(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
Feb 8 The scads of analysts and fund managers at
some money management firms may just be there as window
Rather than generating ideas, much less making it possible
for the firm to outperform for clients, a new study finds that
the true purpose of heavy investment in human talent may be
something a lot closer to an exercise in signaling, not always
Even worse, a heavily staffed fund or fund firm can be a
tip-off that there you will find "closet indexing," the practice
of closely hugging benchmarks so as to minimize career risk for
insiders while convincing clients they are buying a genuine
quest for alpha.
The paper, using a new data set, looked at the relationship
between the number of Registered Investment Advisors (RIAs) at a
given firm and the clients it serves, strategies it follows and
results it generates.
The upshot is that while having more RIAs - investment
professionals who are registered with the SEC or state
securities regulators - per dollar managed is "not associated"
with better performance it does help to attract assets.
"Our paper's contribution lies in explaining why investment
management firms hire and pay buy-side analysts and portfolio
managers who (on average) are unable to beat passive benchmarks
enough to justify their costs. Seemingly, these firms could earn
more money by firing these advisory personnel, indexing the
assets, and splitting the surplus with their investors," Leonard
Kostovetsky of Boston College and Alberto Manconi of Bocconi
University write in the draft published in November.
That isn't happening.
Much of what the study found makes perfect sense and is
utterly uncontroversial. It takes more people per dollar under
care to manage, and to market, funds active in less transparent
and commoditized markets like small-cap stocks. Similarly,
alternative or less liquid assets like real estate or
derivatives are more labor intensive. Individual investors,
particularly high-net-worth ones, were especially
Attracting funds is one benefit of higher staffing of RIAs;
all else being equal doubling the number of employees at the
firm level will increase by 2.5 percentage points the annual
growth in assets under management. As a business strategy,
that's not a bad one, though much depends on the firms' ability
to retain these assets.
Interestingly, the size of a firm's non-RIA staff, many of
whom do marketing, doesn't move the needle on flows, according
to the study.
MUTTON DRESSED AS LAMB
Instead, a larger number of RIAs is associated in the study
with a larger number of holdings and a lower tracking error in
relation to the style the fund says it employs.
In other words, the funds with a lot of RIAs per dollar
managed are, likely, doing something which looks a lot like
Genuine indexers are passive funds: they seek to track an
index as closely as possible at a low cost, usually a small
fraction of an active fund. Closet indexers are funds which
charge like active funds but which limit severely the degree to
which they deviate from the weights in the index against which
they are benchmarked. This is almost certainly a tactic aimed at
minimizing damaging periods of getting soundly beaten by one's
index, something that leads to investor flight and fund manager
"Overall, these findings suggest that firms that are not
able to generate positive alpha are closet indexing and using
their advisory teams to pretend that they are active managers
who should be paid the corresponding fees," the authors write.
A bit of caution is warranted. The study only covers about
four years, and thus may be capturing cyclical rather than
structural issues, much less strategies being knowingly followed
by firms. More study is no doubt forthcoming.
Still, the central observation makes sense to me. Asset
managers, like banks before (and sometimes after) deposit
insurance, depend for their business on making a suitably good
impression. That's why older bank buildings, from before the
days of the Federal Deposit Insurance Corporation, are so
lovely, with much marble and wood and nice high ceilings. They
scream: "We won't go bust!"
If the study is right, asset managers are just using a
different natural selection strategy to get on in the world.
Giving the appearance of having a well of deep expertise in a
firm is, if anything, an expense which is more safely employed
by index hugging than it would be in making big bets and
actually generating, or failing to generate, outperformance.
Hiring is easy, generating alpha is hard.
As ever, the best strategy for investors who want active
management is to look not just at performance against a
benchmark, but at how this was generated.
(Editing by James Dalgleish)