Money on Fire

An Enormous Waste of Money

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Money on Fire

Just how much do investors spend every year on active management fees in pursuit of the ever-elusive alpha? How does $600 billion (or roughly the GDP of Switzerland) grab you? This unfathomably large number appears in a recent whitepaper from State Street’s Center for Applied Research titled "The Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry." One of the most pernicious beliefs is that investors can pay a manager to deliver alpha (excess return above a benchmark). The authors cite their own survey which found that investors are, on average willing to pay 19 cents for every dollar of outperformance. There are two problems with this. First, the amount of alpha that is available to investors is "statistically indistinguishable from zero" according to the authors of this paper whose primary finding is depicted in the chart below.

Second, even if investors are so fortunate as to discover a manager who can reliably deliver alpha, the value of that alpha rightfully belongs to the manager and his or her employers, and ultimately that value can be expected to revert to them. A few moments of contemplation will bring anyone to the realization that the notion of an incredibly generous fund manager who will give you a dollar for your 19 cents is ridiculous on its face. Here is an article we published that more thoroughly explains the economic principle underlying this conclusion. The State Street researchers criticize the industry’s devotion to alpha as reminiscent of the research of Professors Taffler and Tuckett who defined "phantastic" objects as "attractive objects that stimulate high excitement and almost automatic idealization and so, a powerful wish to possess." We at Index Fund Advisors wholeheartedly agree with the authors' conclusion: "Despite overwhelming evidence that alpha is increasingly difficult to obtain, the investment management industry continues to hold alpha as its primary measure of success—to its peril."

Acknowledging that the current models for success in the investment management industry are broken, the State Street authors offer up a revised model: "True success includes not only producing alpha—perhaps more importantly, it also requires helping investors achieve their long-term goals, sustainably, over time." The "alpha" that they refer to is not the simple definition discussed above but rather refers to many different things investors under the guidance of advisors can do to maximize the likelihood of a successful investment experience. We would consider this equivalent to the term coined by Vanguard, "Advisor Alpha", which we wrote about here and here.

A large chunk of the white paper is devoted to helping advisors become better communicators, which is absolutely essential for the realization of their client’s long-term goals. At Index Fund Advisors, we contend that one of the most important functions of a wealth advisor is to work with the client to formulate goals that are actually achievable with a high level of probability, given the client's circumstances. We consider a "goals first" approach to be putting the proverbial cart before the horse.

In closing, we commend the staff of State Street's Center for Applied Research for making a valuable contribution to the realm of thought leadership in the investment management industry. All financial professionals (and their clients) can benefit from it.