feel Squeeze From High and Low Ends

(Bloomberg Gadfly) -- Ordinary investors and America’s wealthiest families may seem like an odd pairing, but they do have something notable in common: They are both upending the decades-long rule of institutional money managers.  

So-called family offices -- which manage private fortunes -- have traditionally turned to high-priced outside managers for investments in private equity and real assets. But more recently, family offices are bypassing those managers and investing directly in private companies and in real assets such as real estate, oil and gas and timber. 

It’s not just that the typical manager’s 2 and 20 fee structure -- a 2 percent management fee and 20 percent of profits -- is absurdly high and that recent performance has been disappointing. After all, fees can be reduced and returns tend to be cyclical. The real driver is that family offices are realizing that there’s nothing magical -- or even complicated -- about investing in private assets.

With that realization, the rest is simple math. Consider, for example, a family with $1 billion that allocates half of its portfolio to private assets. Even if outside managers cut their typical management fee in half, that family would still pay $5 million a year in fees, which doesn’t include the manager’s cut of the profits. For that kind of money, a family office can hire an in-house team of talented and experienced private asset managers and keep all the profits.

Family offices don’t disclose their results, so it’s hard to know if their investments in private assets have paid off. But there’s no reason to believe that family offices will do any worse than the average private asset fund. And given those funds’ fees, there’s good reason to believe they’ll do better.

A similar trend is underway among retail investors, and in this context the data is rich and instructive. Ordinary investors who want a shot at beating the market have traditionally turned to actively managed mutual funds. By now everyone knows that the vast majority of active managers fail to beat the market. But even managers who do beat the market are no longer special.

Looking at Morningstar data, I counted 90 U.S. large- and mid-cap mutual funds that earned a five-star rating -- the crème de la crème -- for their 10-year performance through 2016. The honor is well deserved because 89 of those 90 funds beat the S&P 500 over that period by an average of 1.6 percentage points annually, including dividends. But investors are increasingly realizing that they can achieve the same result through index funds. 

The MSCI USA Diversified Multiple-Factor Index is a blend of four common styles of active management -- value, size, momentum and quality -- and it, too, beat the S&P 500, by 1.2 percentage points annually. When compared with the multifactor index, the five-star managers no longer seem as impressive. Of the 90 five-star funds, 51 beat the multifactor index, and the entire group beat the index by an average of just 0.3 percentage points annually.

The numbers are even less flattering for small-cap managers. I counted 49 U.S. small-cap funds with a five-star rating, and of those, 48 managed to beat the Russell 2000 Index over 10 years through 2016. Only 12, however, managed to beat the MSCI USA Small-Cap Diversified Multiple-Factor Index, and the group as a whole trailed the multifactor index by an average of 0.3 percentage points annually.

There are fewer non-U.S. funds, but the results are similar. Of the 24 international funds that received a five-star rating, 22 beat the MSCI EAFE Index -- a collection of developed-market stocks excluding the U.S. -- but only seven beat the comparable multifactor index. And of the six emerging market funds that received five stars, all six beat the MSCI Emerging Markets Index but none beat the multifactor index. The average return of both groups failed to keep pace with their respective multifactor indexes.

Also, investors no longer need the big brokerage firms to assemble all those funds into coherent portfolios. With the rise of roboadvisers, investors have their pick of sensible portfolios of index funds. Traditional brokers see their obsolescence coming, which is presumably why a growing number have rolled out their own roboadvisers.

Wealthy families and smaller investors are essentially arriving at the same place from opposite ends of the spectrum. They don't need the expensive middleman any longer. That should make Wall Street money managers incredibly uncomfortable.     

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

To contact the author of this story: Nir Kaissar in Washington at nkaissar1@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.