Too much fun with funds
The little question for asset managers is why they earn so much. Buyside pay could soon overtake that of the investment bankers, the traditional “masters of the universe.” But the bigger question is what the industry should do with the $150 trillion it manages.
The high pay was highlighted recently by British consultancy New Financial, which found 2014’s average compensation per employee in fund managers was $263,000, up 56 percent in a decade.
There is both over- and under-counting: this misses both small-time managers and powerful hedge funds. But the overall picture is clear. The New Financial compensation estimate is almost six times the American national average income. Considering that these firms pay much of their staff roughly the going wage, the multiple for investment professionals must be substantially higher.
So why is fund management so lucrative? Simple. The professionals take what they can and most customers are willing to pay up. While low-fee passive funds, which mimic market indexes, are taking market share and price competition is not unheard of, most customers still seem to feel that high fees are a sign of excellence. The managers see no reason to discourage them.
The managers’ high pay is set in a fairly open and competitive market, as are the generous rewards for the industry’s traders, consultants and marketers. Many still suspect the whole business is too generous. Britain’s Institute of Directors, a business lobby group, has called for an inquiry.
Such an investigation would undoubtedly discover abuses and suggest reforms. However, it will be incomplete unless it asks the big questions. It is impossible to decide whether pay is excessive without knowing what the managers should be paid to do, and whether they are succeeding.
Managers generally think their goal is good performance. In technical terms, they want to beat a chosen index on a risk-adjusted basis. More colloquially, their aim is to help savers and investors do really well in the financial markets.
Both sides should think again. The goal is wrong, both practically and ethically.
Practically, it is unrealistic. In today’s asset markets, prices generally reflect all the available information reasonably well. Professional managers contribute to the value-setting with their buying and selling, but the adjustments are generally fast and unexpected. With so much known and new knowledge quickly absorbed, sustained outperformance from outsmarting the market is very rare. Most studies show as much. Long good runs usually come more from luck than skill.
Ethically, it is greedy to want gains that are disproportionately large relative to the effort expended or the contribution to society. Besides, financial markets are not horse races. Not much is lost by coming last in a race, but investment losers are often ultimately pensioners and mutual fund investors who did not understand what their highly paid agents were up to.
For investors in diversified portfolios, moderate expectations are realistic and just. In financial markets, this virtue also brings pretty good monetary rewards – to investors if not to the professionals. Overall and over time, funds which hardly ever trade, do not take big bets and pay their managers modestly do at least as well for holders as more active rivals with more highly paid staff.
Very modest outperformance might be just a reasonable objective, but two other goals are more important. First, managers should bring technical expertise. They understand the financial world and can design appropriately diversified portfolios. That skill is real, but most investors will be well served by standardised products that can be managed by moderately paid managers.
Second, asset managers should help capitalism work well. To be good stewards of their assets, they should work with, and probably serve on, boards of directors, looking out for the long-term good of companies and society as a whole. They should provide additional capital to new and existing companies which can make good use of the funds. They should be thoughtful participants in the public discourse about all economic and financial matters.
If fund managers did all this, they might deserve to be paid as much as senior government bureaucrats, academics or corporate executives – though not as much as today’s overpaid crop.
However, most fund managers now do more to discredit than to help capitalism. Largely vain efforts to outperform, short holding periods, crowd-following trading, and, yes, high pay tarnish the financial system’s already weak reputation.
Reforms are needed, including more modest remuneration. However, the most helpful and fundamental change is the least likely: to repudiate the universal desire for outperformance.