Do you own or use mutual funds, passive ETFs or strategic SMA managers? If so, in all likelihood, you are paying full fees for your manager to do only half the job. Here’s why.
Why Hire an Investment Manager
Why do investors hire an investment manager? The typical retail investor expects a manager to grow their assets in good times and to preserve them during periods of market failure. Buying is easy. New money comes in, it is invested. Selling, on the other hand, is the hard part. For most managers, selling is not a priority. In some cases, selling is prohibited. Sure, equity managers sell one position to buy another, but most will not sell to cash or less volatile asset classes when markets begin to fail.
Why do asset managers stay invested when markets are going off a cliff? In our experience, these are the 5 reasons most asset managers do not do what investors expect them to:
Many active managers are constrained by how much they can sell into alternative asset classes by their prospectus or offering documents. They may have a literal regulatory prohibition on selling to cash or other “safer” asset classes, even if the asset classes they specialize in enter a bear market.
Funds that manage significant institutional assets, such as endowments, are highly constrained by institutional mandates or directives. Institutions have their own specific asset allocations designed for asset pools often upwards of tens or hundreds of millions of dollars. If a manager sells to cash during a bear market, even with the best intentions, they will alter the endowment’s overall allocation. Institutions make their aversion to asset class deviation clear in their RFP and Investment Policy Statement, so managers who do choose to deviate risk being fired.
Portfolio Managers are most often judged by their relative performance against a benchmark. If they stray too far and are wrong, even temporarily, they stand the risk of being reprimanded, or in many cases fired, for their deviations. It takes years of hard work to earn a top fund management position and the rewards can be enormous. Why put all of this at risk? Most simply choose not to, despite the detriments their clients may face as a result.
Like career risk, many managers are on a payment structure based on performance relative to a benchmark rather than on absolute performance. If they deviate from their benchmark, and are wrong, they might be forgoing their annual bonus. Worse yet, many managers and their teams are paid as a group. A manager risking their own bonus is one thing but risking their colleagues’ bonuses is quite another.
If you are invested in an index fund, your manager will follow this index in good times and bad, even if the markets go over a cliff. This low-cost option is terrific during bull markets, but understand that you are also guaranteed downside capture, with many capturing 100% of the downside in a bear market. This means any sell decision is up to you, or worse, your client.
Now that you understand what your manager will or will not do, can you justify investing this way? After nearly 9 years of enjoying the second longest bull market in history, it is easy to become overly confident or complacent. But let’s not forget 2000-2002 and 2007-2009. Markets are cyclical. They go up and down. Will your manager deliver on what investors expect: robust participation in the good times AND preservation in bear markets? Or will you, the advisor, end up getting fired along with your manager in the next bear market for taking no action?
Worst of all, are you agreeing to pay these managers to do only half the job?
For more insights like these, visit BCM’s blog at blog.investbcm.com