Relevant to this discussion is Warren Buffet's 1975 memo to the board of the Washington Post regarding investment strategy for their pension fund. He advised being patient, investing like an owner, and eschewing highly paid money managers. A quote from the memo:
"If above-average performance is to be their yard stick, the vast majority of investment managers must fail. Will a few succeed — due to either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance — just as would be the case if 1,000 ‘coin managers’ engaged in a coin-flipping contest. There would be some ‘winners’ over a five or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly ‘successful’ records — who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)”
At the time of WaPo's sale to Jeff Bezos, the pension fund had a $1b surplus.
This article describes the memo, and includes a link to a PDF (thru Scribd):
For those interested in the coin-flipping analysis, I strongly recommend "Fooled by Randomness", which is a smart, passionate, and funny examination of how that problem plays out in the investment industry.
The article is bs and reeks of ass-covering (and lots of other folks agree). If S&P 500 was such a bad benchmark, why did he bet $320k on being able to beat it? The other points (interest rates etc) amount to "We couldn't predict the future", which would normally be fine, but not when you are charging 2 & 20 to do so.
I'm guessing the money manager was able to get some new client funds because of his ability to put his money where his mouth is. 'I put my own money in this' is a strong argument. If it gained him $500m in funds at 2% fee, then a 1 mil losing bet is covered by new accounts in year 1.
TL;DR:
"So for instance in U.S. equities the funds got annual returns of 8.24 percent for 10 years, versus annual fees for U.S. equities of about 0.08 percent. So the funds got 99 percent of the returns on their investment, and the managers got 1 percent of those returns. Again, paying managers 1 percent of the returns they generate does not seem particularly egregious to me, though I suppose there's an argument the other way."
"None of this seems like a blanket reason to condemn "Wall Street," but, you know, politicians gotta politick. My takeaways are something like:
1. New York pension funds' performance is fine.
2. They pay fees that, over all, are quite low.
3. Their alternative investments seem to somewhat outperform public-market benchmarks, though maybe not as much as they'd like."
The issue isn't how much they are being charged, the issue is that far too many public employee unions have large pension deficits and cities, states, and the like, need a bogeyman. Looking for related stories, this pension went from over funded in 99 to underfunded by 2012, to the tune of only having 63% of what is should have.
Likely this is just the trial balloon, expect similar articles as the truth about government employee pensions funding comes to the forefront. Unlike private pensions the government at different levels can twist the rules quite a bit.
couple of scenarios come out of this
1) cuts to benefits, likely only through bankruptcy like Detroit. NYC should be able to avoid this result
2) tax increases to fund the pensions properly
3) finding new creative ways to fine financial companies for exploiting retirees and the like
4) bailouts, after all we have elections in a few years and what good polio wouldn't be for bailouts.. by the state or feds (again not necessarily for NYCERS, they are bad off but not the worst out there)
Money managers are the least of public pensions' problems. Unfunded liabilities are far bigger; it's easy to blame Wall Street rather than the policy makers who continue down the road to insolvency.
I disagree with #2. I'm an individual investor. I can get into vanguard index funds for around a 0.05 fee, depending on the fund. The author estimates that the NYC pensions were paying a roughly 0.25 fee on their funds.
That's a $10 billion customer paying 5X in fees what a small investor like me pays. I think that's insane.
> The author estimates that the NYC pensions were paying a roughly 0.25 fee on their funds.
Where does it say that? I just did search on the web page and the string "25" doesn't appear anywhere.
Perhaps you're rounding up from this number: "total fees of about 0.24 percent a year on all assets, including private assets."
If you are, you're not comparing like with like. The closest equivalent in the article to your index funds is this: "The fees that NYCERS pays for U.S. domestic public equities are about 0.08 percent a year".
So we're now comparing 0.05% for an index fund vs 0.08% for "US domestic public equities", which almost certainly includes actively-managed funds, which incur higher fees than an index fund (e.g. Vanguard's average active fund expense ratio is 0.27%[1] vs 0.13% for index funds[2]), which would explain the 0.03% difference.
The argument is they are gambling with just a downside, so why are they not just buying indexed funds, right?
If you lose money on actively managed funds, you lose the money. If you win money on actively managed funds, you get a small part of the win, and give away a large part of the win to the guy who was gambling (how large is clearly a contract question). If the part you give away is too big, you are playing a fools game. The article isnt describing how much was fixed costs and how much were bonuses paid on outperforming funds, so it's hard to tell if they are indeed playing a fools game, but it seems at least possible.
Why pay someone to gamble for you if he will take 95% of the winnings but not eat any of the losses? If this is this because the managed accounts actually under-performed to expectation - ok. If it is because you're paying too big bonuses on exceeding some easy to reach baseline - not ok.
> Why pay someone to gamble for you if he will take 95% of the winnings but not eat any of the losses?
From the article:
> So for instance in U.S. equities the funds got annual returns of 8.24 percent for 10 years, versus annual fees for U.S. equities of about 0.08 percent. So the funds got 99 percent of the returns on their investment, and the managers got 1 percent of those returns.
But the important part isn't annual return, it's annual return compared to similarly risked options. Which are in the 7-8% range for the last 10 years depending on when you start counting.
I'm paying you to beat the average - I can achieve the average myself, at a lower risk by just investing evenly across the board.
If the funds delivered 8.24%, and matching S&P would have gotten me 7.5%, then you're in fact keeping 15% of what you gambled for. And if you had delivered 7.0% I would have eaten that loss compared to the average.
The article suggests that the fees were comprised of management fees only.
This is a common structure for "long only" management funds that limit their exposure to public equities and are under significant restraints in how "creative" they are allowed to be.
That is paying a fixed price for someone to gamble for you.
If you look at it objectively, a more sane pricing model would be that you get a discount on the flat fees compared to what you would pay for a non-managed fund, but with a bonus paid on earnings.
The value proposition from the fund managers is that they can significantly outperform a non-managed fund. If that is true, then what they lack is capital to actually play on a large enough scale (if they had the capital they would just play with their own money after all). Pension funds have a large amount of capital that they want to accrue interest on.
The win-win scenario is that the fund managers agree to handle the money at a lower cost than what having them in some form of indexed managed would be, but that in return they take a share of any profits that are generated.
If you just add on a flat % fee that is higher than what the indexed fund would charge, then the fund manager isnt assuming any risk.
They should be. There's no way the 5X charge is worth the active management. And yes, I realize that in this 10 year period it was, but that's just variance.
Vanguard has a total US stock market fund for institutional investors, with a minimum investment of $200M, that has an expense ration of 2 basis points (.02%) The FTSE world ex US fund is 10 basis points and a $100M minimum.
At $57B and $27B invested respectively I imagine the city could negotiate an even better deal if it was going to put all the money in each category into a single fund.
That said, the author of the linked article does have a point. The expense numbers on the public market side don't look outlandish when expressed as an expense ratio rather than a ten year total number.
> annual fees for U.S. equities of about 0.08 percent. So the funds got 99 percent of the returns on their investment, and the managers got 1 percent of those returns.
If you round up 0.08%, it should be 99.9% and 0.1% respectively.
No, because the 0.08% is a percentage of the _assets_. So if your return is 8.24% of assets per year and your fees are 0.08% of asserts per year, then your fees are 0.08/8.24 = 0.0097 of your returns. Or in other words 0.97% of the returns. Rounding gives you the 1%.
You're not supposed to round 0.08, you're supposed to divide 0.08/8.24. The 8.24 is the percentage point return for the pension fund and the 0.08 is the percentage point cost for the fees
Orly? So you're OK with paying an extra 1% above the market rate on your mortgage? Because that's the kind of thing you're talking about. 1% a year will eat quite a lot out of your retirement over 40 years. I.e. 40%.
the fee is not on the return its on the balance. so if you make money, they make money. if you lose money they still make money. mutual fund feeds end up being massive over a long period of time which is why financial advisors do so well if they have a big enough asset base
The public market funds outperformed their passively managed benchmarks, even considering the management feeds paid. To continue your mortgage comparison, New York is paying a real estate professional a certain percentage of money to find them a better deal on their mortgage, and NY still gets a better rate going through them after their fees are paid.
Except with a mortgage you're not running a risk that next year you will suddenly have an extra 50k added to your mortgage.
Actively managed money has a very nice angle going. They can charge money to actively manage your funds, while still getting to keep a share of any profits generated.
Insurance companies have to pay money to get access to the same funds, to do the same gambling.
It is somewhat insane that you can run a business where the choices are:
a) Do admin work to balance an indexed portfolio for price A
b) Gamble with money for price (B + X% of profits)
And somehow people feel its ok that the price of B is higher than the price of A.
The whole article is premised on the idea that Vanguard's fee is low at 0.17%. But is it really? In a free competitive market fees for algorithmic or mechanical money management would probably be a small flat fee. Vanguard's costs are not proportional to the amount of money under management.
The 0.17% is only for the "investor class" shares, which starts at 3k. Invest 10k and you get "admiral class" shares which charge only 0.05%. At $5m you can get "institutional "which only charges 0.04%, and at $200m you can get "institutional plus" that charges 0.02%, which any big pension fund could have
That's really interesting. So you could put $200M of assets into a Vanguard fund and only get charged $40k/y for that. It seems like a very small number when you put it that way.
Because they have $3 trillion in assets under management - which is $600m a year even at 2 basis points in fees, which not everyone pays. Economies of scale ramp up quickly.
I see you're getting downvoted, but no one is bothering to explain.
First, the market in general works in the exact opposite way. You can invest a million dollars a lot of places; with enough luck and skill you'll earn a great return. Keep doing that and soon you'll have, say, 500 million.
But 500 million is harder to invest; you might say "stock X is really undervalued; I'm going to go long!", but if stock X has a market cap of 10 billion, you'll struggle to find 500 million in shares to purchase on a whim, and in so doing, you'll push the price up, and now it's no longer undervalued. Many investments that work for the guy with 1m don't work for the guy with 500m.
But if you keep going and keep being lucky (or skilled) you might end up with billions or hundreds of billions. Now you're basically fucked. Most possible investments don't have the liquidity or capacity to absorb the money you're trying to place. At this scale you aren't picking companies; you're picking industrial sectors or countries. You'll never make a great return like that. Plus you're being watched constantly; the merest rumour that you're about to invest will end prices soaring or crashing before you can move. You can "push the market around", but only in ways that benefit smaller, nimble players, not you. At that scale, your ability to be clever is basically nil.
Which brings us to the second point: Vanguard is an index fund. They simply buy an even mix of the shares that make up an index. Their entire strategy/promise is that they won't "push the market around" (which is the reason they have $3t under management; people explicitly looking for people who won't try and be clever).
So your question is "couldn't Vanguard do the one thing they don't do, because it can't work"? And the answer is no, it can't work, which is why Vanguard exists and has those assets.
Thanks for your comment. I didn't ask if an index fund could move the market, I asked if an investor with so much couldn't move the market.
One guy bought 15% of the world's cocoa and now chocolate prices are high and manufacturers are trying to rip off consumers by filling thick plastic packages with more air and less chocolate bar.
If you had control of that sort of money it just seems you could be invisible. The cost of the entire coffee production of the world is only billions, buy any significant percentage and there's going to be companies who'll either pay or collapse?
> I asked if an investor with so much couldn't move the market.
Well yeah. Start to buy Apple shares, and the price rises, and you pay more than a smaller investor would. Try to sell them again, and the price crashes, and you receive less than a smaller investor would. As I already explained, you've got it backwards.
> One guy bought 15% of the world's cocoa
Yes, years ago. And it was 7%, not 15%. And like pretty much every cornering scheme, it didn't work. Armajaro ended up in trouble when cocoa prices dropped while they were still holding a large inventory, and they had to sell their commodities trading division off just to cover their losses, because of the same dynamics: The only way they could buy 7% of the worlds yearly cocoa production was by paying a premium—and the only way they could get rid of it was by offering it as a discount.
> If you had control of that sort of money it just seems you could be invisible.
The exact opposite of invisible, actually.
> The cost of the entire coffee production of the world is only billions, buy any significant percentage and there's going to be companies who'll either pay or collapse?
I'm going to challenge you for sources on Armajaro - the cocoa price vastly increased following his scheme and his commodities trading business has won incredible gains.
The above FT story reports that the problem with the trade was that customers expected extended credit and despite a $55M for 6% investment the company, doing many other deals, went under; reported as a credit issue. They sold for $1 to another commodities trade company [Ecom Agroindustrial Trading], FT reports Amajaro Trading was valued at $200M-$300M in 2012. I'm skeptical as to whether Amajaro made a personal loss in any of that, whether it's possible that the price was artificially lowered to sell on a lot of commodities for $1 and avoid tax? Does that seem at all possible?
As a complete novice to the field, could you explain why it's not a good plan in general to seize large proportions of a commodity, for example in these two positions with an increasing price and a stable retail demand for the end products?
Armajaro trading arm bought something like 240,100 tonnes of cocoa for around £650 million, or ~£2,700 per tonne, in July 2010. They then sold the cocoa beans "later that year".
Unfortunately, July 2010 was the peak of the market (it's almost as if trying to buy 7% of global production drives prices up), and they were paying above the odds even then. And prices immediately tumbled off a cliff, dropping to a low of ~£1,8200 in November 2010 (it's almost as if trying to sell 7% of global production drives prices down!), before rallying briefly in 2011, then proceeding to briskly tumble to a low of ~£1,330 per tonne in 2012. (They've since recovered, but they've yet to break £2,000.)
So yeah, obviously Armajaro lost a bunch of money on that trade, precisely because of the volume they were working with. By actually taking delivery, they were relying on prices going up, but prices went down, right as they were needing to sell. Except that because they were buying and selling hundreds of millions of pounds of cocoa, they themselves were a leading cause of the markets moving against them. The same thing happened in other famous market corners, for example when the Hunt brothers tried corner the global silver market (and lost a staggering amount of money). It's no accident that there are no famous successful market corners.
> whether it's possible that the price was artificially lowered to sell on a lot of commodities for $1 and avoid tax? Does that seem at all possible?
Not following. If you're asking if it's possible if Anthony Ward sold a key part of his trading empire to a hated rival for $1 not because he'd lost a ton of money trading cocoa and the thing was basically worthless, but because he'd made a ton of money and it was actually hugely valuable? Then the answer is no, of course not.
> As a complete novice to the field, could you explain why it's not a good plan in general to seize large proportions of a commodity, for example in these two positions with an increasing price and a stable retail demand for the end products?
First, cocoa doesn't have a steadily increasing price, and while retail demand might be stable, the supply situation is very volatile due to political and economic instability in the growing regions. Cocoa prices were bouncing around like crazy, and while volatility is good for smart traders trying to make bets about price directions, it's bad for people trying to deal in the physical commodity, because what happens if you get stuck with 240 thousand tonnes of cocoa purchased when the price crashes?
Second, even if cocoa was a safe commodity with stable supply, demand, and price, you can't "seize large proportions of a commodity"; what you can do is start buying it. And the more you buy it, the less stable the price is going to be, because the demand is no longer stable due to some wannabe Bond villain is buying up huge amounts of it. The price will skyrocket. So when you ask:
> why it's not a good plan in general to seize large proportions of a commodity
Because you'll pay a large premium over the fundamental market price. Like, by definition. And buying anything for a large premium over the market price is never a good idea, unless you value it well over the market price. But Armajaro wasn't a producer; all they could do with the cocoa is sell it. Which, inevitably, they'll do at some discount to the market price. Nor would this trade have made sense if Armajaro had known that prices were going to spike due to an external shock; then they should have bought options, not actual physical cocoa.
Bottom line: Buying very large amounts of a physical commodity in order to profit from price movements is a terrible idea.
Edit: The largest purchase of cocoa ever was done in 1996 by...Anthony Ward, working for Phibro at the time. He bought 300,000 tonnes, but Phibro lost money on the deal when prices moved against him. Shocking! Although he is reported to have made money on his 2002 trade. Then again, the 2002 trade was only 5% of the market, or 200,000 tonnes, smaller than the other two. (The Guardian says 15%, but you can't trust the Guardian with numbers, and multiple other reports confirm the lower figure.) Or in other words, Ward has demonstrated the ability to make money on small trades, but lose them on bigger ones.
Thanks for your insight and continued patient responses.
>"Armajaro trading arm bought something like 240,100 tonnes of cocoa for around £650 million, or ~£2,700 per tonne, in July 2010." (Lazare) //
>"Then the answer is no, of course not." (ibid) //
The ICCO [1] has an interesting section at paragraph 31 on page 10 where it discusses this tonnage [at arms length] and says a group of interested parties made appeals that unfair trading was attempting to manipulate the futures market. This suggests that those companies were thinking something along the lines of what I was suggesting: that this purchase was trying to manipulate prices, so the money made would not be from the trade directly.
>"[...] This price development on the London market led 16 cocoa companies and trade associations to send a letter to NYSE Liffe to complain that “a manipulation of the contract” was “bringing the London market into disrepute”. Many market commentators argued that this
backwardation was fuelled by a squeeze, which is a trader or a group of traders deliberately disrupting the supply of physical cocoa to artificially increase the price of cocoa futures contracts which are about to expire, and hence to profit from it while other traders find themselves struggling to fulfil their obligations. In response to this allegation, NYSE Liffe advised that it did not find any evidence of
abusive trading behaviour on the cocoa market." (ICCO report [1]) //
You said the price "tumbled off a cliff, dropping to a low of ~£1,8200 in November 2010". According to the chart you linked a tonne of cocoa averaged [?] £2.11k [in London?] in July 2010 when Amajaro made the trade. So why would companies be complaining about backwardation then? [2] Says the price was pushed up and rose by 0.7% after the purchase.
Presumably then those with warehoused stock that's accessible can undercut Amajaro in order to bring down the price? But if there are sufficient goods for this then the "other traders find themselves struggling to fulfil their obligations" from [1] makes no sense.
Also seemingly there was a major issue with Ivory Coast [aka Cote d'Ivoire] being under a flood warning, that previous years had returned deficits in terms of the global demand vs. the global harvest. Was this the issue that broke Ward: There were various embargoes and shenanigans around the Ivory Coast's presidential elections and when they eventually shipped the harvest proved excellent and there were massive excesses [1].
>So yeah, obviously Armajaro lost a bunch of money on that trade, precisely because of the volume they were working with. //
Looks like a top estimate for that is -£72M based on the July to November price change for 240k tonnes.
>* Nor would this trade have made sense if Armajaro had known that prices were going to spike due to an external shock; then they should have bought options, not actual physical cocoa.* //
Correct me if I'm wrong but you can't corner the market that way because the seller can default; moreover a future glut can come in and wipe out your position and/or movement of goods can alleviate the local shortfall [it's something like 3-4 weeks to ship cocoa from US warehouses to European buyers]. Thus it wouldn't create a clamour in the market to ensure that delivery of the commodity can continue, as was apparently the case here?
- - -
Couple of figures that are pertinent:
* Re your edit [3] puts a figure of £40M on the 2002 trade, Wikipedia reports a £58M gain.
* Ward's CC+ fund made 15% in 2010, not exactly sure how much that is but it seems to have been £25M based on some other figures (all Amajaro funds passing £1B, CC+ being 20%, working backwards from [4]).
However there are strategies available to active investors with billions - being an "activist investor".
If you buy significant stakes in companies - which might be only a percentage point or two, but still putting you in the top individual shareholders, then you have the ability to change the strategy of the company.
The step up from that is into Berkshire Hathaway / private equity territory where you just buy companies, or very significant stakes and run them as you want to.
Vanguard has an interesting ownership structure where the funds own the Vanguard company. They're basically (but not "officially" as far as I can tell) a non-profit, and that's why their fees tend to be the lowest.
No, they would have earned a lower overall return, net of fees. That's the point of the rebuttal article, the original NYTimes piece was a hatchet job.
The article says 0.20% fees. This here says 0.02%.
The article is based entirely on an assumption 10x higher than Vanguard's institutional fees. He declares it cheap relative to mutual funds, which is an absurd comparison.
The lower bound of his fee comparison is 8 basis points, which is 4x higher.
Yes. The math in the article bothered me greatly. It seems that to the author, two fees will be "nearly the same" if they are within an order of magnitude of each other, which is ridiculous.
Not to mention the condescension dripping from every word. This piece is a good example of how not to write an 'informative' rebuttal.
Not sure why you were downvoted, it's true. A market competitor hasn't come out yet with a flat fee structure, but with the FinTech battle heating up between algorithmic advisors I believe its an inevitable product/price offering.
A billion dollars buys a lot of developer and data scientist time.
1. Studies that say "XX% of active managers don't beat an index" include every tiny poorly managed fund. The best attractive lots of capital; Bridgewater has $169 billion under management and has a long track record of large outperformance.
2. A lot of investors aren't trying to beat the market per se -- that's in your own link. If you own safe investments during a bull market, you underperform... but if it (ideally) makes you less susceptible to both boom and bust, that could be a good trade depending on what you're doing. If you're an insurance company or pension fund, you probably want stability more than squeezing every last basis point out of your investments.
Anyway, I could give you many criticisms of many aspects of finance, but I think "index > active management" is a bit simple.
1. Studies that say "XX% of active managers don't beat an index" include every tiny poorly managed fund. The best attractive lots of capital; Bridgewater has $169 billion under management and has a long track record of large outperformance.
The second study linked found
Only 0.6% — you read that right, 0.6% — showed any true skill at beating the market consistently, “statistically indistinguishable from zero,” the three researchers concluded.
So your cavets, whilst valid, I don't think go anywhere near disputing the central point.
It's not so much that you are paying only for algorithmic/mechanical money management, but there are transaction costs as well. For example, an fund that tracks a particular index will need to buy/sell as the composition of the index changes. Even without that, you still have contributions and redemptions to deal with. Ideally, you try to match redemptions with contributions dollar for dollar, but they won't always match up, resulting purchasing or selling stock (which incurs transaction fees). Of course, there's the administrative overhead of managing a fund (keeping records, filing reports, etc.). As such, you aren't just paying for the algorithm.
The Vanguard S&P 500 ETF (VOO) has Expense ratio of Expense ratio 0.05%.
-
this ETF is nearly identical to a mutual fund and it can be traded on the exchange.
The possibility for kickbacks (or just complacency) when the ones selecting the fund managers do not necessarily have significant funds under management is evident.
One side effect has been the inclusion of a greater buffet of options for retirement funds offerings from employers.
This news story seems to be another side-effect, in which people start to realize how large these fees had been in some cases.
Pension funds these days do an awful lot of work to decide how to invest, and who to invest with. They send out RFIs which an awful lot of due diligence questions, have access to independent consultants to advise on active/passive strategies etc.
Active managers compete for business, and retaining clients even when performance is good is not easy. One of the key differentiators isn't just performance but client service - if you're investing $40bn of other people's pensions then you want to get good answers from your active investors about their thinking, where they see things going, risks, performance etc.
Oh and the best active managers charge relatively low fees, it is very much not a case of "you get what you pay for" - low fees and high assets under management is a much better money making model for everyone.
Goes right along with expressing costs in Really Big Numbers! without giving context. For example, the $200M/year spent on pension fees is 0.2% of NYC's annual budget of $78B.
Are you sure that NYC has an annual budget of $78B? That's a humongous number for any city, and an outrageous number for a city with a Subway system that is (supposedly still) in a state of disrepair.
Part of the reason the subway is so messed up is it's run by the state, not the city, as part of the general state-wide public transit. The city/state relationship is messed up, the debacle of the subways shutting down for only 6" of snow was because the governor mandated it without talking to the mayor.
NYC (pop. 8.4M): 78B
Los Angeles (pop. 3.8M): 8.1B USD
Toronto (pop. 2.8M): 10B CDN
Chicago (pop. 2.7M): 9B USD
I expected the city's budget to be in the double-digit billions, but in the 40 - 50 billion range.
I wonder if it's something in how the headline numbers are calculated. Toronto splits out its operating and capital budgets, and there are some services like social housing that are (used to be?) cost-shared between the provincial and municipal government.
That said, most people just don't realize (or take for granted!) all the services that cities provide: police, fire, paramedics, garbage/sewer, water, roads and public transit - many of which are highly labour intensive.
> I wonder if it's something in how the headline numbers are calculated.
This is correct. NYC is basically sui generis for American cities. As examples, there's essentially no county government and the school system is part of the city government. The school system alone accounts for $20B of the $78B and over 100,000 of the 360,000 city employees...AND those school numbers don't include the $900M for the city-funded-and-operated 4-year university system.
That's around $10k/resident (and the city gets immense amount of non-resident visitors). Given things like public schools, transport, fire/police, etc. it doesn't seem particularly high to me.
The $78B budget for the city doesn't include the transit system. MTA's budget is $14B/year, with $7B of that going to NYCTA (the part of MTA which runs the subways and the city's buses).
"Disrepair" is a strong word. There are problems, but most of the time, it runs smoothly for me. It's an enormous piece of infrastructure that mostly works. That's no small feat.
> In a competitive market for investment performance, managers should charge fees equal to their outperformance.
Then what's the value in a fund manager instead of a simple algorithm that follows the market? Would you hire an employee and pay them the entirety of the value they generate for your business?
1. There are some people who can reliably generate alpha -- returns in excess of the market return -- but those people are rare.
2. It is somewhat difficult to tell who those people are; in particular, at any given time, there are more people who look like they can generate alpha than who actually can.
3. If you are one of the people who can generate alpha, you should charge a fee for your services that is equal to the alpha that you generate.
4. If you are not one of those people, you should charge a fee equal to the alpha that those people generate, because then investors might think that you're one of them.
"
Ok, so I'll be the guy on the other side of this hypothetical deal. In the scenario he's described, either I get market returns by paying the elite guy to keep his alpha, or I get sub-market returns by paying too much to a guy who isn't actually elite.
So, best case scenario I get market returns? Then why not just invest in an index fund?
Yes. Note: This is a surprisingly accurate description of reality. Aggregate hedge fund returns are goddamn terrible.
> Then why not just invest in an index fund?
Well, you should, if you're trying to maximise your expected outcome. Of course, not everyone is trying to do that.
In particular, what if you run a pension fund which is currently underfunded, but for political reasons is claiming to be adequately funded through the expedient of assuming that future returns will exceed any reasonable expectation of market returns?
If you invest in an index fund you'll get market returns; since that's not enough this means you will miss your targets, and be unable to pay promised pensions, at which point you'll be fired. But if you give all the funds cash to a hedge fund, or engage in some crazy snowball derivative[1], then you'll probably do even worse than an index fund, be able to pay an even lower percentage of the promised pensions, and you'll be fired. Which is actually no worse for you. But you MIGHT do really well, and actually be able to pay the promised pensions. Not likely, but if it works you avoid you getting fired, and if it doesn't you were going to be fired anyhow, so why not give it a shot?
All of why is completely hypothetical. The fact that many US pensions funds are horribly underfunded using any plausible actuarial projects and are simultaneously investing heavily in exotic asset classes is just a funny coincidence.
If the guy generating alpha keeps most/all of his above-market alpha, then that means there's none for me to get or keep, right? I can't see how that's attractive at all.
That's the point. An ability to reliably beat the market is like having a goose that lays golden eggs.
If the ability exists at all, it's certainly very rare. And if you are one of the people who has it, why would you hire that ability out to other people? The guy who owns the golden goose is going to sell the eggs, not rent the goose out. Or if he did rent the goose, it would be for an amount no lower than the expected value of the eggs because otherwise he's losing money.
But given these dynamics, that means that there's no reason to think that if you see some guy offering to rent a golden goose it would be a great deal for you. I mean, he's actively trying to price it so it's not, and it's his goose, so he's probably right.
B) Change the point of view from the retail investor to the pension fund, funds have a very narrow and constrained mandate, they need to hedge risks and deal with the increasing negative cash-flows. They can't merely park their money somewhere and hope for the best.
The other thing hedge funds offer is alternative markets to track. So while some may track the U.S. stock market (which you can get by just buying SPY), some funds track other markets like commodities, foreign equities, housing, bonds, etc. Almost anything that you can put a price on you can find a hedge fund willing to trade. For these "nontraditional" investments it can be rational to pay someone even if they cannot beat the benchmark, simply because you couldn't do it yourself.
I'm not sure I understand - what's the benefit to the customer? If you gain alpha from hiring (3), you gain proportion of alpha + alpha. If you hire (4), you're paying a fee of alpha for a gain < alpha. The customer assumes a lot of risk, especially the more common (4) gets. It seems the customer is most likely to lose in this scenario.
The model is from the perspective of fund managers. If you believe his model, then from the other side of the board, as an investor, your conclusion has to be that managed funds are a bad deal, or a break even at best if you find a manager with alpha.
If you are a customer for hedge funds, you should be willing to pay anything up to the expected future alpha based on past correlations between previous and future alpha.
That correlation is always affected by regression to the mean. Therefore someone with a good track record will not be able to charge on the expectation of future performance matching past performance. But only on the expectation of future performance being somewhat better than the market mean.
The ideal if everyone does everything perfectly is that, on average, fund managers that can generate excess alpha will, again on average, capture their entire outperformance as fees.
It's difficult to follow a market without losing money. I tried once, which was enough to learn that much.
The market generally has been growing for a long time, with 2008 being a notable exception. If you've been growing money at market pace, then historically you've been doing pretty well.
How come? Wouldn't you have a very low turnover rate since you'd generally only buy during new offerings, and not trade at all in response to valuation changes?
The value is that it's actually quite difficult to follow the market at such huge scale. If you're investing $100 billion and manage to mirror returns of the overall market, you deserve a good commission.
The Vanguard fund mentioned in the article manages $200 billion assets and mirrors the returns of S&P 500. As mentioned in the comments here its "commission" is 0.02% for investors of the scale we're talking about.
How much more than that does one deserve for mirroring the market returns?
Why? If we just want to follow the market, then we only occasionally need to adjust our positions in response to dilution or buyback events, right? Executing large trades efficiently is hard, but with a low turnover it's less of a problem.
I wonder if index funds ever get widespread enough adoption that they start to drive prices of the major indexes up and underperform... maybe it sounds crazy right now since institutional investors don't really go for index funds heavily, but if there's a shift on those parameters I could see it happening.
Also, I've started to get more down on index funds as I look into them more. An index that has a weighted average of the stock market is always paying for past performance -- you're going heaviest on the largest market cap stocks always. In an era with both stability and upside for large market capitalization stocks it'll do well... in an era where the best private companies don't IPO until they've ran out most of their growth trajectory and then IPO once they've relatively stabilized, you're going to get hammered, no?
As you rightly realise, we can't have a situation where all money is blindly invested in passive index trackers, since everyone will be following the herd and no one will be leading it.
If active managers are under-performing, then at some point as passive funds grow we will reach an equilibrium point where they are causing such price distortion that they will produce opportunities for active managers to profit from mispricings, correcting the situation.
If you are concerned about weighting too heavily into large cap, CRSP also has small and micro cap indexes. Take a look at their total market index methodology [1], which points you to the small and micro cap sister indexes. Even in FI/RE (financial independence/retire early) and Boglehead circles, there are a low percentage of people with $10M+ investable assets, the level at which tinkering with the kind of optimizations you are pointing out starts to become interesting. I picked CRSP because Vanguard uses them, but indexes like Wilshire's are about the same.
Most middle- to upper-middle class individuals with a 2+ decade investment time horizon (which should describe the majority of HN readership) are better served with starting on a relatively vanilla FIRE/Boglehead approach, and fine-tuning with allocations to broad bond/EM/International indexes as they go along and get a feel for their personal risk appetite.
The plentiful exceptions are people for whom investing is a hobby, they are good at tracking their own performance, and they have domain knowledge about a specific industry. Small-scale active investment can work, but for the vast majority of people who just want to set aside a comfortable retirement without having to spend a lot of time tinkering with it, I have yet to find a better generic approach than passive index tracking on very broad market indexes, though I'm certainly very open to suggestions.
I somewhat doubt passive indexing will ever catch on to the levels you mention due to human nature. Indexing only really works over extremely long time spans, and the data has so far consistently shown most people do not plan that far out for their personal finances. As long as most people are personally responsible for the majority of their retirement finances, I don't expect the consistently-applied delayed gratification a successful indexing strategy requires to cause "too many" people to sit in indexes. I classify that as a "would be a nice problem to have", so I'm not worried even if it somehow comes to pass.
The revenue model for investment managers is an annual wealth tax on their clients no matter how bad the returns! Hell of a way to charge fees, huh? Would we all love it if computer programming services were charged as a percentage of the market cap of the customer who needed the work done! But it's Wall St so everyone just accepts a wealth tax model. Then we take them seriously when they repeat their bullshit when to distract from their wealth destroying fees they scream "HFT" "Short Sellers" "The Frickin' Bogeyman"
The biggest sham is that Wall Street has convinced us all that they deserve to paid in percentages! Sure %0.2 doesn't sound like much until you realize its $200 million dollars a year. Why is everyone so afraid of just hiring a few smart economists paying them $200k each salary? Nobody really beats the market over the long term anyway.
This looks simple on the outside - is it really necessary to pay a percentage fee when investing this much money? I would suggest that the number of funds in excess of 100bn in the world must fit in a decent sized auditorium. That makes "Unionisation"'of the market quite possible. One could easily see a situation where all the funds just said "50 m pa or fuck off"
So my question to HN is - what is so hard (or not) about making market returns for a fund of this size?
I mean the obvious approach seems to buy 100m worth of shares in the top 1000 companies and just hold?
Perhaps it is worth not being fully invested all the time? Perhaps just making market is not worth it - but if it is, is the saving in fees compensating?
> So my question to HN is - what is so hard (or not) about making market returns for a fund of this size?
Boggleheads have been asking that question for like 40 years. Vanguard funds (which simply pick the top 500 shares, or all the shares... depending on the fund...) outperform something like 85% of actively managed funds.
One theory is that modern markets are extremely efficient, which means that actively managed funds do not provide a benefit over just "trusting the market price" of various things.
So, and this is a naive question, why on earth does a Vanguard fund charge a percentage for what seems to be very simple administration (sell 1000000 shares in X, buy 100000 shares in Y, make sure VWAP is good).
I mean - if I was a trustee of a million fund let alone billion I would expect to know the baseline level of dumbest simplest possible investing process. That approach seem the simplest.
> So, and this is a naive question, why on earth does a Vanguard fund charge a percentage for what seems to be very simple administration (sell 1000000 shares in X, buy 100000 shares in Y, make sure VWAP is good).
Because Vanguard's prices are the lowest. Where else are you going to go?
The typical fund charges between 1% to 2%. Vanguard charges 0.05% if you qualify for Admiral Shares ($10,000 minimum). Various ETFs can drop down to that amount, but you still have to deal with tracking error and commissions. $7 per trade typically... while Vanguard doesn't charge commissions if you own a Vanguard account and buy Vanguard Funds (or ETFs).
I suppose my question is better framed as - why is the cost of trading so high? Presumably the stock exchange will charge per transaction, but if I have 100bn invested across 10,000 equities, at a dollar a piece, that's 10M shares. If I make transactions of just 100 stocks per time, that's a whole refresh in 100,000 transactions. Do that 12 times a year at 5 dollars per transaction and I see a mere 6 million cost to look after 100bn in invested funds.
So ... What am I missing. Exchanges all use electronic trading now, Charles Schwann would give me 5 bucks per transaction.
Larger transactions have higher execution costs. Larger funds have larger transactions. It probably isn't the case that there is a linear correlation between fund -> transaction -> execution cost but it is a close enough approximation that everyone is mostly happy.
Additionally, at least with Vanguard, if you have a lot of money invested you get access to funds with lower costs. For example, for $3,000-$10,000 you can VFINX which costs 0.17%, but if you have more than $10,00 invested you can buy VFIAX, which costs 0.05%. For $5M and up, you can buy VINIXm which costs 0.04%.
So what Mr. Levine is saying here, is that the expense for fund management is expected to scale nearly linearly with fund-size and New Yorkers have nothing to complaint about.
Larger funds do cost more to manage. There's a point at which you have to diversify not to mitigate risk but because large buys drive up the cost of the purchase. Also, there are a whole bunch of extra SEC rules that kick in when you're changing your position in a stock in which you have a nontrivial percentage of outstanding shares.
Why aren't fees capped at some limit? Like...maybe 100 million per year? I'm just curious how much harder it is to manage a $100bn fund vs a $200bn fund. Is it twice as difficult?
It's definitely more difficult. Let me give you an example.
I'm currently running an algo that is giving me returns of about 25-30%/year. I do this as a hobby - I don't generally devote more than 10 hours/week to this. Why doesn't NY just give me their money? Why aren't I the greatest investor ever?
The answer is that my algo consists of watching the market and picking off liquidity from the top of the book (typically < 500 shares) when things get unbalanced. Then I passively (for the most part) close my positions a couple of weeks later, very rarely taking liquidity.
I made $2k last year on approx $10k in the market. If I put $20k into the strategy I'd be losing money by taking liquidity from deeper in the book. I.e., buying 500 shares might cost me $10/share but buying 1000 shares might cost me $10.10/share. I'd lose another $0.10 closing my positions, and shaving off $0.20 in profit per trade would kill my profits.
If I were investing 5-10x as much, phrases like "very rarely taking liquidity" would not even be possible - I'd have to take liquidity and I'd then lose the spread as well. And if I were investing 100x as much, I'd be moving the market and losing even more.
I also earn a bit more than $2k on other strategies. I was just describing my highest return strategy and explaining why it can't scale for the sake of discussion.
The real benefit of trading, and why I encourage most quant devs to do it even if they lose money is that it is great mental exercise. When you make mathematical or rationality errors, the market punishes you by taking your money. That's my real reason for actively trading.
why does the compensation need to be tied to the difficulty rather than the assets under management? you haven't actually made a case for that, just assumed it was naturally correct.
> why does the compensation need to be tied to the difficulty rather than the assets under management? you haven't actually made a case for that, just assumed it was naturally correct.
Because in a competitive market, the price of a good is equal to its marginal cost? "Difficult" here is being used synonymously with "expensive".
OK, then why do the fund managers don't just move elsewhere? The flaw in your argument is that you assume that investment services are a commodity, which obviously they aren't, otherwise everybody wouldn't have to be frothing about how some managers make better returns than others.
You cannot really say its twice as difficult but you can easily say that its more difficult because when you are working with a small amount of money you invest in plenty of small promising companies. When you are working in big money a small profit is not going to affect your results much so you need to find a big fish, its very difficult to find such big fish all the time.
I used to intern at a quant fund and our biggest clients were always pension and social security funds, which we charged a standard fee for assets managed. This would often be around $200 million - $2 Billion. Not sure if it is new information to people. I always felt slightly fishy about it.
It is very common for management fees to follow an 2 and 20 Fee Structure.
Meaning they charge a flat 2% to keeps the lights on and pay outrageous salaries.
Then above a certain threshold an additional 20% of any profits earned.
Why does this matter?
IHMO this motivates funds managers to accumulate large AUM (Assets Under Management) to make that 2% larger. The fund manager is less motivated to make good returns since he knows he will still collect that 2%. So it might be better to remove the 2% flat fee and simple charge a percentage on the profits earned. This motivates the fund manager to actually generate returns before he makes a buck. Even if the market is going down he will still be motivated to outperform.
"Managers should, on the whole, charge more than the value they add." But wouldn't that, trivially, make every managed fund always and inevitably less desirable than every unmanaged fund (assuming they aren't for other reasons)?
Why is everyone focused on the fees being charged and not the total idiocy of the city of New York? The real outrage here is New York doesn't seem to know what they're doing with managing pension funds.
Would it be sensible for a fund trustee to ask to divide the fund in two - one managed as per usual, one simply invested by an internal hire into a simple market tracker (ie no percentage basis).
This.
They get a free option, they get upside exposure for zero downside risk. Hell it's even a sweeter deal, they get paid as though they got the upside even if they screw up royally. How did all those funds miss that all those securitized mortgages were junk and not AAA? Just like this. S&P say it's fine so Larry, fancy a round of 18 before our business lunch?
I'm a bit confused about what the author means when he says that managers should charge equal to the extra value they add to a portfolio.
Why should I hire a manager that beats the market, he he charges the amount he beats the market with? Wouldn't that leave me of the same as simply averaging the market?
Because they aren't charging the amount they beat the market by, they're a percentage of that.
In your example, you suggest that you could get $100 by using an index, but instead, you hire a guy who gets you $200 for not using an index, and then charges you the $100, and you're no better off.
In the article, you could get $100 by using an index, but instead, you hired a guy who gets you $200, and then charges you a percentage of that, keeping $4 for them to your $196.
Do you begrudge them their $4, knowing that you "profited" $96 on the deal?
Yeah, the math gets uglier when you realize you're talking about much larger numbers, but the clients, e.g., the pension funds, still came out ahead against the index, even after the managers took their fees.
Take the numbers you've used and switch them around slightly to reflect the NYC pensions situation and you can see why they'd be upset. It's not $4 in fees to an additional $96 returned to the client, it's $2billion in fees versus an additional $40m. Scaled back to your example that'd be like hiring a guy who gets you $200, keeping $98 for your $2.
That would be incorrect. I just used numbers that weren't reflective of the article.
To keep (dumbly) using my simple numbers, while still using their percentages, it would be more like this:
You could get $100 by using an index, but instead, you hire a guy who gets you $103 for not using an index, then charge you a $2 fee, leaving you with a "profit" of $1.
At the end of the day, the fund recipients still come out ahead, just not as much ahead as if the managers charged no fees. If you can figure out a way to get people to work for free, and do a good job on top of it, then you'll have surely cracked the code (or reinvented slavery). Until then, it's hard for me to demonize a money manager who charged two percent over ten years, even if it was two percent of a very large number.
No, this is the section of the article he was referring to: "Actually my simple dumb model for investment management fees is that managers should, on the whole, charge more than the value they add, since (1) good managers who add value should charge fees equal to the value they add, (2) bad managers who don't add value should charge fees equal to the value that the good managers add, and (3) there are at least as many bad managers as good ones. So I think New York's pensions are doing rather well in getting the managers to give up any of their outperformance."
The way this reads to me is that his idea of an actively managed fund should either match index performance after fees (in the case of a good manager) or perform worse after fees (in the case of a bad manager). In which case, you'd be better off sticking with index funds instead of betting on whether or not you have a good manager.
To put it into your example: The S&P 500 has returns of 5% for the year of 2020. Guy_A has his investments managed by Investor_Good who gets gross returns of 7%, but charges fees that leave Guy_A with 5% net returns (~1.87% management fee). Guy_B has his cousin Investor_Bad manage his scratch-off earnings who ends up matching the index with gross returns of 5%, but charges the same fee as Investor_Good leaving Guy_B with net returns of 3.04%.
Edit: I just wanted to add that this is how the how situation (not the NYC Pension, but the quoted section) sounds to me. Finance is not my area of expertise, so I could be misinterpreting something.
The problem is you can't just create a startup fund and go in there and take on funds from pension funds by undercutting the establishment. You need loads of expertise, relationships, and a proven track record. And if you have all those things then you are a part of the establishment and already making swell money so there's no point in rocking the boat.
Sad to see how hot the quant subject has become on here. Weakens nyc tech. This always happens when the bull market approaches peak.Suddenly every fund feels special because every fund is a winner.
"If above-average performance is to be their yard stick, the vast majority of investment managers must fail. Will a few succeed — due to either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance — just as would be the case if 1,000 ‘coin managers’ engaged in a coin-flipping contest. There would be some ‘winners’ over a five or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly ‘successful’ records — who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)”
At the time of WaPo's sale to Jeff Bezos, the pension fund had a $1b surplus.
This article describes the memo, and includes a link to a PDF (thru Scribd):
http://fortune.com/2013/08/15/the-1975-buffett-memo-that-sav...