Main Street vs Wall Street: The evolution of active money management

Last summer, Moore Capital Management fired portfolio manager Brett Barna for hosting what the media called a ‘Wolf of Wall Street’ party at a $20 million mansion he rented in the Hamptons.

The hedge fund cited ‘personal judgement inconsistent with the firm’s values’ as the firm’s reason for letting him go. That’s certainly one way of describing a party where hired dwarves were tossed into a pool, where art and furniture were trashed, and where used condoms were left scattered across a stately mansion’s grounds as if in preparation for a Satanic easter-egg hunt.

The story received as much coverage as it did because it confirmed everyone’s secret opinion of  “professional” hedge fund managers: they are “party bros” who work hard but who play harder, and who indulge in extravagant art and luxury items.

The Wolf of Wall Street Party may be remembered as the moment that hedge funds lost their allure. It coincided more generally with a slew of stories in the financial press about the death of “active money management.” These two things are not unrelated. After all, while a hedge fund manager’s extravagant lifestyle might raise eyebrows of crusty oil billionaires or Saudi sovereign wealth funds – hedge funds’ primary customers – as long as the financial returns are there, it’s all part of the “hedge-fund mystique.” Now that the returns are gone, all that’s left are wet people of small stature and undiscovered condoms.

Which raises the question: Where did those wonderful returns go? Why did the index-beating numbers, which made the names of so many actively-managed hedge funds, evaporate? Before we try to answer that question, let’s explore the differences between the two styles of managing money.

Wolves vs sheep

Broadly speaking, money managers fall into one of two categories – active or passive.

Active managers, such as hedge funds and most mutual funds, buy and sell investments with the aim of beating an index. They use a variety of strategies, from the lightning-quick high-frequency trading made famous by Michael Lewis’ “Flash Boys”, to longer-term approaches like trend following.

Active managers put a lot of resources into researching, testing, and monitoring their strategies, which requires hiring a team of analysts or quants or researchers. These professionals are expensive to employ. Many of them aspire to host their own Hamptons parties or to hire their own team of pool-side midgets.

More important, the process of trying to “beat” the market requires that you trade frequently: buying before the public recognizes what’s good, selling before they recognize things have turned bad. And trading is costly. So between the overhead of a highly-paid staff and trading friction, there’s a lot of “cost” involved in actively managing funds. Guess who pays these costs? The investors in the active funds.

The alternative is passive investing. This generally involves mirroring the performance of a benchmark such as the S&P 500. This is done by… well, by doing nothing. The entire process is: buy a lot of stocks and just hold them. No analysts, no staff, minimal trading costs.

The theory is that you don’t need to try to beat the market because that’s a fool’s errand anyway; no one can consistently do it, so rather than trying to beat the market, just try to own it. The whole thing. Lots of stocks. Some will go up, some will go down. But overall your performance will mirror that of the market as a whole. And guess what? Over a long enough time horizon, that’s pretty good.

Why has active investing become unfashionable?

The numbers speak for themselves: active management is losing to passive. According to the Financial Times, in 2015 nearly $200 billion was invested in ETFs while $124 billion was withdrawn from active funds.

Here are a few reasons why:

Show me the money

Hedge funds are famous for their ‘two and twenty’ fee structure: they charge 2% of their “assets under management” (AUM), the total market value of their fund’s assets, and 20% of profits. That’s why they can afford to rent mansions in the Hamptons.

Active mutual funds are cheaper, typically charging a management fee of between one and two percent, and sometimes adding a performance fee on top.

Now contrast these numbers with those of passive funds. An “inexpensive” active fund charges 1% of assets as a fee. A similar passive fund charges 0.1% — ten times less. Those fees add up over a few years.

None of this would matter if active funds proved their value and outperformed the market after their fees. Alas, that just ain’t the case. According to Bank of America Merrill Lynch, only 14% of active funds beat their benchmark in the first half of the year.

The AUM game

For some managers, the goal is to amass  AUM rather than to beat a benchmark. Investors pay a management fee regardless of performance. So the higher the AUM, the greater the fees that funds generate without doing too much.

The problem is that while the incentive of a manager is to increase AUM, for an investor things get worse as AUM increases. It’s an old story: a fund gets less “agile” as it increases in size. Not all strategies are scalable. If you have a small fund, you can ferret out a few small, unknown stocks, and invest most of your capital in them.

When these stock picks prove successful, your fund can achieve tremendous results. But when you’re managing a billion dollars, there simply aren’t enough shares of small unknown stocks to buy. So as a fund’s AUM grows, there’s less ability to do what the fund is charged with doing: manage actively.

Coming out of the passive closet

Which leads to the next problem. Active investing isn’t always that active. In fact, some actively managed funds have been exposed as ‘closet trackers’. Which means that they charge their customers much-higher “active-management” fees, but they perform just like a passive fund – performance which could be purchased for much less by investors.

Cynics suggest that active managers choose closet tracking to protect their AUM. If you mirror an index, you can’t really underperform it, so you can leave your AUM nest egg intact, and continue to rake in juicy management fees.

Incidentally, Notre Dame professor Martijn Cremers set up to track this phenomenon. Enter the ticker of a mutual fund, and you get a percentage score indicating the correlation it has to a benchmark. The lower the percentage, the more holdings the fund has in common with the index.

The next generation

Millions of venture capital dollars have poured into Fintech (financial technology) start-ups over the last few years, but most venture-capitalists have backed new passive investing platforms. Which, if you think about it, doesn’t make a whole lot of sense: it’s not the passive side of investing that is fundamentally broken and needs fixing.

My own start-up technology company, Collective2, is taking a contrarian approach. If you want to invest passively, knock yourself out – but please don’t come to us. We’re all about revolutionizing the active management industry.

How do we do it? First, by destroying the entire hedge fund industry. No, we’re not doing this because we weren’t invited to pool parties in the Hamptons (although, sadly, we weren’t), but rather because the hedge fund industry is a cartel, and cartels need to be destroyed. “A cartel?” you say. “I thought the hedge fund industry was filled with ‘party bros’ and frat boys.”

But in truth, despite the media obsession with that part of the business, most hedge funds are run by quiet men (yes, mostly men) in suits who look very much like each other. They all attend the same schools (Harvard, Stanford, MIT). They all come from the same firms (Goldman, Tiger). They all speak the same language (English). They all were born in the same country (USA).

It’s a good gig if you can get it – i.e. if you can be born a white man in the United States, and get into Harvard, and go work for Goldman. But not everyone can.

And, as “revolutionary” as it may sound… isn’t it possible, just possible, that someone who doesn’t fit that profile can come up with a good idea or two about how to beat the market?

Collective2 lets anyone in the world essentially act like a hedge fund. It’s simple in concept. Good traders post their trade recommendations on Collective2, and we verify their performance. More important, Collective2 allows you to make the same investments as trade leaders you like.

Best of all, we get rid of all the bad incentives: there’s no “AUM” fee, no performance fee. You just pay a flat monthly fee to trade leaders you follow. Bye bye, hedge funds. Now you can build your own. Just don’t try to host your own Hamptons pool party.

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