Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

Let’s now take some of the main parts of the fund management business, a huge financial intermediation machine, and look in more detail at fees and risks.

Millions of savers invest in funds – usually mutual funds or unit trusts – either directly themselves or more often indirectly, for example through pensions. The objective of any fund manager is to produce a rate of return for the funds he or she oversees. The benchmark for that return will be the relevant markets in which that fund manager is investing, be it the US stock market, the European bond market, Australian mining companies and so on. Managing your fund to outperform the average market return (or the benchmark) is called ‘active management’, or, more pointedly, ‘picking winners’. Succeeding in doing better than the benchmark is said to be achieving ‘alpha’ (alpha of 1 per cent means that the return on the investment over a selected period is 1 per cent better than the market during that same period). The alternative basic investment management strategy is called ‘passive’. A passive fund is usually an ‘index’ or ‘tracker’ fund, where the manager simply buys shares in proportion to a stock market index and tracks that benchmark.

But performance must be balanced with fees. Consider investing long-term, say over the forty-year working life of a given employee. One of the leading figures in the US fund management industry is John Bogle. He founded Vanguard, a very large index investment group (not an active investor) which charges low fees. Bogle has estimated an all-in cost for actively managed funds of 2.27 per cent of the funds’ value. The amounts may not seem excessive. But Bogle never tires of saying to fund investors: ‘Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns.’ 38In fact, if you assume Bogle’s estimate of fund management costs and also assume an annual return of 7 per cent, the total return to a saver over forty years will be 65 per cent higher without the charges. In hard cash, the difference could mean retiring with $100,000 or $165,000. 39It’s a good deal for the fund manager; rather less so for the investor.

Let’s, however, concede for a moment that there is a role for active management and the associated fees. Let’s also allow for the increase in the volume of assets under management and the application of IT to assess investments, manage them and communicate with clients, which ought to give fund management benefits of scale and efficiency. What should we expect the size of those fees to be? In a presentation to the Asset Management Unit of the Securities and Exchange Commission, the US regulator, Bogle presented the following statistics:

Figure 19.US mutual fund assets and charges 1951 and 2015

The striking and perhaps surprising conclusion is that over more than sixty years, expense ratios, even among the same firms, have not gone down but have gone up – and significantly. Why has this happened?

Fund managers deserve much of the blame. First, fund management’s strategy of divide and conquer is part of the explanation. In the interest of diversification and providing investors with plenty of choice in investment strategies, fund managers have multiplied the number of funds they manage. They have also handed control of funds to individual portfolio managers who take a more short-term view of returns than investment committees of, say, a whole fund management group, which on the whole takes a broader view. The result has been much more aggressive investing and a significant increase in asset turnover as managers buy and sell stocks to try to boost returns. According to Bogle, portfolio turnover rose from 30 per cent in the 1950s and 1960s to 140 per cent in the last decades. 40Another measure of asset management quality is volatility: the degree of uncertainty or risk about the size of fluctuations in a share’s value. Just as turnover has risen, so the volatility of funds has increased significantly from 0.84 to 1.11 over the same period.

Second, there are transaction costs. Greater turnover – buying and selling more shares – keeps fees higher than they might have been, adding to transaction costs without adding to investors’ capital gains given the zero-sum nature of the market. Crucially for the investor, additional fees reduce returns by increasing the cost of managing money. While transaction costs for each trade have fallen over the last thirty years, the frequency of trading has increased exponentially in recent years. Thus, the total amount of fees has risen as well. As Bogle notes:

When I entered this business in 1951, right out of college, annual turnover of U.S. stocks was about 15 per cent. Over the next 15 years, turnover averaged about 35 per cent. By the late 1990s, it had gradually increased to the 100 per cent range, and hit 150 per cent in 2005. In 2008, stock turnover soared to the remarkable level of 280 per cent, declining modestly to 250 per cent in 2011. Think for a moment about the numbers that create these rates. When I came into this field 60 years ago, stock-trading volumes averaged about 2 million shares per day. In recent years, we have traded about 8.5 billion shares of stock daily – 4,250 times as many. Annualized, the total comes to more than 2 trillion shares – in dollar terms, I estimate the trading to be worth some $33 trillion. That figure, in turn, is 220 per cent of the $15 trillion market capitalisation of U.S. stocks. 41

Moreover, this massive trading is often between fund managers, which makes it truly a zero-sum game within the industry. The idea of a financial transaction tax (related to the Tobin Tax, named after the Nobel Prize-winning economist James Tobin, an early advocate) is to reduce this ‘churn’ and make investors hold their stocks for longer, by raising the cost of each sale. It satisfies the conditions for an efficient tax in deterring a practice which imposes deadweight costs – the main obstacle to its introduction being that all large exchanges would have to impose it, to stop trade migrating to those that choose not to.

Hedge funds are in many ways a response to demands from the increasing number of HNWIs for superior returns on their portfolios. As more active share traders, hedge fund managers tend to pride themselves on their ability to pick stocks on the basis of proprietary information. This information may be obtained legally, for example by detailed research by an in-house team, although it might also be obtained in some unlawful way. Superior information should lead to superior returns, but it is also costly. To the extent that superior returns are obtained, the cost may be justified. But we should remember that in the end it is a game that balances winners and losers and has little social value: the gains or above-average returns that some investors enjoy will be offset by losses or below-average returns others suffer.

While some hedge funds have certainly been very successful, moreover, average returns have been less impressive. About 20 per cent of hedge funds fail each year. Even when returns have been high they often owe as much to idiosyncratic gambles as to investment genius. A spectacular example is the American John Paulson, who made $2 billion from betting in the run-up to the financial crisis that US house prices would crash. Since then, however, his firm Paulson and Co. has done less well and some investors have withdrawn their funds.

The middling investment performance of hedge funds stands in sharp contrast to their glamorous image and – more importantly for investors – their high fees. For many years typical hedge fund fees have been called ‘2 and 20’ – a 2 per cent fee on the volume of assets managed and a hefty 20 per cent of realized and unrealized profits. Some hedge funds specialize in high-frequency trading – buying and selling assets very fast and in large volume, sometimes within fractions of a second, by the use of special computers – which raises costs for investors. All this adds up to a total yearly cost of 3 per cent. 42