Competing Against Free
Unleashing Managers to Deliver their Best
03/17/21 | Marc Reinganum, PhD
It is the blessing and curse of our professional lifetimes that knowledge and technology have driven the price of diversification to zero. In 2021, the ability to create a well-diversified portfolio, designed to sidestep unnecessary risk, is essentially free. In 1964, Sharpe proved, under simplifying assumptions, the well-diversified portfolio of risky assets that every investor should hold was the same portfolio—the market portfolio (i.e., the cap-weighted collection of all risky securities). This cap-weighted view of optimal investing has dominated the industry for decades, inflicting interminable pain on managers seeking compensation for the construction of actively managed, diversified portfolios. Yet, the very nature of the market portfolio at zero cost provides new and exciting opportunities for active managers to concentrate their skills on delivering exceptional returns and earning reasonable fees.
To fully understand this opportunity, we would do well to examine what precisely is being offered without a management fee to investors. As of this date, “free” funds consist of a large basket of securities, using float-adjusted market capitalization weights. For example, firms like Fidelity currently offer an array of funds across the large cap, mid cap, small cap and international spectrums without any management fees. Zero. De nada. Even lower than Vanguard. These large baskets, offered and implemented by asset managers to investors, reflect broad categories of stocks such as large cap, mid and small cap, and international. Interestingly, the benchmark indices for these “free” funds are developed by the fund manager and not a traditional index provider such as Standard & Poor’s or MSCI or FTSE-Russell. By using a self-created benchmark index, the fund manager avoids paying even a licensing fee for the use of a “brand name” index.
Rather, the fund manager relies on a widely accepted concept, freely available in the public domain, to create their own index. For example, back in 1981, Banz and Reinganum published in an academic journal some of the differences between large cap and small cap stock investing. Thus, for at least 40 years, the ideas of large cap stocks and small cap stocks as investment constructs has been widely known and accepted. In part, “free” can be created as long as investors are willing to embrace these broad concepts as opposed to specific indices such as the S&P 500 or the Russell 2000. Indeed, one can only wonder whether the top index providers will at some point be compelled, by market forces, to offer their flagship index products at no cost as well.
Funds that make no pretense about being free and charge a management fee were often developed in an earlier era with different expectations and under different economic and technological conditions. While mutual funds are more than 100 years old, their popularization soared in the 1980s and 1990s. Many of these funds professed to offer investors a chance to earn outsized returns within a well-diversified portfolio; some delivered on this promise. In an era where wide diversification for individual investors was an expensive proposition, this combination of high potential returns in a risk-controlled setting was appealing; investors seemed willing to pay for both of these features: return and risk control. Many asset managers spent time and resources on trying to develop specialized insights into future returns. At the same time, they had to mix their best insights into an actual portfolio, a process known as portfolio construction, which often is intended to control risk.
In this era, the Sharpe’s Capital Asset Pricing Model was always lurking with its implication that the market portfolio is the optimal portfolio of risk assets for all investors. As a result, the evaluation of asset managers tended to be based on the risk-adjusted performance of their portfolio relative to the market portfolio.
Yet, as funds became more popular, two countervailing forces were at work. First, as the AUM (asset under management) increased, the investment performance of funds tended to diminish. Secondly, many well-diversified funds struggled to outperform their stated benchmark index. Thus, the promise of outsized returns within a well-diversified portfolio was not widely delivered. This failure could simply come from a lack of skill to identify exceptional securities; alternatively, the failure may, in part, be attributed to portfolio construction that could have impaired the asset manager’s skill to take full advantage of exceptional securities. In any case, this disillusionment led to a shift of flows and assets from “actively” managed funds to “passively” managed funds and ETFs.
So, how can most of today’s asset managers compete against free?
In theory, the answer is simple: Create a niche that utilizes one’s truly unique expertise and that cannot be easily and massively scaled and hence offered for free. For active managers, that niche is not likely to be found in competing against massively scaled “free” alternatives with a well-diversified portfolio.
Ironically, the shift from “actively” well-diversified funds into “passively” well-diversified funds may in fact be a boon to active managers who have the foresight to recognize this as a blessing in disguise. As the competition among the behemoth “passive” managers has driven the price of well-diversified funds essentially to zero, active managers have been unshackled from the obligation and expectation of providing risk control and diversification. Rather they have been unleashed and allowed to implement their best ideas in their purest form, knowing that their clients can acquire however much diversification and risk control they want for essentially free. Furthermore, the best ideas implemented in their purest form will be a scarce resource, implying that the pricing of successful active strategies will not be zero.
With investors, whether institutional or individual, now able to buy diversification for virtually nothing, active managers are presented with new opportunities to innovate. Investment processes need to be carefully analyzed to disentangle return components from risk components. Expertise needs to be fully understood and differentiated. Target audiences and their distinct needs must be carefully analyzed and characterized. Branding, messaging and distribution need to be thoughtfully recalibrated to deliver a candid and compelling case for the new strategy to the optimal audience.
The new model for active managers is clearly disruptive but for those who can navigate this crossroads, the path forward can be invigorating and profitable. In our view, active managers can become the providers of specialized insights and actions. The new breed of active managers may offer insights into exceptional securities, focusing on potential return no longer shackled by risk considerations. They may offer bundles of securities that focus on specific environmental concerns, such as electronic vehicles or clean power generation. Perhaps some managers will want to offer activist portfolios where they take a more direct involvement in the management of the companies in which they invest. Perhaps some managers will want to dynamically time exposures to small and large cap stocks or sectors. There are myriads of potential opportunities to meet the needs of investors without providing a diversified portfolio at the same time.
Driven in substantial part by remarkable technological advances, “free” has disrupted the financial services ecosystem. Perhaps not since 1975, with the end of fixed-rate commissions, has the financial services ecosystem been so upended. As back then, there will be clear winners, i.e., Schwab and Vanguard. But, we are confident that other firms, those willing to move quickly in shaping the right combinations of product, structure and branding will compete very effectively against free in this exciting era.
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