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“Observing this change in 1967 he sized it up pungently: ‘There was only one place to make money in the mutual fund business – as there’s only one place for a temperate man in a saloon behind the bar and not in front of it... so I invested in a management company’.” – Nobel Laureate Paul Samuelson
The debate about the structure of the fund management industry has been raging for many decades. In particular, John Bogle has been a vocal critic of the way the industry’s structure has developed. It might be useful to firstly define the terms on which the debates centre.
To those who see the industry as a profession it means sound investment principles dominate, investment activities are governed by prudent standards and a philosophy of long-term investing, fund management firms “sell what they make” – and what the fund mangers themselves are interested in investing their own money in. Such a firm is generally privately owned and predominantly acts as a steward of clients’ fiduciary interests. Professional firms are usually not great businesses (you’d rather be a client than an owner), as the risk is carried by a few principals and there are limited benefits of scale, with most financial gains going to enhance the research and investment process.
By contrast, fund management as a business is dominated by salesmanship where firms “make what will sell” and investment activities are dominated by developing hot new funds driven by speculative high turnover strategies. Such a firm is generally publicly owned or part of a financial conglomerate and the interests of the principles (shareholders and management) of the firm dominate. There are massive economies of scale and the financial benefits are spent on widespread advertising to strengthen and compound business gains. As a result, such firms are fantastic businesses – where you’d rather be an owner than a client, as Paul Samuelson understood early on.
To be sure, these are descriptors of the two extreme ends of the spectrum. However, I’m sure readers will recognise strong elements of each in the firms they deal with. It’s also true the trend has been a gradual move away from fund management as profession to fund management as business so that today most firms find themselves in the middle ground between those two extremes.
Bogle identifies the beginning of that gradual process as a single landmark legal case, now long forgotten. In 1956, the owners of Insurance Securities Incorporated (ISI), manager of ISI Trust Fund – a mutual fund investing largely in the stocks of insurance companies – sold its controlling shareholdings in the management company to a new buying group for 15 times book value.
In Bogle’s words: “The Securities and Exchange Commission challenged the deal, arguing the sale of a fiduciary office was a ‘gross abuse of trust’ under Section 36 of the 1940 Act. Since ‘the value attached to the (management) contract is an asset of the fund’ its sale to others violated ‘general equitable principles’. The SEC also argued, prophetically, that when an excess value is paid it might ‘prompt the new owners to pursue a hazardous or doubtful policy in an effort to recoup the purchase price’.
“The SEC arguments failed to carry the day and the die was cast. And the floodgates opened. A rush of public offerings of fund management companies followed and by the mid-sixties a score of fund managers had become publicly held.”
How times change! The SEC argument seems almost quaint today. Yet it goes to the nub of the problem investors face today. The financial services industry generally – and the fund management industry specifically – has always been rife with potential conflicts of interest. It’s how those conflicts are resolved – and not whether they occur – that distinguishes profession from business. As greater financial strength has enabled brand-building to replace reputation building, conflicts are generally resolved in favour of the agent or business. And as brands get stronger that trend is reinforced.
Such ratcheting down of industry standards hasn’t been all negative, as many benefits have accrued: a greater appetite for growth, greater efficiency and organisational certainty and greater creativity and innovation. Undoubtedly clients gain at least marginally from some of those. Some fund management businesses have devised new funds that actually serve their clients well. However, the overall effect has been to benefit and strengthen the position of the agent/employee in the chain and weaken that of the client.
To be fair, the fund management profession hasn’t been alone in this “ethics drift”. Many of the great professions that have served society well through the years are slowly morphing into businesses. In some, high standards of accountability mitigate the trend somewhat: think of the medical profession, for example.
But the ratcheting down of professional standards has become a societal trend as the agents in business gain the upper hand over the principals. That’s very hard to reverse and has devalued the “coin of the realm” – the fiduciary care owed to clients. Like inflation, it’s an insidious process and one only realises the extent of the damage when it’s too late.
In defence, one can say the industry is merely responding to the needs of the client. As investors have become more financially literate they’ve demanded greater product choice from their fund management firms, as well as a greater degree of control over their own financial affairs.
The argument goes that fund management as businesses has been better able to respond to the developing needs of their clients. In any case, who are we as fund managers to second guess what our clients need and want? Better just to provide them with solutions, even if thoughtful contemplation shows some of those “solutions” lead to poor outcomes over the long term for the client?
But that also raises the question: Have investors’ perceived needs been manipulated by fund management as business? Have these businesses, through financial literacy and client education programmes, given investors a false impression of what they need – and then provided the product choices through which they can satisfy these false needs?
In her book The art of choosing, Sheena Iyengar shows that once people are faced with more than 10 choices they begin choosing badly. Is that the secret sauce with which the fund management as business seeks to control its clients: a disingenuous programme of choice overload? In fact, as Charles Ellis points out, one of the characteristics of fund management as business is a proliferation of funds catering to every conceivable – and inconceivable – investor need.
This self-reinforcing process creating hot product to satisfy false needs has contributed to stock markets generally coming to resemble casinos. People visit casinos as a form of entertainment, willingly taking part in a process mathematically certain to be a losing proposition. In a similar vein, investors move their money from hot fund to hot fund in a process that can also be very entertaining but on average leads to disappointing outcomes.
Contrast that with fund management as profession, which is akin to a visit to the doctor. The doctor has built a reputation for good advice in the community and patients rely on word of mouth to ascertain the qualities of the different doctors they can choose from. The doctor has in-depth knowledge of his or her subject, generally specialises in a chosen field and doesn’t pretend to be able to cure all ills. In turn, the patient respects the doctor’s judgment – even though he might not get it right every time – and tends not to read books with titles like “Do your own heart transplant in 10 easy steps”.
That’s not to say clients always get fleeced in the environment of fund management as business and clients are always better off in the environment of fund management as profession.
However, as investors our job isn’t to determine the exact outcome of each individual decision – as that’s impossible – but to come up with an investment process where each individual decision increases the odds of attaining a positive outcome. Cumulatively, this gives one a strong edge. If one of those decisions is which fund manager to use, deciding on one that leans towards fund management as profession is a sensible choice.
PIET VILJOEN
RE:CM
WITH 20 years’ industry experience Viljoen has consistently achieved returns that place him in the top tier of fund managers. He began as a lecturer at the University of Pretoria and subsequently joined the SA Reserve Bank as an economic analyst. He joined Allan Gray Investment Council in 1991 as a portfolio manager and in 1995 moved to Investec Asset Management. He’s the founder and executive chairman of RE:CM. He holds a BCom (Hons) and is a CFA.
The debate about the structure of the fund management industry has been raging for many decades. In particular, John Bogle has been a vocal critic of the way the industry’s structure has developed. It might be useful to firstly define the terms on which the debates centre.
To those who see the industry as a profession it means sound investment principles dominate, investment activities are governed by prudent standards and a philosophy of long-term investing, fund management firms “sell what they make” – and what the fund mangers themselves are interested in investing their own money in. Such a firm is generally privately owned and predominantly acts as a steward of clients’ fiduciary interests. Professional firms are usually not great businesses (you’d rather be a client than an owner), as the risk is carried by a few principals and there are limited benefits of scale, with most financial gains going to enhance the research and investment process.
By contrast, fund management as a business is dominated by salesmanship where firms “make what will sell” and investment activities are dominated by developing hot new funds driven by speculative high turnover strategies. Such a firm is generally publicly owned or part of a financial conglomerate and the interests of the principles (shareholders and management) of the firm dominate. There are massive economies of scale and the financial benefits are spent on widespread advertising to strengthen and compound business gains. As a result, such firms are fantastic businesses – where you’d rather be an owner than a client, as Paul Samuelson understood early on.
To be sure, these are descriptors of the two extreme ends of the spectrum. However, I’m sure readers will recognise strong elements of each in the firms they deal with. It’s also true the trend has been a gradual move away from fund management as profession to fund management as business so that today most firms find themselves in the middle ground between those two extremes.
Bogle identifies the beginning of that gradual process as a single landmark legal case, now long forgotten. In 1956, the owners of Insurance Securities Incorporated (ISI), manager of ISI Trust Fund – a mutual fund investing largely in the stocks of insurance companies – sold its controlling shareholdings in the management company to a new buying group for 15 times book value.
In Bogle’s words: “The Securities and Exchange Commission challenged the deal, arguing the sale of a fiduciary office was a ‘gross abuse of trust’ under Section 36 of the 1940 Act. Since ‘the value attached to the (management) contract is an asset of the fund’ its sale to others violated ‘general equitable principles’. The SEC also argued, prophetically, that when an excess value is paid it might ‘prompt the new owners to pursue a hazardous or doubtful policy in an effort to recoup the purchase price’.
“The SEC arguments failed to carry the day and the die was cast. And the floodgates opened. A rush of public offerings of fund management companies followed and by the mid-sixties a score of fund managers had become publicly held.”
How times change! The SEC argument seems almost quaint today. Yet it goes to the nub of the problem investors face today. The financial services industry generally – and the fund management industry specifically – has always been rife with potential conflicts of interest. It’s how those conflicts are resolved – and not whether they occur – that distinguishes profession from business. As greater financial strength has enabled brand-building to replace reputation building, conflicts are generally resolved in favour of the agent or business. And as brands get stronger that trend is reinforced.
Such ratcheting down of industry standards hasn’t been all negative, as many benefits have accrued: a greater appetite for growth, greater efficiency and organisational certainty and greater creativity and innovation. Undoubtedly clients gain at least marginally from some of those. Some fund management businesses have devised new funds that actually serve their clients well. However, the overall effect has been to benefit and strengthen the position of the agent/employee in the chain and weaken that of the client.
To be fair, the fund management profession hasn’t been alone in this “ethics drift”. Many of the great professions that have served society well through the years are slowly morphing into businesses. In some, high standards of accountability mitigate the trend somewhat: think of the medical profession, for example.
But the ratcheting down of professional standards has become a societal trend as the agents in business gain the upper hand over the principals. That’s very hard to reverse and has devalued the “coin of the realm” – the fiduciary care owed to clients. Like inflation, it’s an insidious process and one only realises the extent of the damage when it’s too late.
In defence, one can say the industry is merely responding to the needs of the client. As investors have become more financially literate they’ve demanded greater product choice from their fund management firms, as well as a greater degree of control over their own financial affairs.
The argument goes that fund management as businesses has been better able to respond to the developing needs of their clients. In any case, who are we as fund managers to second guess what our clients need and want? Better just to provide them with solutions, even if thoughtful contemplation shows some of those “solutions” lead to poor outcomes over the long term for the client?
But that also raises the question: Have investors’ perceived needs been manipulated by fund management as business? Have these businesses, through financial literacy and client education programmes, given investors a false impression of what they need – and then provided the product choices through which they can satisfy these false needs?
In her book The art of choosing, Sheena Iyengar shows that once people are faced with more than 10 choices they begin choosing badly. Is that the secret sauce with which the fund management as business seeks to control its clients: a disingenuous programme of choice overload? In fact, as Charles Ellis points out, one of the characteristics of fund management as business is a proliferation of funds catering to every conceivable – and inconceivable – investor need.
This self-reinforcing process creating hot product to satisfy false needs has contributed to stock markets generally coming to resemble casinos. People visit casinos as a form of entertainment, willingly taking part in a process mathematically certain to be a losing proposition. In a similar vein, investors move their money from hot fund to hot fund in a process that can also be very entertaining but on average leads to disappointing outcomes.
Contrast that with fund management as profession, which is akin to a visit to the doctor. The doctor has built a reputation for good advice in the community and patients rely on word of mouth to ascertain the qualities of the different doctors they can choose from. The doctor has in-depth knowledge of his or her subject, generally specialises in a chosen field and doesn’t pretend to be able to cure all ills. In turn, the patient respects the doctor’s judgment – even though he might not get it right every time – and tends not to read books with titles like “Do your own heart transplant in 10 easy steps”.
That’s not to say clients always get fleeced in the environment of fund management as business and clients are always better off in the environment of fund management as profession.
However, as investors our job isn’t to determine the exact outcome of each individual decision – as that’s impossible – but to come up with an investment process where each individual decision increases the odds of attaining a positive outcome. Cumulatively, this gives one a strong edge. If one of those decisions is which fund manager to use, deciding on one that leans towards fund management as profession is a sensible choice.
PIET VILJOEN
RE:CM
WITH 20 years’ industry experience Viljoen has consistently achieved returns that place him in the top tier of fund managers. He began as a lecturer at the University of Pretoria and subsequently joined the SA Reserve Bank as an economic analyst. He joined Allan Gray Investment Council in 1991 as a portfolio manager and in 1995 moved to Investec Asset Management. He’s the founder and executive chairman of RE:CM. He holds a BCom (Hons) and is a CFA.
