In the perennial debate over active vs. passive management, Towers Watson has stepped in with the blunt notion that there are too many active managers — although the problem with that, it says, is “not the quantity, it’s the aggregate cost” to investors.
The firm, which this week announced the launch of its Thinking Ahead Institute, a not-for-profit think tank aimed at “influencing change in the investment world,” compares the world of investments to “a vast virtual warehouse filled with all the securities in the world.”
The analogy in its “thought experiment” is useful, it said, to “introduce the notion that the stock of investible assets is largely fixed,” despite “some coming and going at the edges.”
“It is clearly rational for an individual investor to hire an active manager to try and do better than all other investors. In the same way that it is rational for one person to graze an extra cow on common land,” the Towers Watson nonprofit says on its website. “Unfortunately this just launches an escalating arms race, and the eventual, assured conclusion is a societally-sub-optimal outcome.”
In its analogy, the think tank noted that, periodically, a forklift delivers a big wad of cash to the warehouse. That delivery is important, it says. But not much else that happens between investors with holdings in its figurative warehouse amounts to much. “Collectively they already own what is in the warehouse and there is no point in shuffling ownership rights back and forwards repeatedly,” it said.
Using “a broad brush,” it then assumes “index-tracking managers oversee 15 percent of the assets in the warehouse, active asset managers oversee 80 percent and hedge funds 5%.”
When the forklift comes with the money, the managers are then paid for their services. In its thought experiment, the nonprofit decides to pay the index-tracking managers $1, the active managers get $40 and the hedge funds get $15.
Pointing out that that $56 actually represents 2012 revenues of between $180 billion and $350 billion for global asset managers, the paper notes that investors therefore receive that much less money generated by the very assets they own — and then asks whether those owners “get anything useful for this money paid away.”
Index-tracking managers, it says, “are useful to society because they perform the necessary oversight for minimum cost.” On the other hand, “only a small subset of the active managers and the hedge funds are useful to society” because, while they do “police the access to the warehouse by filtering out bad assets and correctly pricing the new ones,” they also “charge asset owners an active-level or hedge fund-level fee for a passive-like product.”
The pursuit of higher returns, the paper says, results in an excessive shuffling of ownership and is “value-destructive.”
Instead, it would “wave our magic wand” in its thought experiment so about 70% of portfolio duties would be transferred to index-tracking managers, reducing the AUM held by the active managers to about 25% of the total and saving asset owners 41% of the fees they were previously charged.
And while this would be good news for the asset owners, who now have $74 to $144 billion that they can then “credit to the accounts of their beneficiaries, the end saver,” it’s not such good news for the asset management industry and its employees, who “could end up in more value-adding roles elsewhere in finance, or even in the wider economy.”
The paper concludes that, while “none of us is going to voluntarily ask for a 41% pay cut, and few of us will voluntarily retrain, but if we were really putting our clients first, we should.”
After all, it says at another point, “within financial services, public anger has, so far, been directed at the banks, but the asset management industry is arguably only just below the radar.”
Indeed, among various others catalysts, a regulatory trend, it says, is emerging around the world, “looking to cap the total charge that can be levied on defined contribution pension assets.”
For that reason and others, it said, “we should have less active management. Not none, but less.”
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