Trust

I read an interesting paper today, titled “Money Doctors”.  It was written by Nicola Gennaioli (Universitat Pompeu Fabra), Andrei Shleifer (Harvard) and Robert Vishny (University of Chicago).  I want to share some pieces of their research.  This is relevant to all investors – whether you use a money manager or manage your own money.

Key Issue

A tremendous amount of research shows that professional money managers underperform passive investment strategies (i.e., buying an index fund) net of fees.  Two prior studies show that mutual funds underperform passive indexes by 65 – 67 basis points (after fees).

Even worse, many investors pay fees to a manager who then helps them invest in underperforming mutual funds.  When you consider all fees, some studies show that investors underperform passive funds by 2%.

So, you have to ask yourself, why do you pay for a money manager rather than invest on your own?

The Reason

Among other things, money managers offer:

1. Knowledge about how to diversify
2. Trust, experience, dependability — peace of mind

Peace of mind might be the most important thing you get.  Managers help you to invest in risky assets.  They allow you to take risks that you might not have taken on your own.  In effect, while you may underperform the index funds, you may be outperforming your risk-free investments (or your mattress).   In other words, advice may be costly, generic or even (sometimes) self-serving…but, you still may be better off.

Trust reduces the investor’s perception of risk (allowing the investor to take more risk).  While trust may be impacted by performance, it is really based on:

1. Personal relationships
2. Familiarity
3. Persuasive advertising
4. Connections to friends and colleagues
5. Communication
6. Schmoozing

Key Ideas to Consider

1. Investors perceive risky investments selected by managers to be less risky.  This allows the manager to make riskier investments and charge higher fees.

2. Managers have a strong incentive to pander (giving clients what they want, rather than what the manager thinks is best) because pandering increases the client’s trust for the manager.  As a result, professional money managers don’t eliminate investor biases.

3. While there’s a belief that contrarian investing (going against the masses) creates value in the long-term, it can destroy the client’s trust.  This makes it unattractive.  In addition, contrarian strategies usually create their value over a long period of time – another factor that weighs against it.

4. In order to engage in contrarian investing, a manager has to believe that the contrarian strategy will result in outperformance that will lead to more clients.  This has to outweigh the loss of trust involved in this strategy.  Contrarian strategies may also make it difficult to charge high fees.  (There is some research that shows that the managers with the worst performance records charge the highest fees.)

5. Performance may affect trust over the long-term.  But, in order for performance to matter, investors would have to have some understanding of risk-adjusted performance (i.e., you can’t just look at your return, you have to measure it relative to the risk that you took).

6. If you believe that investors are paying for trust (rather than performance), this means that fees are a way of sharing the benefits of market exposure (referred to as “beta”) rather than compensation for outperformance (referred to as “alpha”).  In other words, if you believe this, you believe that investors are paying for anxiety reduction rather than alpha.

7. To the extent that we have more trust (as a population), more assets are invested in risky securities, rather than kept in risk-free instruments.  Ultimately, to the extent that this happens, investors are better off and we are all better off (because there is more capital for risky projects).

8. Research shows that investors who use advisors have portfolios with higher betas (i.e., more market exposure) than similar investors (based on demographics) who invest on their own.  Since we believe that there is value in taking risk, advice from advisors creates value.

9. Trust allows investors to take risk and also allows money managers to get paid to take that risk.  As a result, this may explain why money managers who take more risk (think of hedge fund managers) are able to extract higher fees.  Of course, it could work in the opposite order – higher fees may lead managers to take more risk with their portfolio.

10. You might also argue that higher fees discourage investors from selecting risky investments.  So theoretically, you could argue that higher fees (on risky investments) may discourage investors from taking too much risk.

11. Trust reduces investor mobility – in other words, investors stay with the manager that they trust.  This means managers can charge more (without losing clients) and it means that it’s particularly difficult to “steal” a client (getting him to leave his existing manager).  As a result, being a contrarian may lead to higher returns but still may not attract clients.

12. Managers have to weigh the risk of pandering (lower returns which may hurt future ability to attract clients) versus the benefit (attracting more clients and charging higher fees).

13. When investor beliefs are misguided and highly correlated, money managers pursue similar strategies (pandering to those misguided beliefs), while dividing the market based on the trust of their clients.

14. These same theories could apply to banks.  We can be in a bubble and shareholders or directors may think it’s prudent and profitable to expand lending.  A bank manager might pander to that view (to raise his pay and keep his job).  It doesn’t matter if this conflicts with his real beliefs.  This results in excessive lending and furthers the bubble.

Have a great weekend.

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