Too many cooks.
A question I’m asked all the time as a business owner is, “How many people do you employ now?” It’s almost of as if the size of your payroll has become the standard yardstick for how successful or otherwise your company is.
It’s perfectly understandable; after all, most of us can relate more easily to, say, 10, 100 or 1,000 people, than we can to such-and-such a profit margin, annual turnover or pre-tax profit. But, on its own, the number of staff a company employs tells us next to nothing about that business — nor, in particular, to the value that it add for its clients.
The financial services industry is a case in point. In the UK and the US, the financial sector has mushroomed in recent years. Is that because it’s getting better at what it does? Is there a growing demand for its services? Is it delivering more value than it did in the past? It would be hard to make a case for answering Yes to any of those questions.
Two academics — Leonard Kostovetsky from Boston College in Massachusetts and Alberto Mancini from Bocconi University in Milan — have just released the first draft of a study into human capital in investment management in the United States. As the authors noted, this is a huge industry, employing several hundred thousand people in the US alone in advisory, portfolio management and research rôles. Yet they found no evidence whatsoever of any correlation between the number of people employed by a firm and the net performance delivered by that company to end investors.
That, of course, begs the question, Why do asset management and advisory firms incur the additional expense of hiring more staff if doing so won’t make any difference to net performance? After all, as the authors rightly point out, “these firms could earn more money by firing these advisory personnel, indexing the assets, and splitting the surplus with their investors”.
The answer, say, Kostovetsky and Mancini is simple: firms are employing these additional staff not to deliver alpha but to attract new clients, which in turn makes the company more profitable.
“At the advisory firm level, doubling the number of employees.. is associated with a 2.5 percentage point increase in annual change in assets under management, while at the mutual fund level.. adding another five employees to administer a fund (which would approximately double the staff for the median fund) is associated with a 0.6 percentage point increase in annual flows. In dollar terms, an advisory firm with $10 billion in assets under management would gain an extra $250 million in assets, which (at a typical 1% fee) would lead to a $2.5 million increase in fees each year (assuming the assets remain with the firm).”
The question the researchers then go on to ask is, Why does having a bigger workforce tend to result in attracting more assets under management? They don’t provide a conclusive answer but they do suggest two possible explanations:
1. “It is possible that hiring a large research team is like building a “Potemkin” village, used to show current and potential clients that the firm has the resources to acquire information in order to beat passive and cheaper alternatives. This story is consistent with large teams of advisory personnel being widely cited in promotional literature by the firms that employ them.”
2. “Another possible explanation is that the advisory employees are actually closet salesmen, ostensibly there to do portfolio management or fundamental/technical research, but also paid to market the product to potential individuals, brokers, institutions, etc.”
Another interesting finding in this study concerns active share. As TEBI readers know, the only way, realistically, that an active investor is going to outperform its benchmark after costs is to choose a fund with a high active share — i.e. to move away from the market consensus — and to hope that the manager picks the “right” stocks and avoids the “wrong” ones. You may have thought that having more staff would give a fund a better chance of identifying future winners and losers, and putting together a portfolio substantially different to the index. In fact, however, the opposite is true. As Kostovetsky and Mancini put it:
“In a striking example of the ‘too many cooks in the kitchen’ problem, we find that larger teams are associated with a larger number of holdings and a lower tracking error relative to the fund’s style. One could argue that this result is due to more people generating more good ideas, but this does not seem to be supported by the performance results.”
In other words, the more staff a fund management company employs, the more like index trackers its funds are likely to be (with the exception, of course, of the cost)!
What, then are the lessons to learn for investors?
1. Don’t be remotely impressed by the size of a fund management company or an advisory firm’s workforce. It doesn’t mean that it will be any better at generating net returns than a smaller firm, especially given that its charges are in any case likely to be higher.
2. If you’re sure you want to invest part of your portfolio in an active fund, then funds run my large teams and by big fund management companies are probably best avoided. At the very least, do some research and ensure that you’re not simply buying a very expensive version of an index fund.
Read the full study here:
ROBIN POWELL is a freelance journalist and the founding editor of The Evidence-Based Investor. Based in Birmingham, England, he founded Ember Television and Regis Media, and he specialties in helping disruptive financial firms to grow. He also campaigns for a fair, transparent and sustainable investing industry. You can follow him on Twitter at @RobinJPowell.