Question: When was the last time you walked into Wal-Mart and found $20 bills on sale for $10? I am guessing never. It might not occur to you that your hope of finding a manager with true skill (i.e., the ability to deliver a consistently higher return than the market) who is willing to make you the financial beneficiary of her skill is the intellectual equivalent of expecting something for nothing. The reason why the potential financial benefit of true skill rightfully belongs to the manager derives from the field of labor economics: The scarce resource captures the rent. For those readers who don’t understand what that means or are still unconvinced that the quest for alpha is an exercise in futility, we step into the realm of theoretical physics and present the following thought experiment.
The key players in our thought experiment will be the venerable Warren Buffett and his son, Howard Buffett, who has been designated as the future chairman of the board of Berkshire Hathaway. Let’s suppose that as preparation for his future position, Howard decides to start an investment company where he will accept a maximum of $1 billion from new investors. Warren is so excited by his son’s initiative that he publicly announces that he will personally guarantee that Howard’s fund will achieve a return for the following year equivalent to the return of the S&P 500 Index plus 2%. Specifically, if the return from Howard’s investments falls short of this goal next year, Warren will make up the difference. Likewise, if Howard proves to be the investment genius that his father expects, Warren will keep any excess beyond the guaranteed S&P 500 plus 2%.
So we have now conjured up an investment that is guaranteed to return 2% above the S&P 500, but there is one catch--Howard’s salary will be paid by his investors, so their return will be the S&P 500 plus 2% minus Howard’s salary.
Here is the question to contemplate: What is the fair value for Howard’s salary?
A few moments of careful consideration will lead you to the unavoidable conclusion that his salary should be the value of the guaranteed return above the S&P 500, or about 2% of $1 billion (i.e., $20 million). To see why, suppose that Howard decided to be content with a 1% fee (i.e., $10 million).
This would provide an opportunity for managers who are only obligated to only deliver the S&P 500 return to their shareholders, like passive managers of S&P 500 index funds. They could invest their whole $1 billion with Howard, pay him $10 million and keep for themselves the remaining $10 million as a windfall gain, because Howard (and Warren) guaranteed a 2% additional return.
Since there are many such managers, they would compete with each other to get into Howard's fund. Their offers to Howard would become increasingly generous until they reach the value of his service, which is $20 million.
The scarce resource collects the rent. In this case, the scarce resource is not investor capital but the guaranteed ability to beat a benchmark by 2%.
While there might be a parallel universe where an altruistic Wal-Mart sells $20 bills for $10, it will never happen in ours. Likewise, we should not expect to find altruistic active managers who offer above S&P 500 Index returns for salaries that are less than that value. A competitive market does not serve up free lunches.