In the 1990s, Colonial First State fund manager Greg Perry established himself as an industry doyen. Between 1990 and 2002, the manager’s flagship Imputation fund outperformed the All Ordinaries Index by 11.8% per annum. Together with CEO Chris Cuffe, the duo oversaw a highly successful period, with funds under management growing from $150 million to $100 billion, including $25 billion in Australian equities.
That period heralded an era when a number of fund managers established outstanding track records investing at the blue chip end of the ASX. Fund managers such as Perry, Peter Morgan and the late Robert Maple-Brown all significantly outperformed the All Ords for well over a decade. Long enough to suggest that it wasn’t by chance.
But the industry changed soon after the turn of the century. The pool of talented Australian fund managers seemingly dried up. The game transformed. Being a fund manager became less about outperformance. The new incentive – don’t underperform and you keep your funds.
At the large end of the market, the majority of active managers today are closet index huggers. Their portfolios look a lot like the index with small tilts towards their preferred index constituents. The table below shows the top five holdings for ten of Australia’s largest actively managed funds.
Source: Fund manager websites
It is difficult to tell them apart.
The average can’t be better than average
It is well documented that most active managers underperform the market. Investing is a zero sum game. Simplistically, for every winner there is a (relative) loser and the average investor (which includes fund managers) should perform in-line with the market. But because fund managers charge fees, the average fund manager might reasonably expect to underperform the market.
There have historically been exceptions to the rule. A few fund managers went out on a limb and ran a portfolio substantially different from the index. Either through luck or genuine skill, some would meaningfully outperform the index and perhaps justify their high fees.
But if you hug the index, like the 10 funds above, and charge a high fee, you guarantee underperformance. If you are invested in any of these funds via a platform charging the full retail rack rate, your investment would have underperformed the All Ords over both the past 5 and 10 years. For those with enough money to invest wholesale (which requires an initial investment of anywhere from $25,000 to $500,000), performance was still poor. Despite the lower wholesale fee, most of these funds still underperformed and none outperformed by more than 0.9% per annum.
How did it come to this? As importantly, how are they still getting away with it? How, given their underperformance, do they hang on to the billions of investor dollars they’re entrusted with managing? Surely that money would, or at least should, be out the door by now. And for that matter, how did they end up managing so much money in the first place?
I’m sure you have your own views on things. For my perspective we are going to take a look back over an extraordinary 13 years since I joined the Australian funds management industry.
1: Trapped in the Banks’ Cross-Sell Cross-Fire
Greg Perry’s performance attracted more than just investor attention. Soon after the turn of the century, the Commonwealth Bank acquired Colonial. This triggered a wave of consolidation. NAB soon acquired MLC from Lend Lease, Westpac acquired BT and ANZ acquired a 49% stake in ING Australia’s insurance and wealth management division.
But consolidation wasn’t just about acquiring fund managers and their strong track records. It soon became a battle to capture the entire value chain. Not just the fund managers but the platforms, the advisers and even the custodians. Colonial’s strong relationships with independent adviser networks, forged through its outstanding investment returns, disappeared as the Commonwealth Bank focused on becoming a major distributor itself.
A second wave of consolidation occurred. This time the banks gobbled up the adviser groups. The Commonwealth Bank acquired Count Financial, Financial Wisdom, Whitaker McNaught and BW Financial Advice. ANZ acquired the remaining 51% of ING Australia (and rebranded it OnePath), which included advisory brands RI Advice, millennium3 and Financial Services Partners. Westpac acquired Securitor and St George. NAB acquired JB Were, Apogee, Garvan, and Meritum.
AMP got in on the act, acquiring Godfrey Pembroke, Hillross and IPAC, while IOOF acquired Bridges, Consultum and Shadforths.
The industry changed as the banks and other large financial institutions used their own distribution networks to funnel investor dollars, via their own platforms, into owned fund managers.
Flicking the switch on incentives
A long time ago, Colonial’s business model was based on being a high returning fund manager. Performance was paramount and they had some of the most talented portfolio managers in the country under their roof. Investors certainly benefited. And they raised billions of dollars. A fund manager’s incentive was clear – outperform and you attract funds.
Over the last decade, Colonial’s flagship Imputation fund hasn’t come close to replicating the returns achieved under Greg Perry. It hasn’t even outperformed the All Ords once fees are taken into account. Yet Colonial now has close to $200 billion under management and made a $230 million profit for the 2016 financial year.
When you control the distribution network, the incentive changes. Once you needed to outperform. Now you need to not underperform. The easiest way to ensure that is to hug the index.
2: The 2003-2007 Bull Market. When Volatility Played Golf
Bloodletting was perhaps the most common medical practice from 1000 BC until the late 1800s. It involved the withdrawal of blood from a patient to cure disease. The theory was that bleeding maintained balance between blood and other bodily fluids with proper balance required to maintain health. In most cases, it was harmful to patients. Yet it was widely used for almost 2,000 years. Why? My guess is because no one came up with a better theory.
Less than a century after bloodletting became a thing of the past in medicine, a number of Nobel laureates created a financial form of bloodletting. It is known as Modern Portfolio Theory. This theory is the foundation of any Finance 101 course and is widely taught at universities throughout the world.
Without wanting to deliver a Finance 101 course in this blog post, my six favourite assumptions of Modern Portfolio Theory are:
– expected returns equal actual returns;
– investors are rational;
– a company’s share price reflects all information, including inside information;
– tax and brokerage don’t exist;
– investors can borrow as much money as they want and all pay the same low interest rate;
– share price volatility is the only form of risk.
Some of those assumptions need to be bent in the real world. Some don’t apply at all. But that hasn’t stopped modern portfolio theory becoming the mainstay of financial planning today. That, combined with a period where it actually worked, has pushed genuine investors to the fringe.
The great and efficient bull market
Occasionally a sick patient would recover, despite being bled. Similarly, for periods of time the market can behave in a way that makes it look like Modern Portfolio Theory actually works.
The period I’m referring to was the first bull market of the 21st century, in between the tech bubble and the Global Financial Crisis, or GFC. It produced four consecutive years of returns (2004-2007) that were greater than 15% per annum. In 130 years, this had only ever happened once, when the market recovered from the Great Depression in the early 1930s. The 2003-2007 bull market tortured absolute, benchmark unaware managers.
I happened to work at one such manager, MMC Asset Management, and can attest to the frustration of being a pure stock picker in this market. Owning a portfolio of the 20 largest stocks in the index and playing golf for four years was an extremely effective strategy.
Source: Capital IQ
The only market reversal greater than 10% occurred right at the end of the bull market. Arguably the GFC was already underway at this point. For the first four years there wasn’t one pullback over 10%.
What did this mean for active management?
The lack of volatility meant opportunities to find cheap contrarian ideas were few and far between. And strong index returns meant that profiting from these scarce opportunities didn’t result in standout performance, as it had during the 1990s or post GFC. In response to the absence of opportunities, MMC’s cash weighting increased. But the continued strong performance of the index meant that those who held cash were left behind in the performance tables.
It was a difficult time at MMC. We were led by Adelaide-based Erik Metanomski, in my view the best stock picker in the history of the Australian funds management industry. After establishing MMC in 1993, Erik returned 27% per annum for the next decade.
While MMC’s returns during the 2003-2007 bull market were strong in absolute terms, they paled in comparison to the All Ords. MMC achieved a 23% return on the shares it held, but a near 50% cash weighting diluted overall returns to 13% per annum. This was dwarfed by a market that returned close to 20% per annum.
Following the 2003-2007 bull market, some genuinely active managers disappeared, including MMC. Others were confined to the doghouse, with their funds under management being reduced to a fraction of their peak.
Those managers who thrived seemed to hold a lot of bank and resources shares, which pundits referred to as the barbell strategy. Many had much lower golf handicaps in 2007 than they did in 2004.
3: Gatekeepers Keep the Undesirables In
When I entered the industry, I naively assumed that the best performing fund managers would have the most money to manage. Sound logical enough? So why was this assumption so erroneous?
The answer partly lies with the gatekeepers of the industry. First thing’s first, who are these gatekeepers? They fall into two groups:
1. Asset consultants. Gatekeepers who advise large industry super funds and other big institutions.
2. Research houses. Gatekeepers who provide research to financial advisers, most of whom need said research to recommend a product to their clients.
Between them, they exert immense influence over the entire funds management industry. An aspiring fund manager had little hope of raising much money without the tick of approval from a gatekeeper.
While not suggesting gatekeepers abuse their power, there are inherent biases in how they conduct their research. They also use elements of Modern Portfolio Theory in their decision making process. These include the notion of diversification and measuring risk using volatility of returns when compared to the index.
How would a gatekeeper view Forager?
Let us use Forager as the test subject for a hypothetical review by a gatekeeper.
A gatekeeper would likely conclude that Forager:
A. Is too concentrated and needs to hold more stocks to diversify risk
B. Can and does hold too much cash (currently around 25%)
C. Should sell South32 and call itself a small cap manager
D. Has too small a team and should hire more staff (so long as they don’t lower average years’ experience of the team)
E. Should sell a 40% stake in itself to a big bank
F. Should hold more internal meetings, speak to company management more often and assign analysts to cover all sectors
G. Generates returns that are too risky compared to the All Ords
H. Is expensive
I. Has good performance, but given all of the above, how is this possible?
From the above exercise, it is clear that a gatekeeper would be unlikely to recommend Forager to its clients. (Without the emergence of self-managed superannuation funds (SMSFs), Forager probably wouldn’t exist.)
Their influence has led to many supposedly active fund managers running their businesses with one eye on the asset consultants. Hence more diversification, larger teams and consensus driven decision making, and portfolios that closely resemble the index.
Conclusion – Will the Industry Change for the Better?
In the early 2000s, the banks changed the funds management industry and the main incentive became to avoid underperforming. The 2003-07 bull market cemented the position of the lukewarm money manager. And the gatekeepers have defended them ever since.
Steve might think there is a Fuzzy Future for Fundies. Yes, industry funds are putting pressure on fees. The growing popularity of low fee index funds (particularly exchange traded funds) have created more options for investors. And gatekeepers are becoming less influential as SMSF growth creates a large pool of investors who don’t have to follow their recommendations.
It’s easy to sit in Steve’s chair at Forager and think that things are changing. But the industry is vast and the vested interests are well entrenched. This post has been about how we ended up in an unfortunate situation. My bet is we aren’t going anywhere soon.
20 thoughts on “Active Fees for Passive Returns – How Did it Come to This?”
I heard on a recent podcast (I think it might have been Invest with the Best), where they interviewed Jason Zweig. It was mentioned that 40 % of money on Wall Street is now in etfs, which I think are passive. So maybe this is what will happen to a lot of fund managers who simply achieve the index. Excellent podcast by the way.
holding 25% to 100% cash looks way too much. We can do that ourselves.
I know it is wicked but some of your investors draw down on their home loan and give you the money (to invest on stock markets), a buffer is needed for redemptions but 25% looks enough.
Remember your clients value your services highly and when you said you needed some extra dough recently many of your clients raided their piggy banks (their home loan redraw accounts) and sent it in.
To be clear, we would never be encouraging someone to take on leverage to invest in a fund like this. But as long as we can keep finding the ideas I would like to think we can be mostly invested most of the time. I agree that people should not be paying fund managers to sit on mountains of cash year after year after year.
I’m glad to hear that Steve and I agree also. I would like my fund manager to be fully invested (or as near as practical) since I hold my own defensive allocations.
The world of LIC’s, that you’re about to enter, is interesting and not so rational. As I’m sure you would be aware one of the most prominent and successful managers holds on average 30% cash, year in/year out, and continues to raise capital at a rate of knots. It’s hard to be critical since they have the track record to back it up, but I don’t see how it’s sustainable. I respect what Forager is doing to cap the fund in a logical way in the interest of investors, and have invested my money here instead.
Excellent post. There is one additional factor, I think, that contributes to the sorry state of affairs – the investors in these funds themselves.
Unfortunately, investors are often their own worst enemy, pulling money from fund managers at the slightest hint of under-performance. One of the very reasons value oriented strategies such as Forager’s work in the long term is that in the short term they don’t! It is hard for a fund manager to run a business with a long-term time horizon when your investors have a short-term one and the ability to redeem capital at a moment’s notice.
How do you as a fund manager solve this problem? Well I think one way is through clear and honest communication to set investor expectations appropriately and in that way “attract the investors you deserve”. I believe Forager has done an excellent job on this front. An alternative approach is to seek permanent capital. You probably aren’t going to attract the quantum of funds that a traditional asset manager can but it will let you get on with your job without worrying about redemptions. Clearly, this has been on Forager’s mind as well.
daniel, good story telling…
it would seem, work expands to fill the available time…
testing forager maintained the story
please addit D1 – average years of experience per investment team member
I recently discovered family members have had around a year’s wages in two of Perpetual’s funds for just over 15 years. In addition to a 1.5% p.a. fee (2% incl financial adviser commissions) the only real returns that have been earned on the investments were through distributions (reinvested into more units) and both funds have comprehensively underperformed their indexes. One’s units are worth 5% more than they were in 2001, the other’s are worth 10% less.
You’re dead right about the vested interests in the industry, with customer-facing people (advisers/salespeople) feeding (often unsophisticated) retail clients into big name (index-hugging) funds with higher fees and poorer returns compared to the average ETF. With broker commissions including a % of contributions plus a trailing commission p.a. for ‘managing’ it, there’s very little incentive for any involved (except the poor retail investor) to change. Hopefully as Christian said above, investor awareness will grow and they’ll start voting with their wallet.
Good article and history! I was one of those investors in CFS and Perpetual retail funds for nearly two decades. Starting in the late 90’s probably after seeing Paul Clitheroe on TV. I signed up regular invest plans and got on with my life. Luckily I wasn’t paying additional contribution/adviser or platform fees, but still has the 2%. I suddenly woke up in 2014 and discovered the world of ETF’s and the bogleheads and was simultaneously shocked and amazed. I switched my investments over quick smart. But the fact I had my head in the sand for so long makes me agree the change will be gradual not immediate. There is a lot of inertia in these things. Equally though I reckon change might be a bit quicker than you suggest. ETF’s are growing at a rate of knots (and still a long way behind the US) and the LIC sector is booming again. I think the years a numbered for these huge index huggers.
I probably saw the same Paul Clitheroe on TV endlessly telling us to put money into a managed fund.
I was skeptical, having been investing (modestly at the time) for around 10 years. Eventually I did put money with CFS and Perpetual as a means of diversifying away from my own skillset.
I really really tried with CFS and after 15 years (I figure that’s enough chances) pulled my money out of them – it would have done about as well in a savings account. This was no some silly cash account or something, it was a couple of their high growth share funds.
I’ve been of the view that the funds management industry is by and large a parasite, which does a great job of enriching itself at the victims expense. They dress up their actions will all manner of arcane words, which makes them sound knowledgeable. The moment some wants you to spend time with them so they can “rebalance your portfolio” – run for the hills, the BS has started. The same goes for alphas and betas and all that rubbish.
So why do I have some money with Forager? Same reason as CFS many years ago – diversity my skill set – not my investments, I don’t care about the “diversification” stuff we’re always told there.
The language of value investing makes eminent sense to me – the first time I read the Berkshire Hathaway Owners Manual (and later, the Argo Owners Manual which now seems to have disappeared) I thought – these people are honest, no bull, call the shots as they see them, and take a long view. This is language I can understand, it’s not trying to baffle me, it’s something I can related to.
Forager can find things I can’t find; and delivers with plain speaking. The buzzword bingo BS is not there, and I’m happy to give Forager 10+ years to prove itself. As I didn’t get in right from the start, my returns so far have been OK rather than really good. But I’m happy with what’s been done, and the honesty of the reporting. I’m very happy to pay the higher fee that Forager charges if the performance over 5 – 10 – 15 years beats the index, preferably by a decent amount, and I don’t regard that as parasitical. These days I’m much more selective with who I allow to manage some money – managed funds get < 10% of my portfolio, the rest of which I can only blame myself for.
Hi Wally, perhaps a saving grace for me I put a large amount in CFS’ developing companies fund which I think did actually deliver some value over that time, even despite the high fees. Fortunately they seemed to retain some of Perry’s spirit in their small cap funds, which was completely disbanded in the large caps. I don’t think Perpetual did much for me, and as per Murphy’s Law I exited at exactly the wrong time in 2014 as I was in the Industrial share fund and switched into broader indices including resources. Oh well! I’ve also decided to invest with Forager in recent months. it’s a relatively small part of my overall portfolio but I’m impressed with what I’ve seen and will be happy to sit back and see how it goes over the long-term.
As a professional fund manager working for the asset management arm of a large investment bank, my outperformance was less than 1% per annum, meaning that after fees, my investors would have been barely ahead of the index.
My family’s SMSF which I also manage has managed an outperformance of 14.6% per annum (according to Sharesight), since March 2006 (which includes some catastrophic losses in 2008 – my only down year).
If I had to allocate the reasons for this performance disparity, I’d say that it was 10% due to my professional mandate having a much larger FUM and 90% due to dysfunctional incentives/career risk.
Indeed, I think that achieving a 1% outperformance as a pro was more stressful and difficult than achieving a concurrent 14.6% outperformance in a SMSF. I don’t like to badmouth former employers, so I won’t go into specifics other than to say that this blog post does indeed cover most (but not all) of the reasons why the funds management industry delivers such bad outcomes to most of its stakeholders. Investors get screwed into coughing up premium fees for a generic product. Individual fund managers have to suffer through anti-meritocratic employment practices, and the mechanism by which listed company share capital is priced becomes inefficient. I think that even the big banks would be better served by having a better set of incentives (and hence better performance) in their funds management arms.
Re bloodletting: I once read about an American study that found that prior to WWI, there can be almost no doubt that visiting a doctor actually did more harm than good in terms of life expectancy.
In the period between WWI and the mid 1940s, when penicillin became widely available, it is not clear that visiting a doctor had any material effect on a person’s health/life expectancy.
This means that despite the fact that doctors/healers/medicine men have existed as a profession for longer than recorded history (i.e., 8000+ years), they have only actually been doing their job (i.e., healing people) for about 65 years, and they have been doing the opposite of their job (i.e., harming people) for 7900+ years.
So if the medical profession is anything to go by, the funds management industry should have cleaned up its act by around 9916 A.D.
That’s a very interesting case study, thanks for sharing, and I fully agree with what’s been said that it’s all about measurement, rewards and motivation.
“We aren’t going anywhere soon.” You neglected a player in the food chain – independent financial planners. Being one myself after years with institutions, I agree with all the comments you’ve made. I’ve been recommending Forager to my clients for a few years now. Some told me they had told their friends to put money in too.
What you said about gatekeepers are true. It’s difficult for us to recommend bigger allocations to Forager due to your characteristics. Pity there is not more of us. But that time will come.
I am looking around for a truly independent financial advisor (ideally based in Victoria) How does one even find one?
Great post. I am in a unique position having been an asset consultant, manager researcher, and fund manager. I strongly believe that the small investor is MUCH better off if they invest with small genuinely active boutique fund manager who is aligned to their interests, rather than being swallowed up by a distribution chain of one of the large players. Fund managers should be paid on performance, not for simply gathering assets.
Be wary of index investing as a solution – although all the rage today and very popular; it is in my view typically a very dangerous way to invest, and prone to large occasional losses. Investing with the herd will obviously result in mediocre performance.
Hi Jerome, there’s different types of index ETF’s. I tend to agree if you mean “smart beta” products such as high yield, low volatility ETF’s. They follow fads and usually launch once those fads are already highly valued. However I wouldn’t say investing in traditional low cost index ETF’s is dangerous. As the article points out the average can’t be better than the average. It can’t be much worse either. Maybe that’s what you mean by mediocre but it’s actually not a bad option for most people IMHO, especially for global markets where it is harder to beat the index. In Australia you might consider the equal weighted ETF for better diversification (MVW), I have seen Steve writing about that also in the past. Index investing is my default option and I use boutique fund managers sparingly and selectively since the statistics say the majority do not add value. I’m confident Forager will be an exception.
Accountants will be next to be gobbled up by the banks.
I will also add that people read the army of helpers “Got Rocks Family” story from Warren Buffett. Amusing read as to the state of the markets. I can’t remember the actual figures but a substantial portion of returns disappeared into what warren called frictional costs.
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