By Charles Skorina
“…in every investment transaction you’re part of, it’s likely that someone’s making a mistake. The key to success is to not have it be you.” – Howard Marks, Chairman, Oaktree
There is no business like the money management business.
Private wealth in North America reached $38 trillion dollars in 2011 (note 1, 2) according to a recent Boston Consulting Group study. That includes 2,928 U.S. families who each have investable assets over $100 million. (The corresponding number for global private wealth is said to be $123 trillion.) [Private wealth excludes family businesses, homes, etc; it includes only investable wealth]
In addition to the private wealth there is institutional wealth of about $16 trillion in public and private U.S pensions, including IRAs (notes 3 and 4).
Then add more than $600 billion in U.S. foundation assets (note 5) and $408 billion in U.S. Endowment assets (note 6). There’s another $500 billion in miscellaneous tax-exempt institutions, medical systems and union plans (note 7). Finally, a reputable source says there is $2.56 trillion in the hands of U.S. public charities (note 8).
The grand total is $58 trillion. All that money, public and private, has to be managed in some fashion by someone, and that someone expects to be paid for their efforts.
$ 38,000,000,000,000 Private wealth, North America
$ 16,080,000,000,000 Public and private U.S pensions
$ 600,000,000,000 U.S. foundation assets
$ 408,000,000,000 U.S. endowment assets
$ 500,000,000,000 Misc U.S. tax-exempt institutions, health systems, unions
$ 2,560,000,000,000 U.S. public charities
$ 58,148,000,000,000 Grand total U.S. investable wealth
These assets generate a lot of fees. If we assume that the costs of managing the money is at least eighty basis points (a low-ball estimate), then the investment management business in the U.S. generates at a minimum an eye-popping $465 billion dollars in yearly fees: close to half a trillion dollars!
Our arithmetic says at least $161 billion dollars of those fees annually comes out of the pockets of institutional investors.
And, as Anthony Effinger and Sree Vidya Bhaktavatsalam recently noted in a Bloomberg News piece:
“Even during rough patches like the current one, the [asset management] industry is attractive because profit margins are so high. Baltimore-based T. Rowe Price (TROW) Group Inc., for example, had net income of $773 million on revenue of $2.75 billion in 2011, giving it a profit margin of 28 percent.”
Is 28 percent a healthy profit margin?
Look at it this way: The U.S. Senate periodically (when retail fuel prices spike) marches the executives of Big Oil into a conference room and has the hide off them for their “windfall profits.” According to Yahoo! Finance, those big five integrated oil producers are currently earning a net profit of 7.9 percent in the latest quarter. That’s 7.9 percent for Big Oil vs. 28 percent for T. Rowe Price.
But what goes in one pocket necessarily comes out of another, and some large institutional investors have had enough. To trim external fees, Canadian plans have been in the vanguard of a nascent do-it-yourself investing movement by adding private equity, hedge fund, and real estate specialists to their teams.
In her endowment report for 2010, Harvard Management Company’s president Jane Mendillo prominently mentioned that she was looking at what it costs to manage investments in her shop. She hired an un-named consultant and paid them to figure it out. The consultant reported that, for the portion of the endowment run out of the investment office (about half), it was costing Harvard about 30 basis points of AUM on average over recent years.
Granted, the internal people run mostly passive public strategies and they still invest about half the portfolio externally with a lot of pricey alternative managers. But she argues they are still money ahead. According to Ms. Mendillo, that internal/external cost differential saved Harvard over a billion dollars in management fees over a decade.
See page 4 of the annual report.
On the other coast, Joe Dear, the CIO of CalPERS has also become outspoken on this subject. Mr. Dear is vowing to cut their investment costs. One of his top people worked up a big slide-show to explain it to their board.
In March, CalPERS Chief Operating Investment Officer Janine Guillot told the board that “internal management results in lower total costs, but more staff, and therefore higher internal costs.” And she concluded that it was essential to focus on that total cost, not only internal cost.
Her recommendations include:
* Focus on reducing external management fees, taking full advantage of CalPERS size and brand.
* Reduce use of fund-of-funds and other higher-cost commingled vehicles
* Reinvest external fee savings in internal capabilities. Develop a long-term resource strategy to enable management of portfolio at acceptable levels of risk
There are no immediate plans to bring private assets in-house at CalPERS, Canadian-style, although Mr. Dear and his new (Canadian) private-equity chief Real Desrochers seem to be thinking about it long term. Meanwhile, they’re still trimming the cost of running the public assets as hard as they can. In April, another $500 million of their total $3.6 billion in international fixed income was taken away from external managers and handed to the staff in Sacramento.
Given that internal passive management has generally outperformed external active management for their public market assets in recent years, it doesn’t make any sense, as one board member said, for CalPERS to continue paying fees for underperformance.
Another, unlikely, low-cost leader is the $43-billion dollar United Nations pension fund.
According to our friend Amanda White at Top 1000 Funds, they manage their portfolio with a staff of 58 professionals at a cost of only 15.3 basis points. Over 90 percent of the assets are managed in house, the exceptions being a few, mostly UN-related, private equity and real estate funds.
The fund is run in New York but, since the UN is legally extra-territorial (off-shore from everywhere, so to speak) their pension is often overlooked. It’s run by director of investments Suzanne Bishopric (previously the UN’s overall CFO). She’s a Harvard MBA who previously worked as an FX trader and as Director of Financial markets for McDonald’s. Ms. Bishopric’s salary, I think (according to the posted UN salary scales), is a relatively modest $284,777 ($172,071 base plus a $112,706 cost-of living supplement). However, that extra-territoriality thing means that it’s all tax-free. No New York City income tax; no New York State income tax; no U.S. income tax.
And, since UN expenditures are so well-insulated from actual electorates, Ms. Bishopric can hire and pay a big staff without anybody much caring.
For those endowments, foundations, and pension funds managing more than $1 billion, there is a strong case to be made for running more of the investment strategies in-house. Some interesting recent studies have shown that it’s possible to cut investment costs significantly thereby, and still generate returns equal to or greater than the outside managers they replace. The impediments to doing this are mostly institutional. The salaries of in-house professionals are usually highly visible; the fees paid to outside managers are hard to see.
One obvious, but often overlooked factor is that the external managers are usually tax-paying entities, and the fees they charge must include those taxes. Non-profit institutions pay their in-house managers out of un-taxed income. Even if their skills and performance are completely equivalent, the tax-paying external manager has to charge more to manage a given chunk of assets.
A report issued this spring by CEM Benchmarking in Toronto, Canada concluded that “funds with more internal management performed better after costs”.
CEM found that “for every 10% increase in internal management, there was an increase of 3.6 basis points in net value added; this increase was driven largely by the lower costs attributed to internal management.”
See Rotman International Journal of Pension Management – Volume 5 Issue 1.
Unfortunately, the biggest impediment to more efficient and higher-performing institutional funds is the public perception that paying competitive salaries to hire top talent is just plain unacceptable and unjust.
Behavioral economists try to track down and isolate the specific glitches in the human psyche which cause them to do dumb things with money. One of them is something called the “fairness trap.”
As James Surowiecki wrote in the New Yorker last month:
“The basic problem is that we care so much about fairness that we are often willing to sacrifice economic well-being to enforce it…”
Mr. Surowiecki forgot to put scare-quotes around the word “fairness” there, but I think he’s essentially correct.
To a certain extent, some Canadian and European plans have managed to overcome this bias against paying industry-competitive salaries and bonuses. The CEM study went on to compare compensation levels by region for full time investment employees and found that the average salaries were highest at Canadian funds.
For instance, in Canada the average salary for public pension investment department professionals was $536,000; next were European/British funds at $246,000, followed by American funds at $148,000 and Australian/New Zealand funds at $139,000. [all figures in U.S. dollars]
Fees are looming in importance in investor’s minds for a very good reason.
Industry pundits are forecasting more near-zero interest rates and poor economic growth. For instance, Mr. Bernanke testified in front of the Senate this week, noting that the Fed had just lowered its GDP growth forecast for calendar 2012 to a range of 1.9 – 2.4 percent.
JPMorgan Chase just weighed in with even darker tidings, looking for only 1.7 percent growth for 2012 as a whole, and that means things are getting worse quarter by quarter. They just lowered their Q2 forecast from 1.7 percent to 1.4 percent. For Q3 they’re penciling in an awful 1.5 percent. And, of course, Mr. Bernanke will do what he can to hammer interest rates even lower.
It’s no wonder that investment boards and institutional fund managers are looking for a better deal for their stakeholders.
Running an investment portfolio may be more prestigious than running a carwash, but it’s still a business, and the same principles apply. There are only two ways to improve the bottom line: boost revenue or cut costs. Right now, the latter may be more fixable than the former.
1. BCG does not provide a breakdown for U.S., Canada, and Mexico, so my numbers are a little high if they are taken as an estimate for U.S. only.
2. Includes cash and deposits, money market funds, listed securities held directly or indirectly through managed investments, and other onshore and offshore assets, but exclude the investor’s own businesses, residences, and luxury goods.]
3. Source: Towers Watson
4. Source: EBRI.org IRAs = $1.414 trillion,
5. Source: Foundation Center
6. Source: NACUBO
7. Source: my own count
8. Source: National Center for Charitable Statistics. I am assuming that NCCS is not counting endowments even though they are technically “public charities” per the IRS. Even if they are, it doesn’t affect my grand total much in percentage terms.