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Are Consultants Hampering Active Management?

Probably much less than the managers themselves believe.

John Rekenthaler, 08/04/2015

How's this for a headline? Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog. If that makes a lick of sense to you, then you read far too much about investments. (But thanks.)

The article itself, however, is lucid.

Jason Voss, a former portfolio manager who now works for the CFA Institute (the research affiliate of the organization that runs the Chartered Financial Analyst program), writes that active investment managers could perform better but are hampered by institutional barriers. Voss is not the first to make that argument, but he states the case particularly well. He also is fair in pointing out that if he is correct, that investment managers have nobody to blame but themselves: "The wounds are self-inflicted."

Voss posits that investment-management companies follow a predictable life cycle: fast out of the gate, receding over time. This performance erosion occurs because the company loses focus. At the beginning, the only way for a new investment-management firm to attract clients is through investment gains. Once those early returns have been scored, though, the firm begins to think, "With these returns in hand, we can now gather assets by telling the world our good news story." Its attention then turns toward sales, away from investment-management activity.

Worse, these sales conversations end up affecting the investment-management function. As the company visits with what Voss calls "investment adjuncts"--private wealth managers, registered representatives, consultants, and others who assist in the distribution process--it is asked a barrage of questions. (For clarity's sake, I will use the more common term of "consultants," rather than "adjuncts.") This exercise is innocently intended, as consultants have every right to try to understand why they might favor this particular investment manager "from among the vast sea of such beasts."

Unfortunately, the effect is smothering, as the questions are accompanied by measurements that bind. Voss writes, "Now if a manager wants to raise assets under management through marketing, the price is to clear the preferred mathematical hurdles of the adjuncts. Particularly pernicious, and especially germane to the current discussion, are the concepts of 'style box', 'style drift', and 'tracking error.'"

Voss' tale is clear. An investment-management firm initially pursues its craft as best it can, free from the burden of expectations. As the company accrues clients, however, and spreads the word among the investment community, it is prodded and poked by well-meaning observers into becoming something different. The animal is tamed. It moves in the investment-consultant zoo, and behaves accordingly.

Examining the Claim
Is the tale correct? Well, it is consistent with the facts. Emerging investment-management companies often do post outsized performance. It is also true that as they receive assets, they expand their marketing (and client-service) departments, and that the larger and more mature they become, the more conservative they tend to get. For a tiny investment-management firm, mistakes of omission are worse than mistakes of commission: They need to do something. For a giant firm, the reverse holds true: Better to trudge along than to surprise a client.

is vice president of research for Morningstar.

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