#NoAlphaNoPay
Published on February 1, 2022
Payment irrespective of alpha in the asset management industry is an ESG issue that needs to be addressed urgently if the industry has to evolve.
It’s not about the investors
“No Alpha No Pay” is not a protest line from investors (and asset owners). It’s not about them because the technology, the innovation, the access to information, the supply of data, the education, and the experience has empowered them. They know their power. This is why they are leading the passive investing revolution and, in the process, reducing the asset share under active management. The story has a lot of similarities to the ETFs overtaking mutual funds not just because of convenience and low fees but because of tax efficiency that came out of their passive investing approach. Investors have embraced innovation because it’s better. So, for investors it’s not about “No Alpha No Pay” because they don’t have to say it, they are walking into the board room, uninvited, and taking the seat at the negotiation table without uttering a word.
What may seem like a fortuitous trend regarding zero-fee trading and the mushrooming passive instruments, which helped the investor’s cause, has actually been a part of a chain of change that has always been happening in the industry. Investors affected the idea of zero-fee trading by asking, why should I even pay for trading? How can I reduce the fee? How can I commoditize the last mile of what we used to call brokerage? How can I make it free? Two millennials (investors) were behind setting up Robin Hood.
So now that we have zero-fee trading, zero-fee funds, do you really think investors are eager and waiting to tell the asset managers, “No Alpha No Pay”. It’s the active managers who need to accept the challenge that the fight has reached home and protecting the management fee is all water under the bridge. The industry has reached an inflection point, it has to transform before passive colors everything.
The Performers Purpose
The Asset Management should wake up to its purpose, stand up and say, “We the active managers believe in #No Alpha No Pay! We want to innovate. We want to change old practices. We see the writing on the wall. We can change and differentiate”.
The 1993 ETFs are an old innovation. The industry will churn out new innovations and eventually the power will shift from the incumbent to the new entrant. Investors are no longer going to pay for maintenance of assets that incurs a recurring cost. They would rather pay for the top decile of skill and give the bottom decile skill set another chance to perform. The top performer's purpose should be to differentiate itself from the underperformers who charge more than half a trillion dollars in fees in such times [1], while people have died, jobs have been lost and the society is living on bail out. And this can only happen if better asset managers decide to stop subsidizing underperformance in the industry.
Innovation is relentless
The technological innovation is going to give the second movers an advantage to challenge the incumbent. An incumbent is the one who invests in legacy systems and when technology changes, it finds itself owning legacy systems, infrastructural costs, and inefficient processes, which create the David - Goliath disequilibrium. We have seen this happening again and again, from discount to electronic brokerage, from conventional to Robo-advisors, from electronic brokerages to zero-fee trading, from Index to smart-beta funds, from mutual funds to ETFs, from Indexing to direct indexing, from market making to NextShares, from private equity to liquid alternatives, from cryptos to NFTs, and maybe soon from ESG to ESG assets.
Human capability is about constantly nudging at its environment to make it better while the older creations become cumbersome and ineffective. Information gets bundled, indexed, and repackaged into an improved design. Investors continue to drive product sophistication and may have failed on occasions with products like Inverse ETFs but still, there have been more ayes than nays.
The Prudent Investor Act and the elderly widow
Don’t test the patience of the weak. We are in the land of law and investors who sit at the table can take you to court and win rulings. And if this can happen to asset owners, it can happen to asset managers. The reckless fee-charging can come back to bite. The Supreme Court recently unanimously found that retirement plan sponsors need to act in a prudent manner associated with fiduciary responsibility. The U.S. Supreme Court’s 8-0 ruling in Hughes v. Northwestern University [2] has indicated that employers that sponsor defined contribution retirement plans should step up efforts to ensure that their plans’ mutual fund offerings are still prudent investments. The lawsuit was brought by current and former university employees who claimed that the plan fiduciaries violated the Employee Retirement Income Security Act's (ERISA's) duty of prudence by failing to monitor and control record-keeping fees, resulting in unreasonably high costs to plan participants.
Regulation and legality are about providing a framework, enhancing it, adopting it, raising it to a higher standard is the unspoken role for Asset Managers. Just because there is ambiguity regarding what is alpha for the Prudent Act, processes take precedence over performance, and diversification and risk-weighted returns don’t emphasize alpha, does not mean that asset managers should shy away from their core implicit fiduciary duty, which is to give above-market returns.
How can an asset manager ensure that while it adheres to the law that states the risk of an elderly widow with modest means needs to be understood, it is not levying underperforming fund fees on the elderly widow? There are limited checks and balances regarding how this implementation should be and why anyone should be paying for the underperformance.
If the traditional trust law also allows the beneficiaries of the trust to excuse its performance, when they are all capable and not misinformed, why can’t the trust be more prudent regarding fees charged?
The idea of charging a fee for maintaining assets and allowing them to trail the markets is difficult to justify in the times of Blockchain. The decentralized technologies of today make it easy to maintain assets and decimate transaction costs. The idea that an implicit claim of performance should have a management fee attached to it, is a hypothesis, whose ship has sailed.
The standard of prudence is relational. This brings ambiguity regarding its interpretation and measurability. Hence the concept becomes self-regulatory in nature rather than something enforceable and just because there is a reference to Modern Portfolio Theory (MPT) does not consequently mean a direct relationship of prudence with alpha.
Closet Indexing and Governance
Whether we find the courage to say, “No Alpha No Pay”, the eventuality of passive is obvious. John Bogle talked about mutual funds underperformance vs. the benchmark in 1975 and innovated the first Index Fund. The underperformance of mutual funds could easily have been happening since 1924 when the first mutual fund was launched in Boston because selection’s idiosyncratic risk is generally higher than the overall market risk.
Since it is legal to charge fees for an active process, product innovations like closet Indexing claim to actively purchase investments while investing in a portfolio like the benchmark, just to charge fees, a clear example of poor governance. It is difficult to identify a closet indexer but a meticulous look at the prospectus can bring out the truth. Taking a passive process but charging fees like active is an act that harms the capital market integrity in the long run. Closet indexing is a textbook case of agency conflict and the strategy is more widespread than initially thought [3]. Canada was disturbingly the biggest distributor of Closet Indexed funds in 2015 and the problem continues to exist to date.
The Alpha Conversation
We need to have an open conversation with our stakeholders and community at large about the conflict, the financial theories that fail to create alpha, and what should be the leadership role asset managers want to play in the changing world. The Emperor is dead or claiming its nudity [4], might seem disparaging thoughts on first impression but conflict resolving conversations are not always beautiful and pleasing. A conflict resolution is about allowing stakeholders to speak their hearts out. The community is speaking out and it demands to be heard. Asset managers can’t shy away from this discussion and it’s better to talk openly about the problem before the conversation becomes louder.
The industry has a call to action, a call to change. Let’s prove the naysayers wrong about governance and social inequity issues tarnishing asset management’s image. Let’s start the conversation. Let’s accept what should be improved. Let’s talk innovation. Let’s show that we are capable of innovation. Let’s be honest about brilliance. Top discretionary managers, the last of their creed need asset support, assets they should deserve compared to the assets they are able to acquire. The top percentile managers subsidizing the balance 90 percent of underperformers is an inefficient way to attract talent and strengthen the industry.
There is no one tool that works in the market. Despite the purity of the fundamental process, we have seen information drift and markets ability to price divergently away from valuations. The capability of technicals and the whipsaws that accompany it. The objectivity of the quantitative approach and the incompleteness of linear regression. The alpha conversation is not a crisis but an opportunity.
Transition to a better Governance
The industry may not need a dramatic implementation to #No Alpha No Pay because the same investors who are disrupting the active process are also the ones in a relationship with us. There is humanness in an investment management relationship that has patience and understanding with a transition process.
The fees are not distributed equitably and do not reach the back and middle office in the industry. This brings seriousness in respect to the social issues concerning the industry. The industry should come up with a transition plan. If Microsoft can plan to go carbon negative by 2030, Investment management could come up with a plan for fees reduction to zero management fees by 2030.
We should find ways that elderly widows and no investor should pay for underperforming products beyond a certain time. Charging fees for 5-year underperforming products is poor governance. A policy framework should be put in place for such contingencies. There could be a fee reduction process, a scorecard on the factsheet of a product suggesting how a fund has fallen to the zero-fee category and revisit it when the product performance recovers. If we can’t commit ourselves to a #No Alpha No Pay world, the Active is exposing itself to potential redundancy. We don’t want everything to become some version of Passive. Committing ourselves to #No Alpha No Pay forces us to explore the unexplored areas of innovation like asset allocation, alternative assets, advisory, technology, and design which are tied back to differentiation, product innovation, and alpha.
ESG in asset management begins with the self. I teach the usage of water at home to my 4-year-old. I have to prepare her for a burning earth. It is not easy to teach a child that her home is on fire and firestorms have destroyed so many homes. I am educating her on how to live sustainably but I don’t want to explain to her, how trillions of dollars were legally stolen every year from simple people who trusted their asset managers and why there was a time when markets could not be beaten for 150 years of its existence.
#NoAlphaNoPay
Bibliography
[1] Sam Benstead, Investors pay out £400m in fees to poorly performing fund managers, Telegraph, January 2022
[2] Hughes v. Northwestern University, SCOTUS, January 2022
[3] Shaun William Davies, David Brown, The Rise of Closet Indexing, 2015
[4] Robin Wigglesworth, The hidden ‘replication crisis’ of finance. November 2021, Financial Times