No Failure Like Success

This article originally appeared in the Winter 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

This issue of Morningstar magazine details the many changes in the bond market since the financial crisis, but one constant remains: Debt is big business.

The paradox of active managers’ struggle to beat their passive benchmarks in recent years is that the quality of active management has not deteriorated, it has improved. But for a subset of investors to better the averages, there must be some other subset regularly underperforming. For years, active managers assumed, with some accuracy, that a large pool of uninformed individual investors underperformed the market, thus allowing the bulk of professional investors to better the averages. This line of thinking gave rise to the “odd-lot” theory, which postulated that increased volume of odd-lot trades (stock purchases of less than 100 shares) signaled a market top, as the dumb money of small investors was now in play.

But somewhere along the line, the dumb money wearied of picking stocks and threw its lot in with the pros, opting for mutual funds. This move was magnified by a new breed of advisor who shifted their clients’ assets to funds rather than the individual securities that old-fashioned stockbrokers had favored. The pros were increasingly competing against other pros or corporate insiders who knew their own stocks better than the fund managers. The inferior participants who made the superior performance of many active managers possible were out of the game. The Washington Generals were no more.

When this mass migration to funds was in its infancy, it was still possible for some firms to beat the averages, since there remained a relatively large number of weaker players among the professionals. The fund industry of the early 1980s had a wide spectrum of talent levels, with some shops very astute, and others far less so. Investment talent was also scarce. The asset management industry had experienced a fallow decade, with fewer people entering the business following the 1973–74 bear market.

Hence, when the mutual fund boom began in the mid-1980s, there was a scarcity of trained analysts. Those shops that had them were able to produce markedly better numbers than others. A scramble to train new talent ensued and the Chartered Financial Analyst designation offered a welcome means to meet this need. As the CFA designation proliferated, higher standards of due diligence became the norm, which in turn, made it more difficult for some subset of managers to materially better their peers.

In addition to a talent edge, some shops also had an information edge before fair disclosure regulations mandated that corporations release material financial information to all potential investors at the same time. Prior to such regulations, well-connected fund shops often enjoyed privileged access to corporate management. This access likely contributed to the superior investment performance of some powerful investment firms during the 1980s and 1990s relative to their less-connected peers and to index funds, since the indexes obviously received no trading insights.

As regulation lessened the information advantage and the CFA program lessened the talent advantage, the investment landscape grew more homogeneous. Investment teams were peopled with analysts who had the same training and the same information and hence, viewed securities through the same lens. With more funds making similar decisions, all in the name of prudency and professionalism, costs rather than security choices increasingly became a larger determinant of performance, setting the stage for the rise of indexing.

Meanwhile, the index competition got smarter, as firms offering indexes also hired CFAs to create and manage their offerings. Early indexes like the Dow Jones Industrial Average were created not by financial analysts, but by journalists seeking a simple gauge of market moves. These indexes were designed for speed of calculation, not for their merit as investment options. Modern indexes, however, are built on astute academic and practical insights. The benchmarks are now arguably as smart as the pros.

The success of the CFA program created unintended consequences. With fund flows today tilting so heavily toward passive products, and those offerings being controlled by a handful of cost-conscious firms, and with active managers generally experiencing outflows, there will inevitably be lessened demand for securities analysts. This quandary perhaps led to a remarkable move on the part of the CFA Institute earlier this year—full-page ads in places like The New Yorker asking investors “Does your wealth manager measure up?” This shot across the bow to the Certified Financial Planner designation suggests that CFAs would be better financial advisors. Why would the CFA Institute take this rare tactic of invading another designation’s territory? If there is lessened traditional demand for your service, the logical move is to try to create new opportunities.

A turf war between CFAs and CFPs would be interesting to watch. I don’t question that any financial planning practice would benefit from having CFAs on staff, but I wonder if the STEM-like training offered by the CFA could supplant the more humanities-based behavioral counseling the planning community has embraced in recent years. In theory, the designations can be natural complements, leading to planning practices better positioned to guide investors toward their goals.

Although the oversupply of CFA skills has lessened the competitive position of active managers, I doubt that such a scenario will play out in the field of financial planning. The demand for quality financial counsel seems too great and the supply still far too small. But, of course, one might have said the same about active management in the 1980s.