FYI | Mar 26 2007
“If you don’t know who you really are, the stock market is an expensive place to find out.” – ‘Adam Smith’ (George G. W. Goodman).
The Financial Times’ Lex column last week printed an imaginary letter from TCI, the activist hedge fund which has taken a stake in ABN Amro, to the new CEO of BarclaysABN, the presumed merged entity that may yet arise from the rubble of the beleaguered Dutch bank. The letter in question urged the nascent entity to consider demerging many of its newly acquired operations. What this hypothetical piece all but spelled out was how the balance of economic power has shifted in the past five years – from investment banking giants to boutique partnerships, specifically hedge funds and private equity.
The Children’s Investment Fund versus ABN Amro is only the latest example of buccaneering (i.e. genuinely risktaking) capitalism returning to its roots and flexing its muscles at the expense of a failed investment model to which we can give the catch-all title ‘agency risk’ – exemplified by mutual funds that are in reality anything but mutually owned.
Perhaps the single biggest commonality between the hedge fund and private equity business is the concept of management ownership and the alignment of corporate interests. No wonder supposedly ‘alternative’ asset management is attracting all the column inches (and the best people) – the seven-stone weakling model of ‘agency’ fund management is rightly having the sand kicked all over it.
The failings of traditional fund management approaches have been long discussed, not least within these commentaries. One of the more trenchant criticisms of the industry was penned in ‘The Financial Analysts Journal’ of July / August 1975 by veteran investor Charles D. Ellis, the founder of Greenwich Associates, in an essay entitled ‘The Loser’s Game’:
“The investment management business (it should be a profession but it is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.. The belief that active managers can beat the market is based on two assumptions: (1) liquidity offered in the stock market is an advantage, and (2) institutional investing is a Winner’s Game.. The unhappy thesis of this article can be briefly stated: Owing to important changes in (recent) years, these basic assumptions are no longer true. On the contrary, market liquidity is a liability rather than an asset, and institutional investors will, over the long term, underperform the market because money management has become a Loser’s Game.”
Ellis goes on to amplify what he means by a Winner’s, as opposed to a Loser’s, Game. Tennis played by professionals is an example of a Winner’s Game. Victory is due to winning more points than your opponent wins: not simply to getting a higher score, but getting that higher score by winning points. The amateur tennis player, on the other hand, invariably scuffing the ball into the net or serving double faults, seldom beats his opponent, but often beats himself.
Institutional investing, Ellis suggests (and this was written over 30 years ago) was at one stage a Winner’s but became a Loser’s Game with the passage of time, not to mention the inflow of thousands of new participants, some even with talent. As Ellis points out, “Competitively active institutional investing has resulted in sharply higher portfolio turnover.. how can institutional investors hope to outperform the market.. when, in effect, they are the market today ?”
The outcome, we now know, was clear. First, the rise of indexation (of which the exchange-traded fund is an intriguing and generally useful more recent variation). Next, the rise of so-called alternative asset managers who eschewed benchmarking with the aspiration of generating pure absolute returns. These twin trends succeeded in polarising the investment industry: the former was and remains the low cost (beta) option; the latter, the nominally high cost but putatively higher alpha alternative. (As for ‘high cost’ – please see ‘net returns’.)
Which made life doubly difficult for the closet-trackers in the middle, resolutely hugging the benchmark, plus or minus a percentage point or two, but charging active fees and thus dooming their unit holders to underperformance. All, that is, except for John Bogle, whose Vanguard Group remains the only legitimately mutual fund business (making unitholders part owners) in the US.
But the increasing trend towards ‘professionalism’ (certainly, ‘overcrowding’) in asset management has not killed off traditional asset management entirely. Rather, just as Ellis first indicated, long-only managers, for example, should probably focus on simplicity, concentration, and economy of time and effort. If other traditional managers are turning over their portfolios like the tub of a washing machine, there is a high likelihood that fortune will favour the more patient mind.
This may be doubly true given the (relatively short-termist) involvement of so many alternative managers on the short-side: ‘time horizon arbitrage’ may come to benefit the value investor with strong convictions, concentrated holdings and no real urgency to book a profit. Or in Ellis’ words:
“Why not bring turnover down as a deliberate, conscientious practice ? Make fewer and perhaps better investment decisions. Simplify the professional investment management problem. Try to do a few things unusually well.”
The supposition of late has been that the extraordinary capital inflows into hedge funds and private equity have permanently compressed their returns. This supposition is wrong for at least two reasons. One: hedge funds and private equity per se do not represent one distinct asset class, but rather an alternative philosophy on the management of risk capital that embraces an alignment of manager and investor interests, the varying use of leverage and to an extent a steely commitment to contrarianism.
Two: while it may well be the case that ‘average’ returns are dragged down by competition, the entire raison d’etre of so called alternative asset management is the belief that exceptional people can deliver exceptional returns on a sustained basis irrespective of broader market conditions. The recent Gadarene flood of variously clever money into the sector may well compress returns for ‘noise players’, but part of the problem given the well-flagged opaqueness allied to these sectors is the huge dispersion in returns between top and bottom decile managers. A more crowded pond does not automatically extinguish prospects of life, but it does raise the requirement to conduct appropriate due diligence on those players most likely to thrive.
Working in investment in 2007 feels like being part of a gigantic science project.
Two almost contradictory styles (traditional and so-called alternative) are duking it out while more passive low-cost providers dart and nibble at them from the periphery. On the evidence of capital flows to date, the traditional managers are under siege, and possibly being kept afloat only by savvy marketing skills (not a trait one can realistically associate with alternative managers since the regulators essentially prohibit it) and a generally supine investment media. But it is difficult to remember the last time traditional fund managers made the headlines – except to jump ship to boutiques, or to take themselves private in some other form.
26th March 2007.
Tim Price
Union Bancaire Privée, London
This commentary was republished by FNArena on authorisation by the author, Tim Price.tpr@ubp.ch ;Weblog: www.thepriceofeverything.typepad.com
For direct feedback please email: tpr@ubp.ch
Bloomberg wire: NH UBP <GO>
