But, Mousie, thou art no thy-lane,
In proving foresight may be vain;
The best-laid schemes o’ mice an’ men
Gang aft agley,
An’ lea’e us nought but grief an’ pain,
For promis’d joy!To a Mouse, on Turning Her Up in Her Nest With the Plough, by Robert Burns (1785)
It’ll be Burns Night this Friday, which in my house merits a dram or two more than the usual end-of-week celebration. It will involve no more haggis than the usual, which is to say, none. Most of all it will mean a great deal of poetry – Burns poetry – which is written in a way that all but forces you to try your hand at a Scottish accent. One of the great joys of marrying a theatre scholar is her shocking facility with such dialects, the result of studying under one of the best voice coaches in the world. My own attempts are less impressive.
All the same, bad accent or not, I’ll drink a toast to Burns. But a Burns Supper isn’t just whisky, haggis and poetry. It’s a meal of joy, melancholy and respectful remembrance of times and people now departed. In this house, this year’s will also be a Bogle Supper. On Friday, we will drink a toast to Jack, a genuine treasure who did more to make markets work for the individual investor than any person. Ever. He wasn’t just someone who was in the first place at the right time to capitalize on an inevitable idea. He made something happen that wouldn’t have happened otherwise, perhaps for many years.
It’s an achievement that none of us will equal.
So remarkable was Bogle’s role in the advent of low-cost investing that commentators and media have run out of things to say. And when we run out of things to say, we usually start saying some rather silly things, too. One of these silly things I’ve read several times this week is that the ‘truly great’ achievement wasn’t massively reducing the cost of investing (yes, it was), but the operation of Vanguard as a client-owned enterprise (no, it wasn’t).
It isn’t that client ownership of the firm isn’t a really cool idea. It is. It’s an admirable idea. It also works for Vanguard and the culture that they sought to build. It isn’t perfect – Vanguard employees aren’t angels, and they want to make more money and have more prestigious jobs, too. But it’s pretty damn close, especially for a passive investment firm that isn’t selling that it’s got a better strategy than the next firm over. To the extent you believe that there are necessary investment strategies and forms of advice where results will vary across practitioners, however, most of us would say that an approach that limits the financial rewards of success probably doesn’t create all the right incentives. That’s part of the reason why lower fees have changed the world, and client ownership of investment firms hasn’t.
Still, none of this has stopped us from inventing countless ways to solve the alignment problem between asset owners and asset managers. Not one of those methods truly achieves it – not fully, anyway. Not even Vanguard’s. So why do all these best-laid schemes gang aft agley?
Because we cannot scheme away the principal-agent problem.
As allocators, we first learn to hate fixed management fees – not necessarily from the justifiable hatred of paying excessive amounts for strategies with no hope of producing the alpha that would justify such a fee – but under the belief that it creates the wrong incentive. Management fees exist to keep the lights on, we reason, and if a fund company or financial adviser takes in more than this, their greatest incentive may become to avoid losing the business. There’s no denying this. It’s true. Then the inevitable bout of volatility hits. Then come the headcount reductions. Then the adversely selected departures of a couple of their brightest analysts. Then, as allocators, we start wondering about the stability of the business. We really have so many options, and it’s really not worth taking a risk…
Then we learn to hate incentive fees. The fund had a banner year the year we invested, you see, and we (happily) paid through the teeth for it. Then two brutal years followed, and washed away all the alpha. Somehow we didn’t get our money back for all those incentive fees we paid in the first year. Are we going to stay to let them earn it back and to lower our effective fee? Or do we call it a sunk cost and move on?
Then we focus on related alignment questions. To be most aligned with us, shouldn’t the portfolio manager invest a significant portion of his or her own wealth in the same product? Some skin in the game? And then, in the depths of a draw-down for that product, when we’re comforted by our own diversification, the portfolio manager we applauded for the 80% of their wealth they invested in their long/short biotech fund is acting very strangely. Panicked. I wonder if that’s why they’re doing so poorly. Maybe they’re having a mental breakdown. Might be time to redeem.
Then we realize, come to think of it, that if we were going to be truly aligned, the alignment can’t come through the fees or our investment in the product. We should own part of the firm. After all, it’s our commitment that keeps them in business, and if we own a portion of it then we can be sure that we are maximizing what we get out of every dollar we invest. The fund manager won’t be able to focus on growing the business over investment quality without us participating in that upside. Then, over time we discover the extent to which many of the conflicts with our interests occur not at the company level, but at the employee level, where all of the self-interested behaviors and conflicts with us as principals continue unabated regardless of our ownership. When that sharing of ownership is less voluntary than it was with, say, Vanguard, we allocators soon recognize how much our interest is also resented over time by those who now reason that they could have achieved the same without us.
My career has been split into equal thirds: a third spent buying stakes in fund managers, a third spent allocating an institution’s capital, and a third spent leading a fund management business. What I have learned from being on each side of the table is this: the reason most asset owners fail to achieve alignment is that they focus entirely upon rigidly engineering the incentives of their agents, and because they focus not at all upon constraining their own behaviors in ways that will exert much larger influence on the incentives of the agent. Said another way, we have adopted such a short-sighted and perverse view of what it means to be a fiduciary that we are hell-bent on squeezing every bit of apparent advantage we can out of our prestige, asset size and credibility, ultimately to our own harm and that of our charges.
What do I mean? I mean that our heavily negotiated fee structure with an active manager will have a paltry influence on our adviser’s or manager’s behavior relative to their fear of being terminated or kicked off our approved list after a bad quarter or year. I mean that the incentive effects of an ingenious incentive fee structure that calculates alpha over some rolling set of regression-calculated betas will be nothing compared to the manager’s knowledge that we’ll put them in the penalty box if they terminate those two underperforming analysts and exceed our headcount change threshold during our annual diligence meeting. The incentive to waste time on clever visualizations, the incentive to memorize useless facts about companies with no import on the investment thesis to prepare for ‘knowledgeable’ stock chats with clients – these are the kind of things that we justify as demands because we deserve everything that’s coming to us as fiduciaries or principals, even if getting what we demanded ultimately harms us.
A long-time friend and business relationship asked me and Ben the other day, “What is the single most important thing you look for in a portfolio manager or adviser?” The answer is alignment! But I don’t mean alignment between them and us, as agent and principal. That is almost always a kind of fool’s gold, the kind of thing that you can never find by looking for it – which lea’e us nought but grief an’ pain for promis’d joy. No, I mean alignment between the temperament and circumstances of the portfolio manager or adviser on the one hand, and the investment strategy employed and the commercial terms for that relationship on the other.
It’s a nuanced difference, but an important one. If we want an aligned relationship with a passive manager that isn’t selling specialized expertise, Jack Bogle and Vanguard went most of the way toward showing us what that should look like. But what if we want an aligned relationship with our financial adviser or active fund manager? If our oversight structure permits it, instead of beginning with the cartoon version of ‘fiduciary’ that requires us to squeeze every basis point out of them, we can instead ask them these four questions:
- What worries you about your existing client relationships?
- What do you think your clients are too focused on? Give me some examples.
- In a perfect world, what would you change about your existing relationships, like how you meet, what you talk about, and how the investments are structured?
- How could we structure our relationship so that these issues occupy less of your mind?
In the end, as allocators we don’t have to do any of those things. There may be a poor alignment between their strategy, their fears and a commercial arrangement that will work for us. That’s OK. We really can move on. But if we really mean alignment when we talk about the term, and not just squeezing every possible commercial term we can out of the negotiation process, we will do much better by understanding not only explicit financial incentives, but the implicit incentives embedded in the nature of our relationships with our agents.
If you want to read some thoughtful exploration of what this can look like in practice, I highly recommend our friend David Salem’s contribution from a few weeks back: Everything Has Its Price.