Should I Give my Savings to a Banker?
Investment Returns - Fees - Short Term - Herd - Margin-of-Peril - Incentives
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A common question arises when deciding what to do with the hard-earned money one has managed to save. With the pace of cash depreciation, a long-term cash position means losing one’s savings. The consumer price index shows a 155% increase in inflation since 1982 in the US. One has to invest to preserve, and even grow, the purchasing power over time. Investing is hard. Time and skills are required for a winning strategy. Isn’t it more comfortable to give my precious savings to a money manager? After all, it is their full-time professional activity!
The issue is that, on average, money managers perform poorly. Over a 15-year period of time, 92% of investors underperform the market, and the figure is close to 99% if you add one decade. It even seems that the more sophisticated and smart the managers are, the worst the returns are. For instance, Long-Term Capital Management was a hedge fund founded by John Meriwether, a Wall Street veteran, and Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Prize. LTCM won, after fees, an annualized return of 21% the first year, 43% the second year, 41% the third year before losing everything. They lost $4.6 billion in four months. These blow-ups are, alas, too familiar. Why do such dedicated and smart people achieve such low returns?
It starts with an incentive problem. Money managers usually compensate up to 2% of the funds under management plus 20% of the profits. They are paid with the amount of money they manage rather than the returns. The incentive is thus to chase on funds to grow the AUM rather than good investment ideas. The more money they manage, the more they earn. However, the more money under management, the harder it is to make money because of the diminishing returns of capital use.
There is also a moral hazard because most bankers and investors don’t have a significant portion of their net worth in the funds they manage. They enjoy the profit and don’t bear the cost of bad performance. It’s like a chef who is afraid of eating at his own restaurant. As Seth Klarman wrote: “the conflict between the best interests of the money manager and that of the clients is typically resolved in the manager's favor.”
Growing the asset under management requires spending a lot of time marketing the funds. Thus, there’s a necessity to capture the attention by making bold macro-previsions or to be perceived as an expert on everything ranging from predicting interest rates to market behaviors. This is a costly distraction in such a competitive business. Most money managers can’t also afford to miss the latest hype or exotic product out of the fear of being out of fashion. Customers drawing back their money is more painful for money managers than making a bad investment.
The truth is, most money managers’ customers are speculators. They expect exotic and risky strategies that quickly out-perform the market. A short-term orientation in a long-term game is a recipe for disaster. This reinforces the vicious cycle. Instead of having a margin-of-safety, most money managers have a structural margin-of-peril. They avoid holding contrarian opinions and often go with the frenetic crowd. This is the fastest way to lose money, yet the money managers' alternative is to lose their job.
There are also a lot of constraints in the investment business. The most detrimental one is the need to be invested at all times. It means choosing from the best available investment out of a bad pile instead of avoiding the bad pile. Sometimes the best strategy is to do nothing for years and wait for opportunities. Other constraints might be buying products created by the firm whatever their cost, investing only in specific asset classes, or selling an investment if the volatility is too high. There are constraints but also questionable practices. The most doubtful one is "window dressing,” in which the manager sells out investments whose price is falling or avoids marking up some investments to their latest value for the reported performance to look better.
Managing money is a hard job. The competition is fierce, and the market is cruel. It’s too easy to be harsh on people who are managing money. Yes, most live comfortably out of fees while their customers end up as the loser. But, in my opinion, it’s the consequence of an incentive problem that favors short-term views. People or institutions who give their savings to money managers know or should know the rules of the game. Money managers are no scapegoats. The responsibility lies on both sides.
A better incentive system can be designed. For instance, Warren Buffet created a specific compensation for his late partnership: “I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited.” First, Buffet put almost all his net worth into the funds, and second, he had unlimited commitment to pay back losses. That’s real skin in the game!
Overall, there is nothing wrong with hiring a money manager as long as people know the risk associated and the cost. I, personally, won’t do it. I think the sad part is when pension and endowment funds buy risky mutual funds or hedge funds, jeopardizing the money people need. Individuals need to do extra research before buying into the money management industry. Weirdly, some people spend hours reading consumer reports before buying a TV but giving money to money managers in a second. Better be careful and remember Buffet’s rule: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”.
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