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In the financial marketplace, the biggest players determine long-term trends. Pension funds, followed by insurance companies and sovereign wealth funds, represent more than 70% of the US$ 85 trillion in assets under management globally; their views on issues and opinions on what’s working are important.
At the 71st CFA Institute Annual Conference, three of these large asset owners held an engaging discussion on the future of global investing. Christopher J. Ailman, CIO at CalSTRS; Hiro Mizuno, executive managing director and CIO at Japan’s Government Pension Investment Fund (GPIF); and Alison Tarditi, CIO at Commonwealth Superannuation Corporation spoke at length and shared their perspectives.
Active Management’s Struggle Is Real
The panel was clearly unhappy with active management’s difficulties in generating a return net of fees. The disappointment that asset owners express to asset managers is neither new nor surprising.
Vanguard’s John Bogle, in The Little Book of Common Sense investing, has empirically illustrated the impossibility of active managers beating the broad market index for extended amounts of time.
Daniel Kahneman, and many other behavioral economists, have demonstrated how information processing limitations can impair the decision-making process in active investing.
Howard Marks, a well-followed active investor, has remarked that staying near the 50th percentile — not even the top 5 — for long periods of time is a tough ask. Warren Buffett, despite being an active advocate of Benjamin Graham’s ideas on value investing, has explained how difficult it is to be on the winning side of active investing.
The case that active managers can make for their ability to consistently beat the market is indeed quite weak.
Performance fees complicate the problems facing active fund managers. Large asset owners do not like the fixed fees charged by active managers. There is a reason: In GPIF’s case, they have found active performance returns, net of fees, to be disappointing.
Typical active performance fee structures include two basic types. One is a symmetrical structure, where the manager is exposed to the upside along with the downside, but it includes a base fee. The other is a bonus structure, where managers are exposed to a combination of base fee, upside, and/or downside.
Large sovereign funds, like GPIF, have a ticket size in the billion-dollar range. Given the limitations of active managers, the fixed fees inherent in these structures make it costly for large asset owners to back them. And in most of these fee structures, the base fees hurt asset owners more than managers when returns turn south.
There will be increasing demand for fee structures that only pay when the investments generate returns. The current trend for active management fees, at least in the mutual fund industry, is already downward. Mutual fund expense ratios have steadily declined from 99 bps in 2000 to 63 bps in 2016.
For index investing, costs have also been falling. The average expense for an index ETF in 2016 was 23 bps – 40 bps lower than active managers.
Asset owners play an important role shaping the future of asset management, acting as force that opposes short-term thinking. The entire appraisal industry, not just fund managers, uses a one-year evaluation period, pressuring active fund managers to perform over the short term. Shorter time frames introduce a disturbing array of chain reactions in the system, and everyone ends up pressuring capital to show quick results.
This is not to say appraisals should not take place on a yearly basis. But decisions to hire, fire, and incentivize based on a one-year timeframe can become dangerously flawed.
Pension funds and sovereign wealth funds fill a critically important gap: the availability of long-term capital. The world has struggled to meet the demands we face today without compromising the ability of future generations to meet their own needs.
Large asset owners are uniquely positioned to promote long-term thinking. The CalSTRS board draws members from the California school system — teachers generally start from a perspective that makes it easier to take a long-term view. Long-termism is the only tool that can nudge users of capital to nurture business environments that deliver sustainable value.
Experience the 71st CFA Institute Annual Conference online through Conference Live. It’s an insider’s perspective with live broadcasts and recorded video archives of select sessions, exclusive speaker interviews, discussions of current topics, and updates on CFA Institute initiatives.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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