Most of the time when I talk to people about the investment industry I get the distinct sense that they would rather talk about almost anything else. While there are certainly many potential causes for such an understated response, I also don’t get the sense that an overwhelming degree of satisfaction is usually one of them. Rather, there seems to be a persistent state of frustration lurking under the surface that occasionally reveals itself in comments like, “I’d like to be able to get more confident with my investing”, and, “Do you ever get to talk to the person managing the money?”
To the extent that lurking frustration exists, it is not for lack of investment expertise. Not only are there thousands upon thousands of investment professionals, but there are also terrific credential programs like the CFA and the CFP, a substantial and diverse active management industry that has a business model predicated on developing proprietary insights, and research that suggests it works. For example, the study “Best Ideas” [Cohen, Polk, and Silli, 2010] shows that the typical active money manager actually does outperform with his/her best ideas (the problem is that most portfolios also contain a lot of other ideas which aren’t nearly as good).
So why do investors continue to be frustrated when all of this expertise is available? The answer, in a word, is friction.
Sources of friction
Just like the progress of any vehicle is slowed down by the friction created by its contact with the road, so too is the efficient transfer of investment expertise constrained by a variety of structural sources of “friction” in the industry.
One important source of investment friction is the tendency of many firms to focus more on the business of investment management than on the profession of investing. Because the universe of significant investment opportunities is limited in a competitive environment, managers must settle for progressively less attractive alternatives as a fund grows larger — and this dilutes performance. The conflict of interest between an investment manager’s desire to grow assets (and therefore business profits) and an investor’s desire for a smaller fund focused exclusively on best ideas is one way in which investment expertise often fails to benefit clients.
A second source of friction is essentially a corollary of the first: Many firms fail to focus on the types of activities that are closely associated with generating superior investment returns. For example, many firms persist in charging high fees for investment services despite widespread evidence that high fees detract from returns. Many run portfolios that look very similar to their benchmarks rather than concentrating on best ideas (i.e., high active share). Many react (and overreact) to short-term results for which there is very little information content (i.e., low signal to noise ratio). Each of these types of activities is a well-known structural impediment to good investment performance and each is the result of a choice, a tradeoff, made by an organization’s leaders. While it is unfortunate such impediments exist, they are absolutely avoidable.
A third source of friction is over-specialization. When an environment remains stable for a long period of time the most successful entities are those that focus on a very narrow area of expertise. Examples include narrowly defined functional silos such as industry-specific analyst coverage and very narrowly defined investment mandates. In such an environment, flexible business approaches and policies to insure against large losses represent unnecessary opportunity costs. In a more tumultuous environment, however, the costs of focusing too narrowly can be debilitating and sometimes even deadly. It’s fine to pack only swim suits and t-shirts for the beach as long as the weather stays nice. If it gets cold and rainy, you’ll wish you had better choices.
What you can do
While various sources of friction often prevent investors from deriving as much benefit as they might from the industry, the good news is that they also provide a clear target for improvement. If you want things to run more smoothly and efficiently, just reduce or eliminate the sources of friction. For investment firms this is simply a matter of making policy choices — of choosing to focus, on the margin, more on the exercise of investing than on the business of investment management. For investors, this is just a matter of identifying the firms that are not only willing to accept, but to actually encourage, making the tradeoffs that benefit investment results.
Another way for investors to derive more benefit from the investment services industry is to find better user interfaces. Steve Jobs revolutionized the computer industry by developing a graphical user interface (GUI) that made it much easier for normal people to interact with computers. The same needs to be done with investment firms. While a great deal of investment expertise does exist, only a small subset of that resides with organizations that have cultures truly oriented to helping people. Without such a culture, the path of least resistance is for that expertise to first benefit investment firms and their employees.
The investment services industry is interesting as a case study because it defies so many well established norms in other industries. Exceptionally few businesses in a competitive environment can afford to persist with processes and behaviors that impede performance and client satisfaction. If you went to a nice restaurant and ordered an expensive meal and the waiter came out and just threw it down in front of you without explanation and walked away, you would probably be miffed and might consider never coming back. Oddly, the same behavior happens with investment firms all the time — except in these cases investors tend to resign themselves to accepting such treatment. You can do better, but you will almost certainly need to look for new approaches that avoid old, and predictable, sources of friction.