What Investment Managers Aren’t Telling You
Originally published by Barron’s, November 26, 2024
As a co-founder of a firm that connected the most prestigious and richest institutions with the most successful global managers over many decades, I have had a unique vantage point on the investment management industry. I have personally observed that, despite disclosure requirements, investment managers do not always tell you everything you might want to know about them.
If you are planning to hire a manager, here are a few less obvious considerations to keep in mind.
Referral arrangements between big brokers and “independent” investment managers increasingly dominate the industry. Here is how they work. A particular broker brings clients to the manager. The investment manager may in turn keep all client assets in the broker’s custody, including cash, and direct all or most trades through the broker.
What could go wrong? First, broker custody in my opinion is considerably less safe than bank custody. If the broker fails, the client may or may not be able to reclaim funds and may or may not have adequate or effective insurance. In addition, investing cash or trading through the same broker may conflict with the client’s best interest in other ways.
Larger, multi-asset managers do not usually tie themselves to a single broker custodian, but there are other issues. This kind of manager will typically claim to be able to provide particularly expert advice on asset allocation as well as security selection. There are reasons to be wary.
Firm revenues and expenses related to each asset advisory area and thus profits earned from that area may differ greatly. This puts overwhelming pressure on the manager to put your money into a high-profit area for the firm, regardless of the outlook for that investment market.
I had to wrestle with this particular conflict. When I co-founded my own firm, it was initially just my partner and myself advising Harvard University.
Having no staff at the time, much less staff specializing in particular areas, we did not have to worry about covering overhead or suffering profit losses if we shifted our recommendation among asset classes. Later we had scores of analysts specializing in particular asset classes, and so had to develop ways to address the resulting conflict.
Since then, this particular conflict has become magnified across the industry because investment management, once a small but respected profession, has instead become a large and very profitable industry. Legally, managers are still defined as fiduciaries, but the reality is that they are likely to be selling one-size-fits-all products, which would seem to be incompatible with rendering unbiased advice.
Client swapping is an even less palatable and more hidden feature of the investment industry. It is simple and hard to detect.
Manager X brings in a friend, manager Y, to manage an account where X serves as treasurer or investment chair. Manager Y in turn repays the favor by bringing a similar account to X’s firm. Nonprofits are more likely to fall into this trap because they seek out knowledgeable investment professionals to be treasurer or investment committee members, and may also hope they will become major donors.
Everyone understands that fees are an inescapable conflict between manager and client, but there may not be full disclosure of how hard they bite. Consider the retirement accounts of investors A and B. If A pays a fee of 2% while B pays 1/2%, the math tells us to expect A’s account to be only about half the size of B’s after a lifetime of investing.
Some managers charge high fees specifically to generate the advertising funds needed to reach a larger public. If so, the more you hear about the firm, the worse choice it may be for you.
Warren Buffett’s partner, the late Charlie Munger, estimated in a 1998 speech for U.S. foundation investment officers that nonprofits were paying investment costs closer to 3%, which Munger thought ruinous over the long run. These costs in part rose because of the success of the university investment model, which I helped develop with clients and colleagues. Times change and I no longer endorse that model, only partly because of its cost.
Conflicts between clients and managers are further magnified by “benchmarking,” which I helped popularize. That should have been a useful idea, but ever-shorter measurement periods have encouraged manager speculation rather than investment.
Benchmarking in turn led to indexing. This is commonly deemed to be conservative, but is actually more speculative than it appears. New funds are usually concentrated in the stocks that have recently risen the most, a fact that may not be disclosed.
The basic regulatory rule is that investment-manager conflicts must be disclosed. Regulators are active in enforcement. The U.S. Securities and Exchange Commission recently fined investment managers and brokers over $3 billion for using private cell phones outside approved and stored communications networks. They have also issued fines specifically for failure to disclose conflicts.
Despite these protections, investors should themselves probe as deeply as they can into the motivations and arrangements of prospective managers.
WRITTEN BY:
HUNTER LEWIS | CHIEF INVESTMENT OFFICER
Hunter Lewis is Chief Investment Officer of Hunter Lewis LLC, as well as a co-founder and former CEO of global investment firm Cambridge Associates. Learn more about Hunter Lewis.