Photo: Dominic Alves via Flickr
The May 6th, 2010 “flash crash” sent the equity markets into a free fall, plunging 700 points in a matter of minutes and sending shockwaves throughout the financial system. The Securities and Exchange Commission, together with the Commodity Futures Trading Commission, investigated the matter and published an extensive report.While the report didn’t point the finger at any particular event or firm, there has been much media speculation that some trades by Waddell & Reed Financial, Inc. may have contributed to the market volatility that day.
The Wall Street Journal ran an article on October 6th about the Waddell link to the flash crash. Referring to his firm’s overall approach, Waddell’s CEO, Henry Herrmann, stated in the article that, “We are focused on not blowing up,” and he added, “We don’t reach for the brass ring for fear of falling off the merry-go-round.”
But aren’t investors paying for the brass ring?
Mr. Herrmann’s comments captured our attention because active investment managers are always touting their competitive edge, it’s in their DNA. We’re not picking on Waddell, however we think that the comments provide some candid insight into the broader investment management industry.
When investors pay premium asset management fees, they should demand the brass ring. Investment managers who can’t consistently get the brass ring (without falling off) are just along for the ride and aren’t adding value.
J.P. Morgan recently reported that year-to-date through the end of the third quarter, 63% of domestic mutual funds underperformed their benchmark index by more than 2.5% and 29% of funds were trailing by more than 5%. For that same time period, the S&P 500 was up 3.89% and was up 11.2% for the third quarter. Most of the upside came in September, which was up nearly 9%.
This dismal relative performance by the mutual funds is likely related to investment managers’ fear of blowing up, which we translate to be “career risk.” Investment managers want to stay on the ride (or keep their jobs) so they can continue to collect their fees and bonus checks every time the carrousel turns.
How do they stay on the ride? By having a conservative bias, or taking less risk than the market, which is well illustrated by the recent results. Fund managers clearly missed a market turn and got left behind. In a scramble to make up for this underperformance by the all important year-end, it’s foreseeable that they’ll get whipsawed on the other end of the current rally.
Watered Down Returns
Equity investing is inherently risky, and in theory investors should expect greater rewards as they take on greater risk. The investment industry is far too focused on reducing the risk and volatility of their equity product offerings. In an effort to avoid blow ups and fund outflows, the industry is effectively trying to tame, or change an asset class. But if we take too much risk out of the market, we should be prepared for muted returns.
We hear over and over again asset managers touting their abilities to generate superior returns while taking less risk. When the results don’t pan out you’ll get the line, “well, on a risk adjusted basis we actually did very well.” Risk adjusted return is code for “we underperformed our index.” The industry would love nothing more than to have a high fee equity product that behaves just like a CD, or some other savings vehicle.
We’re not advocating that investors take unreasonable risk, our point is that if an investment manager tells you up front that they’re not going to try to grab the brass ring, you’re probably better off removing the manager risk, pocketing the investment management fees and finding a low cost index fund. Portfolio risk decisions belong at the asset allocation level, investors shouldn’t settle for watered down returns because someone is protecting their job.
Andrew Haigney is Managing Director of El CAP.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.