Why do asset managers place so much emphasis on the role of our regulator? This has been an abiding mystery to me for many years.
When the Financial Conduct Authority (FCA) published its interim report into competition in asset management in 2017, our industry ‘welcomed’ it and made positive noises about supporting improved transparency on costs and objectives, in order that clients might make better informed decisions.
Implicit in our response is an acceptance that we as an industry act in the interests of our clients only when we’re told to. How do we expect to gain trust if this is our attitude?
According to Edelman’s Trust Barometer, the general public views asset managers as competent, but is doubtful whether we act in our clients’ best interests.
Logically then, if firms have been less than forthcoming with the information clients need to make informed decisions, there must be a reason.
What is that reason?
Maybe it’s that collectively we don’t add much value beyond market returns (certainly after fees) and we’d rather not shine a spotlight on it. I don’t think however we can simply pin this on a lack of investment skill.
What is really going on is that our industry has – with a few exceptions – allowed the terms of engagement with our clients to almost completely depart from the wealth-creating reality that is the fundamental deployment of capital to fund investment projects.
Too many of us are not even trying to do our basic job anymore.
The Capital Asset Pricing Model
How and when did this happen?
I don’t think that’s easily answered, but it likely dates all the way back to the 1970s creation of the Capital Asset Pricing Model (CAPM), and its corrosive effects in a world where complexity has become confused with value.
CAPM artificially divided investment returns into alpha (stock-level or ‘idiosyncratic’ risk and return) and beta (market-level risk and return), thereby creating the notion that an efficient market return is available to any investor without reference to, or even knowledge of, any actual investment decisions.
Hence beta became the default investment portfolio and ‘outperformance’ of that became the value proposition of the active management industry.
This, in turn, led to active managers focusing less and less on fundamental investment analysis, and more and more on the completely circular activity of trying to marginally outsmart each other.
In this marginal world the definition of investment success became a relative one, along with costs and transparency.
‘Active’ started to mean being different to the market, and became conflated with activity. Managers started to employ ever more sophisticated and costly trading strategies with no reference at all to making fundamental investments. Cue market failure, both in the sense of competition in our industry and with respect to the fundamental deployment of capital.
So here we are. Most investing is no longer about taking long-term risks in definable investment projects.
It’s more about free-riding on the mythical ‘market return’ at minimum cost; participating in an expensive zero-sum arms race of better, faster, smarter analysis of markets and their participants (actual companies nowhere in sight); about risk-shifting through financial engineering disguised as value creation; and about confounding and confusing on costs which are often not justified by managers who have lost sight of their core purpose.
The necessary U-turn
Perhaps the most remarkable thing of all is that we actually benefited financially – in the short term at least – from making our industry so utterly impenetrable that assessing value became nigh on impossible.
That, of course, is now changing rapidly with the rise of passive investing and a focus simply on minimising cost – a decision which is sensible for individual investors but collectively self-destructive.
The asset management industry may be losing its social licence, but I don’t believe we have completely lost our social compass or sense of purpose.
Rather, we have allowed ourselves to be pushed down a road that we should not be on, and we do not know how to make a collective u-turn.
We should not be trying to justify our existence solely with reference to outperforming a stockmarket which in the short and medium term is essentially random.
We should be explaining our purpose in terms of how investing in companies can help society by encouraging research and development, innovation and technological progress, creating wealth and social development in the process.
We should exercise our rights as owners on behalf of investors by engaging with company management in overseeing these activities, not driving them to hit short-term financial targets.
We should, essentially, ignore the stock market other than as an occasional facilitator of liquidity between investors.
Wouldn’t it be so much better to be able to justify our livelihood by describing to clients how, with our help, their savings contribute to society as well as generating investment returns?
How they are helping to cure diseases and clean up the environment? Maybe then we would not feel so ashamed about justifying our fees that it takes a regulator to make us transparent about it.
It was Ernest Hemingway who said, ‘the best way to find out if you can trust somebody is to trust them’. If active managers want that opportunity, it is high time we return to our core purpose.
Stuart Dunbar (pictured) joined Baillie Gifford in 2003 and currently serves as director, financial institutions