High Finance

Michael Lewis in Portfolio wonders if the whole world's gone mad:

One day, someone may look back and ask: At the end of the 20th century and the beginning of the 21st, how did so many take up financial careers on Wall Street that were of such little social value? Just now, the markets are roiling, money managers and investment banks are reporting disappointing returns, and people are beginning to wonder if they chose the wrong guy in Greenwich, Connecticut, to take 2 percent of their assets and 20 percent of profits. But what if the problem isn’t the guy in Greenwich but the idea that makes him possible: the belief that the best way to invest capital is to hand it to an expert? As a group, professional money managers control more than 90 percent of the U.S. stock market. By definition, the money they invest yields returns equal to those of the market as a whole, minus whatever fees investors pay them for their services. This simple math, you might think, would lead investors to pay professional money managers less and less. Instead, they pay them more and more. Twenty-five years ago, the most successful among them took home a few million dollars a year; in 2006, more than 100 money managers made more than $100 million, and a handful made more than $1 billion. A vast industry of stockbrokers, financial planners, and investment advisers skims a fortune for themselves off the top in exchange for passing their clients’ money on to people who, as a group, cannot possibly outperform the market.

The whole piece is great. A related issue is what are the barriers to entry here. Sometimes unimpressive-looking NBA players make a ton of money because very, very, very few people could play as well as a middling NBA player. But how hard can it be to do the job of a middling financial manager? You could just flip coins.

Comments

No wondering necessary: Yes, the whole world has gone mad. The only way for active management of a portfolio of any breadth to reliably outperform the market after costs is through insider knowledge; anyone paying 2 and 20 is expressly paying for a fund to be illegally managed.

Posted by R Johnston | December 9, 2007 12:10 PM

But how hard can it be to do the job of a middling financial manager? You could just flip coins.

I wonder how hard can it be do be a blogger for the Atlantic.com? You just throw a few words on a computer...

Now, I'm sure Matt could respond and give all the details as to just how difficult this little gig can be, especially to the outsider who's not done the job before... the same way a middle financial manager could have explained to him had he just bothered to call one up and ask.

Posted by David | December 9, 2007 12:34 PM

Reminds me of this classic Dilbert comic.

Posted by Jacob | December 9, 2007 12:36 PM

Of course as the piece explains in more detail, none of this is new. Academics like Eugene Fama and others have been making this point since at least the 60s. Burton Malkiel tried to bring the message to the public with A Random Walk Down Wall Street in 1973. John Bogle founded Vanguard in 1974 and has been giving investors low cost passive options ever since (DFA, profiled in the piece in more detail, does the same, although not as inexpensively as Vanguard).

The problem, of course, is not madness, but marketing and human psychology. The marketing of expensive financial management basically works by telling investors that everyone else is making easy money, and you are a sucker if you "settle" for market returns. Yes, it makes no sense that everyone else could be beating the market since the market is everyone else, but that point is just subtle enough that it gets lost on a lot of people.

Moreover, it is counterintuitive to most people that with a task like managing your personal investments, after a fairly early point, spending more time gathering information and making decisions is likely to lead to worse, not better, results. So, the idea that you can't expect to do better than something as simple as an index fund with a little extra effort is very hard for some people to accept.

Posted by DTM | December 9, 2007 12:51 PM

David sorta has it right. Just like what we supposedly care about in a pundit is having useful, correct opinions, that's clearly not what they are paid for. If it were then almost every single pundit would be out of business. (Can you actually imagine Brooks or Krauthammer being paid for the crap that is printed if accuracy was a criteria.) Instead, since we know that anyone can have an opinion, ill-informed or otherwise; we pay pundits to have "controverial", but not too controversial ideas. We pay them to write coherently, and to turn a phrase often enough for us to admire their skills. We pay them to do a little research so as not to be blatantly non-factual. To reitirate, what we don't pay them for is to be right.

In the same way, investment managers are paid to know how to set up a fund, to understand the legal regulations governing subscription, to assume risk, but not too much risk, and to have some basic understanding of the markets so they are not blatantly stupid. Just like there are probably only 2 or 3 pundits whose opinions are consistently superior (Krugman), there are only 2 or 3 investors whose judgement is consistently superior (Buffett).

Posted by elliottg | December 9, 2007 12:52 PM

The managers get the 2% based on reputation but they earn most of the 20% by outperforming the market. To make the premise of the arguement that is impossible to outperform the market is nonsense.The stupidity of the piece is almost impossible to address. It is like saying paying Kobe Bryant to outperform the average NBA player doesn't make sense because everyone can look up the league scoring average. Epically
stupid post.

Posted by phg | December 9, 2007 12:55 PM

Also, most people don't understand that competent financial management is in the 'opposite of sex' category-- if it's exciting, you're doing it badly.

Posted by MattF | December 9, 2007 12:55 PM

But how hard can it be to do the job of a middling financial manager? You could just flip coins.

I'm very skeptical of these folks, but the question of whether they ultimately help their customers or improve society has nothing to do with whether "anyone can do" what they do. From Lewis' article:

Blaine set a goal for himself: Reach 100 people a day by telephone. Half the time, people hung up on him, but about one in every 300 calls led to a sale.

Admittedly this guy wasn't a "middling" financial manager. But, as the anecdote indicates (and as you'd expect, given that they're ultimately selling a worthless product), these people are great salesmen. One trait of a great salesman is shamelessness about cold-calling people, which would certainly prevent Matthew Yglesias from ever becoming a middling financial manager.

Posted by JB | December 9, 2007 12:58 PM

I'm very skeptical of these folks, but the question of whether they ultimately help their customers or improve society has nothing to do with whether "anyone can do" what they do.

This is silly.

It's sort of like saying that not anyone can be an NBA player becuase you have to get up very early in the morning, you have to spend hours in the gym being yelled at by weird little men without hair, you have to travel constantly and be away from your family.

That's not why not anyone can be an NBA player. To be a professional basketball player you have to be incredibly good at basketball. The work schedule is pretty much beside the point.

If financial managers aren't actually any good at managing finances, then who gives a crap if they're good at cold-calling wealthy people?

Posted by DivGuy | December 9, 2007 1:10 PM

Have the people slamming Matt ever put 2 minutes of thought into this? I can't be an average NBA player. I can buy an index fund and get average returns in the market. Why is this so hard to understand? The point is well known and has been made many times in many places.

Posted by DJ | December 9, 2007 1:16 PM

phg,

The thing is, they don't give you back 20% of any underperformance of the market. So to make the big bucks, all you have to do is make sure you do not exactly track the market. The times you do better, you get 20% of the excess and the investor takes 80%. The times you do worse, the investor takes 100% of the shortfall. And all along you also get your flat 2%.

Posted by DTM | December 9, 2007 1:16 PM

DTM: You are correct, but most hedge funds require that the managers be invested in the fund as well. In that case, they take their losses right along with the investors. However, even with "skin in the game," the risk/reward is lopsided and the managers' incentives are not completely aligned with the investors.

Posted by DTM | December 9, 2007 1:21 PM

Matt is absolutely right.

The concentration of wealth means that the market is driven by the 90% controlled by money managers.

Scale economics (remember Wal-Mart) should dictate that the fees should go down, rather than up, in this situation.

But they don't. Why? (Money managers and their frat boy children, please fill in your justification here).

it's about the game being fixed. Either the manager is claiming illegal, inside knowledge, or we hire our Ivy league college buddies (or their sons/daughters) to handle our money.

Either way, it's either illegal or irrational. And there is no benefit, other than saving frat boys from a life of (violent) crime.

Posted by dollared | December 9, 2007 1:36 PM

That's not why not anyone can be an NBA player. To be a professional basketball player you have to be incredibly good at basketball. The work schedule is pretty much beside the point.

If financial managers aren't actually any good at managing finances, then who gives a crap if they're good at cold-calling wealthy people?

I don't particularly give a crap. I'm just considering the possibility that financial managers get rich people to buy things they don't need because financial managers are great salesmen. Great salesmen are fearless about being rejected, which means they pitch over and over and over again and become even better salesmen. The very best can convince very wealthy people to spend lots of money on financial advice that isn't worth anything. I don't know if that's really the explanation, but it seems like a possibility. From the article:

But when he stepped back from his job and really looked at it, he realized that a huge amount of his time and energy went into making people feel happy about his advice when they should have been furious....

And these weren’t bucket shops; they were Wall Street’s most distinguished firms....

His father had been right: His persuasiveness and ability to get people to like him went far on Wall Street.

Snowing rich people isn't admirable. Nor is it easy, or something the average person (or coin-flipper) can do. I don't see the contradiction between a job being hard and lucrative, on the one hand, and its being bad for customers/society, on the other.

Posted by JB | December 9, 2007 2:05 PM

The term "money manager" can cover a lot ground, and typically that term doesn't include cold calling stock brokers like the one in this article. Certified Financial Analysts, those that actually help pick the horses in the race for a Mutual Find or Hedge Fund and "manage money" are typically what you would call a money manager, and they usually don't do any customer contact at all. A CFA license is a three year study program beyond college. These folks also typically work in teams and even then very few are impervious to market cycles.

I guess its become sort of a tradition to write pieces like this one when the market begins to tank, but this one basically lumps a number of professions together and calls them all hacks. Well, maybe so, but then again you are free to manage your assets yourself, and it can be done fairly cheaply these days.

Posted by Condor | December 9, 2007 2:08 PM

Business is amoral. Almost every great businessman is amoral. In a corporate structure the most amoral often win. So much so that huge swaths of our corporate leaders are sociopaths. The message isn't lost lower down the ladder.

Wall Street was handed the keys to credit creation and thus money creation by Greenspan and both political parties. Enron was a tiny iteration of the fractal that is todays financial structures. The very foundation of the Wall Street centered financial world is corrupt.

Now the Treasury is a subsidiary of Wall Street and heaven and earth will be moved to slow the disaster and socialize as much of the cost as possible. Before Paulson went to Wall Street he worked for John Ehrlichman:

The skewing of asset distribution was the result of the inflation of financial assets which in turn was the result of a political decision. Wall Streets financial alchemy of securitizations and derivatives were created mostly not to serve some need but rather to generate income and most importantly to avoid regulation.

Posted by rapier | December 9, 2007 2:38 PM

The managers get the 2% based on reputation but they earn most of the 20% by outperforming the market in the short run even though they can't outperform the market in risk-adjusted returns in the long run.

Edited for accuracy. People make that 20% by instituting high variance management styles that result in significantly outperforming the market some of the time (20% bonus time) and significantly underperforming the market some of the time (without any penalty to the manager). The 20% on 2+20 deals functions as a bonus for screwing the investor by increasing risk through higher variance without regard to long term profitability.

Posted by R Johnston | December 9, 2007 3:03 PM

Look if you buy "spiders" or put your money in index funds, then you too can perform about as well as the average manager. But that is obviously not a solution for everyone.

The reason composites like "spiders" work is because not everyone invests in composites. If everyone just bought "spiders" then they'd become just another security with much of the volatility that goes with any security.

As for index funds, even if your strategy is just to hold a market weighted version of the S&P, how do you get into such a position? How do you change your protfolio as the market changes? You need market makers (ie other money managers willing to buy stock and sell stock from/to you). And if the vast majority of investments had as their only guiding principle "maintain the market portfolio" then a handful of money managers would make even more out of the rest of us.

Look, like any ohter business with plenty of participants, investing is a game where you have to work really hard just to stay even with the pack. Doesn't mean managers are stealing peoples' money.

Posted by WillieStyle | December 9, 2007 3:11 PM

If the markets really are perfectly efficient, then why are so many stockbrokers making so much money?

If the markets are perfectly efficient, then the advice of the stockbrokers is basically worthless. However, if the markets were perfectly efficient, then the stockbrokers who give this basically worthless advice would be unemployed. This is not the case though.

Either the markets are not efficient and the stockbrokers perform a useful service by finding inefficiencies and profiting from them, or the markets are not efficient because they allow a rather large number of people to make a rather large amount of money for no particularly good reason.

In any event, the continued employment of the stockbrokers seems to imply that the markets are not perfectly efficient.

Posted by JSmith | December 9, 2007 3:29 PM

Look if you buy "spiders" or put your money in index funds, then you too can perform about as well as the average manager. But that is obviously not a solution for everyone.

Why is it not a solution for everyone? Something like 75% of funds fail to beat the market. This implies to me that most people would be better off putting their money in index funds, rather than listening to the advice of a broker.

At the end of the 20th century and the beginning of the 21st, how did so many take up financial careers on Wall Street that were of such little social value?

Because they were effectively free for employers to hire.

The problem is that businesses depend on sales, and salespeople are free-- they cost almost nothing, and you can pay them only if they generate revenue. Thus, our economy drives a lot of people into sales positions, and they make money by finding people who can be convinced to buy something they probably don't need. The American economy seems to have such a huge surplus of white-collar labor that the natural outlet for them seems to be to put them in "sales" where they won't suck up costs but have the potential to generate revenue. This got extended to finance, where there isn't much money to be made in commissions selling people index funds, but there is a fair amount of money to be made selling people worse-performing funds and convincing them that it's a good deal.

The issue isn't why so many people end up in finance. The issue is why so many people end up in sales hawking goods that are worse than things you don't need a salesman to tell you about.

Posted by Tyro | December 9, 2007 3:34 PM

Either the markets are not efficient and the stockbrokers perform a useful service by finding inefficiencies and profiting from them, or the markets are not efficient because they allow a rather large number of people to make a rather large amount of money for no particularly good reason.

Ok, this represents a misunderstanding about the role of stockbrokers. A broker does not know anything about any market inefficiencies in the securities market that can be exploited. If he did, he would not be a broker and would instead be a financial manager or quantitative investor/analyst. The role of a stock broker is to buy and sell, and the broker makes money by facilitating transactions. Insofar as a broker is exploiting a market inefficiency, it is by creating a market inefficiency by convincing his customers to keep using him as a go-between and investment advisor, even when he does not add enough financial value to justify his compensation.

Posted by Tyro | December 9, 2007 3:41 PM

Look if you buy "spiders" or put your money in index funds, then you too can perform about as well as the average manager. But that is obviously not a solution for everyone.

Why is it not a solution for everyone? Something like 75% of funds fail to beat the market. This implies to me that most people would be better off putting their money in index funds, rather than listening to the advice of a broker.

Ok say everyone has their money in a market-weighted portfolio and is determined to keep it that way. You're a young woman who just started her first "real" job and would like to start investing. So you decide to buy a bunch of securities so that you too end up in a market-weighted portfolio. How do you do that?

Worse yet, say everyone is determined to keep a market weighted portfolio but you decide you no longer want to hold on to GE stock for whatever reason. How do you get rid of your GE stock?

The "market" porfolio is simply the agregate of everyones portfolios. Everyone trying to maintain the average of everyones portfolios is ultimately untenable.

Posted by WillieStyle | December 9, 2007 3:42 PM

Management strategy needn't rely entirely on getting more trends "right". If the trends you get right, you get right before the average competitor (and the trends you get wrong you abandon quicker), due to superior intelligence or analysis, that can work just as well.

Posted by Senescent | December 9, 2007 3:48 PM

WillieStyle, ok, I was obviously confusing "spiders" and "market-weighted" portfolios with index funds. Nevertheless, I do maintain that index funds are probably the best solution for most everyone. The only exception to this would be those with the time, patience, and intellect to be value investors, but my impression of doing your own investing is that it requires one to take on the task as a second job, and not everyone is both willing and able to do that.

Posted by Tyro | December 9, 2007 3:51 PM

There's really no mystery here, folks. About 98% of individually managed stock portfolios (those where the investor makes his/her own stock picks) are consistent losers. So why do people keep trying? Ask any casino owner.

This is why people pay to get average returns and besides, it saves them the time and trouble. If broker fees bother you get into a passively managed index fund.

Posted by kafka | December 9, 2007 4:02 PM

Almost everyone should be investing in index funds, but people seem to be having a hard time understanding Williestyle's point that not literally everyone can be a passive investor. Passive investors just copy all the active investors; there need to be some active investors for this to work.

Posted by Barbar | December 9, 2007 4:11 PM

Sure, everyone cannot be a passive investor. But index funds represent about 1% of the market. Right now, and for the foreseeable future, the market can absorb a massive amount of passive investors without significantly altering the dynamics.

I think Kafka has it right though: no matter what the research says, most of the market will be actively managed for the same reason that Las Vegas is never going to disappear and for the same reason that state lotteries are going to be immensely profitable over the next few decades.

This talk about how passive management can't work for everyone is really just a distraction.

Posted by Turbulence | December 9, 2007 4:21 PM

Sure, everyone cannot be a passive investor. But index funds represent about 1% of the market. Right now, and for the foreseeable future, the market can absorb a massive amount of passive investors without significantly altering the dynamics...

This talk about how passive management can't work for everyone is really just a distraction.

Nonesense. If a nontrivial number of investors decided to move to index funds (and other passive investment vehicles) then it would simply become more expensive to aquire or unwind the market position as market makers took advantage of passive traders. The savings you got from lower fees would simply go to higher transaction costs.

Posted by WillieStyle | December 9, 2007 4:31 PM

I think it's great that the free market has developed this very efficient way for foolish wealthy people to get hosed. Why interfere?

Less glibly, it is the case that fierce competition and very difficult exams do make it difficult to become a professional money manager. Those are union-style barriers to entry though, not clearly related to job performance (like the NBA's barriers to entry are).

Posted by southpaw | December 9, 2007 4:32 PM

Public customers represent a vanishingly small percentage of the profits on Wall Street today. They have always been sheep to be fleeced but the natural systematic bias that inflates stock prices (M3 money growth and tax advantages etc.) has served the public reasonably well over the long term. Certainly since the great post Depression turn from whenever you date it:; 32,37 42 or 48

85% of stocks are now owned by the top decile. Currently as much as 90% of daily volume is program trades. (baskets of 15 or more stocks worth $1 million or more) Virtually all the volume is based upon short term trading strategies of hedge funds and Wall Street itself trading for their own account. (The great Wall Street giants now turn their hundreds of billions of assets as much as several times a day!) Arguing about if that makes sense is an interesting parlor game which ignores the larger issues.

Posted by rapier51 | December 9, 2007 5:18 PM

"But index funds represent about 1% of the market."

I'm certain this is wrong, at least for the U.S. equity markets. 1% is on the order of about 200 billion. Vanguard by itself has about over 1 trillion in assets, most of which is in index products (granted not all in the U.S), and this doesn't even count all the other index providers, including giants like Barclays and Fidelity.

Posted by ed | December 9, 2007 5:24 PM

> Why is it not a solution for everyone?
> Something like 75% of funds fail to beat the
> market.

Everyone _should_ put their core investments in index funds, but I am pretty sure if literally everyone _did_ the modern stock and financial instruments markets would collapse.

Cranky

Posted by Cranky Observer | December 9, 2007 5:49 PM

It is true that you need a few non-passive investors around to make markets efficient. But you don't need many of them.

Rather, you just need a few of them around who are sufficiently well-funded to quickly identify and exploit arbitrage opportunities. Even with just a few such people in the markets, they will quickly compete down any aribitrage opportunity that arises to an efficient price.

Of course to keep them well-funded, the markets have to be just inefficient enough to give them enough profit to stay well-funded. I'm not sure exactly how much profit there needs to be, but I suspect it is somewhere in the billions, which would likely only be a tiny fraction of the trillions being transacted. I also suspect the necessary profit is growing smaller all the time as information and computing power gets cheaper and cheaper.

Posted by DTM | December 9, 2007 6:03 PM

To say, as Lewis does, that fund managers as a group can't possibly outperform the market supposes that the whole market is in the hands of fund managers. But there is a sizable amount of equity in individual onwership-- for example, thanks to firms that use their own shares as compensation or a pension/ retirement investment option for employees. Those of us who work in academia or the media don't run into this, but a lot of employees working for publicly-traded firms end up holding a lot of stock (as a proportion of their net worth) in their own companies.

These folks are very likely to underperform the market due to lack of diversification and hedging. The same goes for everyone sitting at home buying ten shares at a time online. And indeed the same might well be true of highly informed active individual investors up to and including the T. Boone Pickens crowd of people who can aspire to buy companies themselves. The market isn't *just* made up of passive funds and active funds, and so active funds might (though they generally don't) outperform the market as a whole.

Posted by Jacob T. Levy | December 9, 2007 7:21 PM

It's worth noting, given the article's repeated mention of Warren Buffett, that Buffett thinks that EMT is bunk. Fama's strong-form EMT is a useful theoretical shorthand, particularly for Chicago school economists, and is good advice for individual investors. But it's kind of absurd for Michael Lewis, who surely knows this stuff, to accept as written the idea that Buffett's success is entirely due to luck.

Buffett himself saw this argument and gave a lecture at Columbia Business School, "The Super-Investors of Graham and Doddsville", in which he noted a few successful value investors by name and predicted that their success would continue rather than, as EMT would suggest, revert to the mean. The only one I can remember is Walter Schloss, but I think it's held up pretty well and the named investors continued to be market-beating investors. To flip sports on Matt, Blaine Lourd is totally right that only a sucker trades for a 19-year-old after seeing him pitch one game on the assumption that he's the next Roger Clemens; Buffett's claim is more along the lines that a historically freakish 37-year-old Clemens is likely to remain historically freakish as a 38-, 39-, and 40-year-old.

Posted by Steve | December 9, 2007 8:22 PM

Ok, this represents a misunderstanding about the role of stockbrokers. A broker does not know anything about any market inefficiencies in the securities market that can be exploited. If he did, he would not be a broker and would instead be a financial manager or quantitative investor/analyst.

That is not consistent with the information provided in the reference link of the blog. Really, from the self-admissions of stockbrokers in that link, it seems that stockbroker is synonymous with stock salesperson.

If all stockbrokers did was facilitate transactions, then, well, again, in an efficient market, why do they exist? Computers can do their job in facilitating transactions. If you doubt this, try out Schwab. Really, computers can do their job.

The primary point of their job appears to be sales though, which computers aren’t really good at, at least at this point in time.

In a perfectly efficient market, I don’t see a reason for stockbrokers to exist, much less make large amounts of money.

The existence of stockbrokers almost proves that markets are not totally efficient.

Posted by JSmith | December 9, 2007 10:43 PM

Is this Michael Lewis the same as the Money Ball asshole?

Posted by MNPundit | December 9, 2007 11:18 PM

Yes, this is the same Michael Lewis who wrote the outstanding book Moneyball.

Posted by djw | December 10, 2007 12:47 AM

Yes, this is the same Michael Lewis who wrote the outstanding book Moneyball.

Posted by djw | December 10, 2007 12:47 AM

Everyone knows Billy Beane wrote Moneyball. The nerve of some people, making themselves the hero of their own book.

Posted by Joe Morgan | December 10, 2007 1:21 AM

Its pretty ridiculous to consider lumping all of wall street together in the same boat. There are a lot of different people doing different jobs there. Never-the-less, I think JB gets it pretty close to exactly right. Even if not everyone is doing that sales job, its still a competitive and profitable industry. There are plenty of other roles that need to be filled and for the simple fact that it is lucrative, they will become selective in their criterion. I thought about moving into the field myself, but as the primary criterion for nearly all of them seems to be to work an insane number of hourse, I opted not to (so far).

At the end of the day: none of this means that the service is useful to society. As others have noted: we need some people to be keeping the market efficient. But it does not cost what we are paying wall street.

Posted by mpowell | December 10, 2007 11:57 AM

Condor was pretty on target - except CFA stands for Chartered Financial Analyst. It's a 3 year series of postgraduate study and exams, including ethics and technical issues. Really hard.

Some of the advantages you might have in going with an investment advisor instead of an index fund are issues like how best to position yourself w/r/t taxes and assessing your goals and horizons in determining how aggressive or conservative to be.

Posted by ed in vermont | December 10, 2007 3:17 PM