Since I became an institutional investor, my #1 learning is: this is a highly unusual and somewhat baffling industry. Asset management shows the traditional earmarks of an industry ripe for disruption — most obviously, unhappy customers and extremely profitable incumbents.
Despite this, it’s hard to think of good examples of disruption to asset management in the classic, Clay Christensen sense. The best examples I can think of include index funds (Vanguard); ETFs (iShares); crowdfunding (Indiegogo); discount/online brokerages (Charles Schwab); online wealth management (Wealthfront, Betterment); back office management (Addepar); principal-protected investments (JP Morgan, numerous others); and expert network investment research (my former company, Circle of Experts).
Clay Christensen observes that disruptive companies often emerge from firms that serve one use case well (“jobs to be done”), and then grow from there. In investing, I can think of a few examples of this paradigm. Index funds serve the goal of returns well, but do not satisfy the need of an allocator to think that he can pick above-market returns providers. Inflation-linked bonds serve the goal of inflation protection, but also do not satisfy the need of an allocator to pick an above-market return provider. They also can generate low returns in a low-inflation world. Angel investing provides good returns, but typically provides poor liquidity, mediocre transparency, and requires a lot of manual effort per dollar invested.
I think there are many more opportunities to disrupt the space. At our firm, ff Venture Capital, we’re trying our part to rethink how the industry works, and also actively looking for opportunities to invest in companies creatively disrupting this sector, e.g., our portfolio companies Addepar and Indiegogo. We think that one vector for identifying great entrepreneurial opportunities is to identify disruptable behavior patterns which are probably not sustainable.
Asset management is a highly unusual and somewhat baffling industry. We see seven main examples of just how peculiar our industry is, relative to other industries:
- The asset management industry collectively plays a near-zero-sum game. By contrast, most industries are positive sum: if you eat a great steak dinner, it doesn’t imply that others have to eat hamburger. In asset management, each new Money Manager that is able to generate Alpha (returns above the passive benchmark performance) normally does so at the expense of other Money Managers who underperform. Your own investment’s value may change because of a change in value of the underlying asset and/or market preferences. However, few investors can impact the value of the underlying asset, except for typically private equity and venture capital investors. And only luminaries like George Soros can influence market preferences. In fact, it is mathematically impossible for the median investor in a given publicly-traded sector to beat a low-cost index of that sector, after expenses.
- The asset management industry rarely delivers the alpha that it promises. Delivering alpha on a net of fees and costs basis consistently over many years is incredibly difficult. For example, hedge funds on average have underperformed on a net of fees basis in both US equities and bonds since 2000. Hedge fund performance looks attractive for the period of 1970 – 2013. However, one can argue that hedge funds were different in the 1980s and 1990s as the industry was smaller and more nimble. Recent hedge fund underperformance, coupled with steep typical 2% management and 20% performance fees and additional hidden costs that can be charged to fund investors, make investors more likely to ask questions.
- Standard compensation models motivate Money Managers to add more assets under management, but size often hurts returns. This contributes to the ‘winner take all’ trend in which we see steadily growing concentration of AUM into the largest money managers. For example, venture capital funds earn on average two-thirds of their compensation from management fees, not carry. However, there is an inevitable tension between size and returns. Large hedge funds over time hit liquidity limits and start impacting market pricing when they trade, losing their ability to exploit arbitrage opportunities. Similarly, large VCs earn lower returns than small VCs, who in turn earn lower returns than angel investors; angels writing small checks have among the highest returns of any asset class. Of course, it is true that large size does create certain proprietary advantages, e.g., some large fund of funds negotiate preferential management fees from funds in which they invest.
- Money managers can earn more money at less personal risk than in most other industries. Simon Lack reports in The Hedge Fund Mirage that from 1998 to 2010, hedge fund managers earned $379 billion in fees, while their investors earned only $70 billion in investment gains net of fees. In the asset management industry, the norm is that the General Partner puts in just 1-2% of the total assets under management and keeps the remainder of her personal assets in a diversified portfolio. Some hedge fund managers have even set up their own sophisticated family offices specifically to diversify their holdings out of the core product in which they made their wealth. In contrast, entrepreneurs in most other fields risk a significant portion of their own capital in their new venture, better aligning incentives.
- The financial services industry, including asset management, has disproportionate power to create systemic economic risk. This negative externality is unique to financial services, and was particularly obvious in the 2008 financial crisis. Similarly, when the highly leveraged Long Term Capital Management fund collapsed in the late 1990s, sixteen leading financial institutions had to agree on a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve. By comparison, when oil prices doubled between 2009 and 2011, it created stress for some industries but there was no concern that the global economy would collapse.
- The “broken agency” problem can cost money holders far more than the same problem does in most other industries. All companies face some form of the principal-agent problem: The chief executive of a public company may be tempted to manage financial results to optimize the short term stock price if a significant portion of her compensation comes from company stock options. In asset management, the principal-agent problem is exacerbated by the presence of so many conflicted intermediaries. For example, an individual allocator is often motivated to allocate to the most popular fund or type of investment in which her peers are investing, to protect for career risk. If an allocator hires a known player, underperformance will not cause the employee’s judgement to be questioned. The resulting herd mentality hurts innovation and leads to suboptimal returns.
- The investment management industry is far more homogeneous than the clients it serves, ironically for an industry that worships “diversification” as the one true free lunch. Only 10% of mutual fund AUM and 3% of hedge fund AUM are managed by women, and a similarly small percentage is managed by traditionally underrepresented minorities. This, despite the fact that funds run by women outperform. That outperformance quantifies the cost of money holder bias. The bias has two other main negative effects. First, it limits investors’ understanding of the world. America alone will be a majority minority country by 2040, and inevitably consumption and behavior patterns will evolve accordingly. Second, according to Carol Morley, CEO of the Imprint Group: “It is hard to attract top talent if firms are looking at a small slice of the population and their immediate peer group.”
Update: I’m now working on a research study on this topic with Katina Stefanova. Here’s a slide deck on this topic that I’ve presented to some institutional investors:
The opinions expressed in this research project, paper, and at DisruptInvesting.com are mine alone and do not represent the views of ff Venture Capital, any other employee thereof, or of any other institution with which I am affiliated.