The EconomistNovember 14th 2020 Special reportAsset management 51T
he storyof a quiet revolution in asset management begins
with Jack Bogle. Actually, it starts in 1974 when Paul Samuelson,
an economist and Nobel prizewinner, published an article in the
Journal of Portfolio Managementarguing that the bulk of mutual-
fund managers should go out of business. Most failed to beat the
market average and those that did could not be relied upon to re-
peat the trick. An archetype was required. Someone should set up a
low-cost, low-churn fund that would do nothing more than hold
the constituents of the s&p 500. Mr Bogle decided that Vanguard,
the mutual-fund group he founded in 1975, should take up the
challenge. His index fund was denounced on Wall Street as un-
American. It received only a trickle of inflows. But by the time of
Bogle’s death last year, Vanguard was one of the world’s biggest as-
set managers, largely on the strength of its index funds.
An investor can now buy exposure to the market return (beta,
as it is known) for a few basis points. Indeed, “beta is becoming
free” is an article of faith among industry bigwigs. Technology al-
lows access to stockmarkets at vanishingly low cost. BlackRock
and State Street Global Advisors, the other firms of a leading trium-
virate, owe their growing heft to index (or “passive”) investing.
These three are the industry’s big winners; everyone else is “fight-
ing for scraps”, as the boss of a midsized asset manager puts it.
These firms benefit from a virtuous circle, in which lower costs
mean lower fees, more inflows and yet lower costs. Their domi-
nance is only the most salient sign of consolidation in the asset-
management industry. The biggest firms are getting bigger. A glo-
bal elite has emerged of firms that each manage more than a tril-
lion dollars in assets. Unsurprisingly the idea has taken hold that
size is a strategic advantage. If you are not a niche player in an in-
dustry, you had better be a scale one, says business-school wis-
dom. No one wants to be stuck in the middle.
Bigger is not always better in asset management. A point ar-
rives when size becomes a spoiler of performance. The portfolio
manager may lose focus. The size of the fund begins to push up
trading costs, notably in illiquid assets in which the buying and
selling of large tranches tends to move prices adversely. But asset
managers benefit from operational gearing. As the value of man-
aged assets goes up, profits rise even faster. Fees are a fixed per-
centage of assets under management: the bigger the fund, the
higher the revenues. But costs—mostly the wages of research an-Passive attack
How index investing is reshaping the asset-management industry
Index fundsDouble trouble
The trouble with delegating choices about what to invest inS
omeone wiseonce said that all the
problems of capitalism are agency
problems. Agency costs arise when
somebody (the principal) delegates a task
to somebody else (the agent) and their
interests are at odds. In the textbook
example, the principal is a manager, the
agents are employees. It is in the manag-
er’s interest that the agent works hard.
The more effort each worker puts in, the
higher the firm’s output and the greater
its profits. But the employer cannot
gauge the true effort of the workers,
especially if the results are a team effort.
Each worker has an incentive to shirk.
Asset management has a double
agency problem. The first lies with the
separation of ownership and control in
large public companies. Shareholders are
the principals, who delegate running the
firm to managers. Shareholders care
about returns on their investment, but
managers have different goals. They may
value perks and prestige—a plush office,
a company jet, a high-profile merger
deal—more than profits. Running a big
company is a complex task. It is hard to
be sure if the bosses are making a good
fist of it. No individual shareholder has a
big enough stake to make the effort of
monitoring worthwhile.
Mechanisms have emerged to limitsuch agency costs. A classic paper pub-
lished in 1976 by Michael Jensen and Wil-
liam Meckling argued that loading a public
firm with debt was a useful device to stop
managers frittering away shareholders’
cash. Bosses feel greater pressure to cut
costs and raise revenues if they must meet
regular interest payments. The leveraged
buy-out boom of the 1980s was predicated
on the idea of debt as a tool to focus the
minds of managers. Private-equity firms
employ this trick.
Another way to limit this sort of agency
problem is to give managers the right tobuy discounted shares once their price
reaches a predetermined target. Stock
options, it is argued, make managers act as
if they were shareholders. Yet this device
just creates a different sort of agency prob-
lem. Traders of shares use quarterly earn-
ings as a rough-and-ready guide to how
well a company is run. Managers know
this. So they eschew investment projects
that are in the long-run interests of share-
holders in order to boost short-term pro-
fits, lifting the share price and the value of
their stock options.
The second agency problem arises from
conflicts of interest between asset manag-
ers and those on whose behalf they invest.
It is in the interests of investors that asset
managers seek out the best long-term
returns. But fund-management firms are
paid a fixed percentage of the value of
assets. To attract capital into their funds,
they may opt for faddish stocks that do
well in the short term, but whose short-
comings become apparent only in the long
run. They may shun unfashionable stocks,
even if they believe they are good long-
term investments. Once an asset manager
has captured funds to manage, they tend to
stay. A good recent run will lure in more
funds. This agency problem has no easy
solution—but investors could be quicker
to ask searching questions.