The Rise and Fall of Performance Investing

From The Research Puzzle:

the ironic triumph

Charles Ellis has witnessed, chronicled, and helped to shape the modern asset management industry.  He has been a leader of the investment profession for decades and has authored a number of classic works on the business.

In recent years, Ellis has written a number of notable essays for the Financial Analyst Journal, the latest of which, “The Rise and Fall of Performance Investing,” is required reading for asset owners, asset managers, consultants, and advisors.

It is, first of all, a tidy summary of the rise of performance investing over the last half century.  A combination of innovation, demographics, government action, technology development, and globalization drove tremendous growth in the business of managing other people’s money — and built vast fortunes for those who rode the wave and reaped the fees.  As a result, the business became a magnet for talented people, who have been aided by “extraordinary new data-gathering and data-processing tools,” all resulting in “an increasingly expert and successful (or ‘efficient’) price discovery mechanism.”

But the title of the piece heralds not just a rise but a fall to come, which will surprise those most involved, “who do not yet recognize a seismic change in their profession.”  For, as with the economic forces of other industries that are studied, tracked, and capitalized upon by investment professionals, “The dynamics that produced the rise of active investing to prominence also carried the seeds of its inevitable peaking, to be followed by an increasingly recognizable decline — first in the benefits accruing to clients and then in benefits to practitioners.”

Ellis deals with the odd fee design of the industry (“fees are quietly and automatically deducted by the investment managers and, by custom, are stated not in dollars but as a percentage of assets”) and the fact that when looked at in a proper light, the managers are taking an extraordinary amount of the incremental returns for themselves.  (After all, he notes, the investors already have the assets; they’re looking for the returns.  With most managers underperforming, “their incremental fees are over 100% of long-term incremental, risk-adjusted returns.”)...MORE

Here is the FAJ paper via the CFA Institute:

Abstract

Performance investing has enjoyed a remarkably long life cycle, but the costs of active investment are so high and the incremental returns so low that, for clients, the money game is no longer a game worth playing. Investors—both institutions and individuals—are increasingly shifting toward indexing. As acceptance of indexing grows, clients and managers have an opportunity to stop focusing on price discovery (which has made our markets so efficient) and refocus on values discovery, whereby investment professionals can help investors achieve good performance by structuring an appropriate, long-term investment program and staying with it.

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