The asset management industry needs to be dismantled and rebuilt to ensure its own survival, says the head of a key investment education body.
With encroaching regulation and apathetic investors taking their toll on the sector, managers need to enact wholesale reform to ensure clients get the products they need.
Paul Smith, Hong Kong-based global CEO of the CFA Institute, said the investment industry is experiencing a “slow death” brought on by a combination of investor apathy and invasive regulation. “We have to stand up for the value we bring to society if we want the investment profession to thrive,” he said in a keynote address to AsianInvestor’s Art of Asset Management forum in Hong Kong last month.
“I believe we are missing the point in the way we think about our industry. We have focused on cost and alpha generation, but I believe the debate should be reframed, to focus on the purpose of investment professionals and the value we bring to society.”
This isn’t the first time the loss of trust in investment services has been raised since the financial crisis. It’s unusual, though, for the head of a major industry organisation to suggest a root and branch re-think.
“We need to change the debate from focusing on short-term performance to long-term investment outcomes,” Smith said. “Investors are self-medicating nowadays because they find little use for investment professionals and have even less desire to pay them for advice.”
One fundamental problem Smith perceives is that, unlike many other professions, investment management is structured around product push. “We are paid by the fees embedded within the products we sell,” he said.
“We advertise the one thing we know to be unsustainable – quarter over quarter outperformance of a benchmark. After fees, this is less than a zero-sum game.”
Benchmarking, he said, “is one of the great tragedies of the modern world, because the average investor is not remotely interested in relative performance.” All they want, he said, is to make money, without having to pay a hefty fee for the privilege.
Jack Bogle, head of the US index fund giant Vanguard, recently predicted the demise of active investment management in the next 25 to 30 years. Whether he is proved right or not, Smith believes the rise of passive investments is a good thing.
“It may not seem so, but it forces us [in active management] to think about what we are doing,” Smith said. “It also takes fees out of product and makes us charge for a service. I am not an apologist for passive investment, but I think its rise is due in part to our inability to explain the value we bring to our clients and to society.”
He reasoned that by making markets more efficient, through the (expensive) process of price discovery, active managers are creating the environment where index funds are appealing.
However, Smith suggested the cost of indexed investments is much higher than generally perceived because they increase market volatility and risk. “But our addiction to benchmarks has stimulated their increase,” he said.
In Smith’s view, there isn’t a simple solution to the problems faced by the industry: “The whole structure of the industry is inappropriate.”
Asset managers, he says, are just responding to the way the industry is set up: “You ask any CEO of a fund management company the challenges they face and it’s all short-term pressure. We need to change the rules of the game.”
Nobel laureate economist Myron Scholes agrees the investment management industry should focus more on the long term and on dynamic asset allocation. To achieve this, Smith said investment managers will need different skills.
“Our profession is tasked to direct capital to its best uses. However, short-term investing pushes us to ignore the longer-term impact of our investments on the world we live in. If we have a short-term investment horizon, we don’t make use of our power to change how companies conduct their businesses and treat the environment, for example.”
By ignoring the responsibility to invest responsibly and hold others to the same principles, Smith said, “we are abandoning our potential to catalyse a better world for future generations.”
Since increasing amounts of retail money is passively invested, Smith asked: “What are the large passive asset managers doing about engaging in corporate governance? Since, by their very nature, they are in the market forever, they need to actively engage in corporate governance.”
And for asset owners, Smith suggested that even the large sovereign and endowment funds “are not set up with the human capital to engage with corporate management on governance issues. It’s one of the skills that need to be developed.”
Realistically, changes will need to be made to accounting rules, tax regimes, and to investor education to help stimulate this structural change. Smith urged, “We must begin now to lobby for those changes if we are to thrive.”