February 2017 IssueLong scroll reading

Survival of the Flushest?

By Edward A. Studzinski

“Cynic, n. A blackguard whose faulty vision sees things as they are, not as they ought to be.”

Ambrose Bierce

A question I have been pondering with increasing frequency is, of the mutual funds around today, how many of them will still be around in ten years? This grew out of a year-end luncheon with a friend of mine who heads up the strategic planning effort for a large financial services firm out of Chicago that has gone global and now has its fingers in many pies. Our discussion started around the problem with the mutual fund model – an investment vehicle of infinite duration that must provide daily liquidity. Add to that the fact that the definition of long-term investor has now morphed into about three months, if you are lucky, as a portfolio manager. Then, if you are part of one of the large for-profit fund complexes, there is the fact that the parent is allocating capital and skimming forty to fifty basis points off the top. So the senior managers at the subsidiary of the parent (the individual fund companies) start under-investing in the business in terms of hiring and retention compensation so that they can pad their own paychecks (another Maserati bonus). The end result was a convincing argument that many well-known firms in Chicago will probably not survive the next ten years.

All things being equal (which they usually are not), it might have been easy to find flaws in the thesis. But based on many conversations with individuals running very scared in this world, it seems to me that it will have legs. And, as we have commented in this publication over the last few years, we are not living in a static world. Fund flows out of high-priced actively managed funds to passive index funds or alternatively, exchange traded funds, have stood the mutual fund investment management business on its head. Funds that have started in the last five years and made their way through the $60M break-even level in terms of assets under management (at least with a 1% fee), now find themselves hovering on the brink of financial extinction, especially if their performance relative to the indices or germane benchmarks has been middling to poor. And we see the pressures mounting on other firms which had been successful. With recent performance issues, GMO in Boston laid off staff in 2016 (and allegedly has been trying to sell itself for some time now, with no takers). We also have the example of the Harvard Investment Management Company, which is charged with running the Harvard University Endowment. Last week, it was announced that 50% of the staff will be let go. With the exception of the certain specialty areas, such as real estate, many of the functions will be outsourced. We have Pioneer in Boston being sold from an Italian financial services firm to a French one, much to the surprise of many. These examples are but a few indications of the sea change occurring as the perfect storm of fee pressures, poor relative performance, and the approaching implementation of the new Department of Labor fiduciary standards as they apply to ERISA accounts come clashing together.

Now I recognize the black humor in the fact that I and my strategic planning friend, having both done well from our time in the mutual fund business are skeptics of its longevity. And I also recognize that David and Charles both are still committed to finding a pony somewhere in the room full of manure. But, much of investment management these days is a commodity business. This is especially true in the area of large capitalization active managers. And while you may think you are getting two heads looking at a portfolio rather one, or two for the price of one, in reality you are getting two for the price of two. Except one co-manager is usually playing the role of Leporello to the lead co-manager’s Don Giovanni.

Which brings me to the question of what is the actionable advice here? First, determine what your time horizon and investment goals are, and then set your asset allocation in such a fashion as to give you a comfortable shot at meeting those goals. The long-term Ibbotson return numbers for various asset classes should be your reference in making those allocation decisions. Then, for large cap and mid cap stocks, find the lowest cost passive funds that you are comfortable with, and determine what amount of assets you want to allocate to them. Focus on firms that have the financial wherewithal to survive, such as Vanguard, T. Rowe Price, and Fidelity. For small cap and microcap securities, look for active managers with at least five year track records, and again allocate assets to them in terms of your overall asset allocation model. Here, a somewhat counter-intuitive approach is appropriate, as you don’t want managers who have too much in the way of assets that they end up style-drifting out of the category. Follow the same advice for large cap and mid cap international securities. For small cap international securities and emerging markets, look for active managers who are not engaged in asset gathering for large firms and have long-term track records

Alternatively, what my friend is doing rather than investing in mutual funds, is to put together a concentrated portfolio (twelve to fifteen) of equities that are long-term compounders of wealth and where you get some degree of investment exposure through their internal portfolios (both Berkshire Hathaway and Markel Corporation would be examples of same). But, and this is crucial, decide upon an approach, implement it, and then leave it alone. An annual review should suffice (not necessarily tied to year-end, so as to avoid the artificiality that often creeps into calendar year-end market valuations).


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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. A Chartered Financial Analyst, Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.