Just How Useless Is the Asset-Management Industry?

Just How Useless Is the Asset-Management Industry?

by Justin Fox  |   8:00 AM May 16, 2013

Writing under a pseudonym in the Financial Analysts Journal in 1960, mutual fund executive Jack Bogle made “The Case for Mutual Fund Management.” Bogle took the track records of four leading mutual funds going back to 1930 and compared them to the performance of the Dow Jones Industrials. Not only had the four beaten the Dow, handily, but during the period from 1950 through 1956, for which the brokerage Arthur Wiesenberger & Co. (the Lipper/Morningstar of its day) had calculated mutual fund volatility, all but one of them had fluctuated less than the Dow.

“[M]utual funds in general have met the test of time, and performed in keeping with their stated policies and goals,” Bogle concluded.

As tests go, Bogle’s had its flaws. The fact that four funds (they’re not named in the article, but Bogle once told me they were Massachusetts Investors Trust, Investors Incorporated — now Putnam Investors — State Street, and Wellington) that had survived since 1930 had performed well didn’t say anything about the performance of the many funds that didn’t survive, or the new ones that popped up in the 1950s. But it’s quite possible he was right that the tiny mutual fund industry of the 1930s, 1940s, and early 1950s had served its investors admirably.By 1960, though, the mutual fund business was booming, and selling investors on high-cost, high-risk products called “performance funds.” Within a few years, researchers armed with more statistical skills (and these new things called computers) were examining the industry’s performance and finding it wanting. “[W]e find no evidence to support the belief that mutual fund managers can outguess the market,” Jack Treynor and Kay Mazuy of the consulting firm Arthur D. Little reported in the July-August 1966 HBR (sadly, we don’t have the article online). Multiple academic studies soon backed up that conclusion.

They’ve continued to back it up ever since. After costs, actively managed mutual funds trail the market. Yet while passively managed, much-lower-cost index funds have been available since 1976, when Bogle — who had a change of heart and, perhaps more to the point, had been ousted from his job running Wellington Management — launched the Vanguard 500 Index Fund, most investors still put most of their money in the hands of active managers.

Why they do this a long-running puzzle. In the new issue of The Journal of Economic Perspectives, economist and long-time Vanguard board member Burton G. Malkiel poses it for the umpteenth time, and adds to it the observation that expense ratios on actively managed funds have over the past three decades risen substantially, even though economies of scale would seem to dictate that today’s much larger funds ought to have lower expenses as a percentage of assets (domestic equity funds in the U.S. had $3.5 trillion in assets in 2010, up from $25.8 billion in in 1980). And while it seems essential that we have at least some active managers in order to set security prices (if everybody put all their money in index funds, there would presumably be no link between stock price and value), Malkiel says that there’s no evidence that stocks were less efficiently priced decades ago than they are now. He concludes:

The major inefficiency in financial markets today involves the market for investment advice, and poses the question of why investors continue to pay fees for asset management services that are so high. It is hard to think of any other service that is priced at such a high proportion of value.

It’s a pretty harsh indictment. Malkiel is basically saying that the asset-management industry has no economic justification for being as big and rich as it is. He’s probably right about that, although I wouldn’t say his evidence is conclusive. The way he purports to show that markets haven’t become more efficient through the years is simply that mutual funds found it just as hard to beat the indexes in 1980 as they do now. And the troves of performance and expense data available for mutual funds allow us to subject them to scrutiny not really possible for most industries. I’d definitely be a little scared to learn what the true economic value added over the years by management advice has been, for example.

One other thing that Malkiel fails to mention (although it’s clear from his data and even clearer in arecent report from the Investment Company Institute, the mutual fund trade group), is that the expense trend shifted a little over a decade ago. After rising sharply in the 1980s and modestly in the 1990s, mutual fund expense ratios actually dropped (from 0.84% to 0.69%) from 2000 to 2010. Part of that is the result of a continuing shift into index funds, which accounted for almost 30% of all equity mutual fund and ETFs in 2010 (up from 0.3% in 1980). But expense ratios on actively managed funds have also been falling, from 0.94% to 0.91% now in 2010.

It’s possible that, thanks to the rise of index funds, investors have finally wised up to the role of costs in investment returns, and we’re entering a glorious new era of declining investment fees. It’s also possible that this is a cyclical phenomenon. During a bull market, investors don’t pay much attention to fees (or to the size of executive paychecks). When markets struggle, they do. So all it will take to get the asset-management industry down to an economically appropriate size and level of profitability is another decade or two of sideways stock markets. That should be fun.