Fund staff may be there to impress, not outperform: James Saft

Rather than generating ideas, much less making it possible for the firm to outperform for clients, a new study finds that the true purpose of heavy investment in human talent may be something a lot closer to an exercise in signaling, not always truthfully, talent.

Even worse, a heavily staffed fund or fund firm can be a tip-off that there you will find “closet indexing,” the practice of closely hugging benchmarks so as to minimize career risk for insiders while convincing clients they are buying a genuine quest for alpha.

The paper, using a new data set, looked at the relationship between the number of Registered Investment Advisors (RIAs) at a given firm and the clients it serves, strategies it follows and results it generates.

The upshot is that while having more RIAs – investment professionals who are registered with the SEC or state securities regulators – per dollar managed is “not associated” with better performance it does help to attract assets.

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“Our paper’s contribution lies in explaining why investment management firms hire and pay buy-side analysts and portfolio managers who (on average) are unable to beat passive benchmarks enough to justify their costs. Seemingly, these firms could earn more money by firing these advisory personnel, indexing the assets, and splitting the surplus with their investors,” Leonard Kostovetsky of Boston College and Alberto Manconi of Bocconi University write in the draft published in November.

That isn’t happening.

Much of what the study found makes perfect sense and is utterly uncontroversial. It takes more people per dollar under care to manage, and to market, funds active in less transparent and commoditized markets like small-cap stocks. Similarly, alternative or less liquid assets like real estate or derivatives are more labor intensive. Individual investors, particularly high-net-worth ones, were especially labor-intensive.

Attracting funds is one benefit of higher staffing of RIAs- all else being equal doubling the number of employees at the firm level will increase by 2.5 percentage points the annual growth in assets under management. As a business strategy, that’s not a bad one, though much depends on the firms’ ability to retain these assets.

Interestingly, the size of a firm’s non-RIA staff, many of whom do marketing, doesn’t move the needle on flows, according to the study.

MUTTON DRESSED AS LAMB

Instead, a larger number of RIAs is associated in the study with a larger number of holdings and a lower tracking error in relation to the style the fund says it employs.

In other words, the funds with a lot of RIAs per dollar managed are, likely, doing something which looks a lot like closet indexing.

Genuine indexers are passive funds: they seek to track an index as closely as possible at a low cost, usually a small fraction of an active fund. Closet indexers are funds which charge like active funds but which limit severely the degree to which they deviate from the weights in the index against which they are benchmarked. This is almost certainly a tactic aimed at minimizing damaging periods of getting soundly beaten by one’s index, something that leads to investor flight and fund manager job seeking.

“Overall, these findings suggest that firms that are not able to generate positive alpha are closet indexing and using their advisory teams to pretend that they are active managers who should be paid the corresponding fees,” the authors write.

A bit of caution is warranted. The study only covers about four years, and thus may be capturing cyclical rather than structural issues, much less strategies being knowingly followed by firms. More study is no doubt forthcoming.

Still, the central observation makes sense to me. Asset managers, like banks before (and sometimes after) deposit insurance, depend for their business on making a suitably good impression. That’s why older bank buildings, from before the days of the Federal Deposit Insurance Corporation, are so lovely, with much marble and wood and nice high ceilings. They scream: “We won’t go bust!”

If the study is right, asset managers are just using a different natural selection strategy to get on in the world. Giving the appearance of having a well of deep expertise in a firm is, if anything, an expense which is more safely employed by index hugging than it would be in making big bets and actually generating, or failing to generate, outperformance.

Hiring is easy, generating alpha is hard.

As ever, the best strategy for investors who want active management is to look not just at performance against a benchmark, but at how this was generated.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by James Dalgleish)