Why are fund managers so well paid, given the paucity of the value that, in aggregate, all the statistics tell us they add? And what are the ancillary risks that flow from such a persistent anomaly? The first question has been a puzzle for a long time. Thirty years ago fund management was a backwater of the financial services industry, relatively poorly paid, and certainly not one that attracted the best graduate talent from highly regarded universities, as it does today.
Yet ironically, it was probably easier to produce superior performance then than it is now. The better paid and professionally qualified investment managers have become, the less evidence there is that they can produce a credible and legitimate long-term performance advantage to justify the economic rent they and their firms are clearly capable of harvesting.
One part of the answer obviously lies in the increasingly globalised nature of the financial markets. Together with a massive improvement in the availability and reliability of fundamental data, this has raised the competitive barriers to outperformance.
Combined with the ad valorem nature of the typical fund management fee structure, which disproportionately rewards asset gathering, managers have been able to earn extraordinarily large sums for what are often marginal and all too frequently temporary phases of outperformance. That is one reason why in rising markets you will typically obtain a better return by buying the shares of investment management companies than by buying the market itself.
It would be surprising if this lucrative career path were not to attract a new and less scrupulous breed of employee, more intent on personal wealth accumulation than fulfilling a mandate to manage money in their clients’ best interest. Despite widespread breaches of trust and fiduciary duty in investment banking, the phenomenon has yet, as far as one can tell, to spread to fund management on quite the same scale.
But could that be changing? Last week saw the publication of a disturbing survey by a US law firm. It found that the scale of financial rewards now on offer in the banking and investment industry was creating a powerful temptation either to “compromise ethical standards or violate the law”. Almost two-fifths of the surveyed professionals said, for example, that they would commit insider trading for a gain of $10m if they believed they would not be caught.
It is no surprise perhaps that professional bodies now place increasing weight on the importance of ethical behaviour in their training programmes. The problem is, in the face of powerful financial incentives to put self-interest above client welfare, learning what constitutes bad behaviour is not the same as actively preventing it. History suggests personal behaviour – good character, in the language of another era – can never be taken as a given.
In fund management, the problem is compounded by the unique emotional stresses the job of managing money typically entails.
These stresses, it seems, tend to manifest themselves in a range of suboptimal behavioural outcomes – such as index-hugging, screen-watching, and window-dressing – that ultimately stem from the dissonance of knowing that consistent outperformance, the objective against which fund managers know they will be judged and rewarded, is both difficult and unlikely to be achieved.
In these circumstances, the survey reports, many fund managers fall back on constructing plausible and comforting narratives that allow them to remain sane and functioning, while retaining an aura of confidence they do not always feel when communicating with their clients. Worry remains a persistent feature of their professional lives. Cutting corners – or worse – under pressure is an all too obvious way out. Even Bernard Madoff, it appears, did not set out to cheat his investors.
There is not much point in feeling sorry for a professional class who are extravagantly paid for doing a job that is not, in many cases, as worthy or deserving as it is made out to be; after all, bankers and lawyers have got away with it for a long time too. The fact remains that, from the investor’s point of view, the integrity of their fund manager is an essential matter of interest, but one which remains extraordinarily difficult to measure or to judge.
Jonathan Davis is editor of Independent Investor