The Asteroid & the Portfolio Manager

Charlie Smith in Quarterly Newsletter 13 September, 2018

Fidelity Investments has finally done it. The large Boston-based fund manager recently cut the management fees on two of their index-oriented stock mutual funds to zero—nada—NOTHING. Their arch rival Vanguard Group pioneered cheap, index-based investing in 1974. Forty-four years later, after decades of competitive innovation, fee-cutting and marketing hocus between Fidelity, Vanguard and third rival Charles Schwab, we’ve reached a crossroads in the industry. Money management is officially a free service! How can Fidelity (or anyone) make money at zero? Could fees actually go below zero in the future? Where is the “value add” in the investment industry today? What about so-called “wealth managers”? What’s their place in the industry? With this latest news from Fidelity, these are a few of the key questions facing providers and clients alike. We’ve got a few tentative answers.

First, on the matter of whether money managers can be profitable without charging fees, the answer is… it depends. Large players (like the Big Three mentioned above) can generally make it work because of two things—scale economies and securities lending. Schwab and Fidelity, for example, have custody of trillions of dollars in stocks and bonds. They can lend your Boeing or Exxon shares to short-sellers in return for fees. Likewise, Vanguard can sell and later repurchase your Treasury bonds from a hedge fund in return for interest payments. In this way (and others), large securities portfolios (portfolios technically “owned” by customers) generate material levels of income—enough to cover the cost of running an index fund, for example.

Remember, in money management as in most personal service businesses, costs are mostly people costs. Substituting a rote equity index and a computer program for the (well paid) people formerly managing the money can generate big savings. This is one of the secrets of the Big Three, and they’re making it work—for themselves and millions of retail investors. In the future, the benefits of automation will continue to flow, and as competition between the big players continues to heat up, there’s no practical reason that fees can’t go negative, at least for short periods. Imagine being paid by your money manager for the privilege of handing him your nest egg! Cry no tears for your Big Three custodian, however; they’re making it up on the securities lending side.

The next (and far more important) question: With these trends in place, what is happening to the value equation in the wealth and money management businesses? The answer here depends, critically, on the definitions of these terms. Wealth managers and money managers are two different things. Simply put, wealth management is defined as helping people with every aspect of their money EXCEPT the actual portfolio management. Wealth managers consult with clients about their goals and risk tolerance, calculate needed rates of return and project future cash needs and flows. In a word, they plan. They then HIRE money managers to execute the plan. Finally, and most critical of all, wealth managers counsel and help clients stick to their plan when it matters most—when the financial world is going haywire.

As noted above, current trends are making one of these skill sets obsolete. Can you guess which one? Hint: any service priced at or below zero is likely not long for human habitation. Portfolio managers are modern-day dinosaurs, soon to be extinguished by the asteroid known as index funds. In early 2017, Moody’s calculated that passive (index) strategies accounted for 29 percent of the U.S. stock market. This fraction has likely since passed the 1/3 mark, and is projected to grow to 50 percent by 2024. What happens when more than half the stock market is priced “automatically”, so to speak, and human price discovery is less and less relevant? No one knows. But assuming the 50 percent barrier is broken with no problems, there’s no reason to think index funds can’t eventually capture the large majority of investor’s money.

And that’s OK, because the typical retail investor has no business trying to manage on his/her own. Particularly not in the method popularized by the financial media, where the equivalent of carnival barkers endlessly implore the little guy to play the “Game of Wall Street”. They promise you can out-pick, out-quick and out-trick your way to wealth, but it’s a loser’s game. Sad fact: professional investors fail to beat the market 80 percent of the time. This is all you need to know about your chances for success as a small fry, even if you manage to ignore the siren song of Jim Cramer, and employ a sensible buy-and-hold strategy.

Indexing is the future. Portfolio managers are in eclipse everywhere. Interestingly, this megatrend makes the skills of the wealth manager even more critical. Here’s why: As more and more people experience the benefits of indexing (instant equity exposure and diversification at low cost), they need to live, learn and internalize another basic truth of investing to be successful in the long run: Think like a business owner, and stay invested no matter what.

Index investors, who are trained to “set it and forget it” and often don’t fully understand what they own, may not feel the need for a guiding hand. But they absolutely need one at certain crucial times. When are those times? The week after 9/11, the dot-com crash and the fall of 2008 are just a few examples. These are the times when even the most technically sound financial plan can be crushed by the herd impulse, and a lifetime of good planning can be wiped away in an emotional instant. The best wealth managers are true psychologists and counselors, willing to answer the call at these times, and able to provide a calm voice in a storm. Always a key component of the advice equation, skilled and compassionate wealth managers will be an even more valuable cog in the indexed future.

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