Tuesday, November 13, 2012

Going Over the Falls: Part 4

Going Over the Falls: Part 4

While most everyone connected with the financial crisis has been roundly criticized, money managers have escaped scrutiny.  As banks failed and Washington bailed out institutions, money managers scurried into the shadows.  In those instances, where a client or congressman raised questions, money managers denied any responsibility.  I am sure you received one or more quarterly letters from a money manager in 2008 or 2009 that took one or more of the following approaches:

‘The credit bubble was an unanticipated event that no one could see coming.’

‘The credit crisis involved business practices, including fraud, that were not amenable to analysis through publicly available information.’

‘The sharp decline in your portfolio was the result of lax regulatory policies and poor Congressional oversight.’

They couldn’t tell you that they relied on the rating agencies.  They couldn’t admit that they didn’t conduct thorough research and depended instead on Wall Street research.  However, all too many money managers used Moody’s or Standard & Poor’s ratings instead of doing their own analysis.   They based their investment decisions on research reports from the very investment banks that endangered the financial system.

Marketing Reorganization (1995)

How did they get away with it?  Unfortunately, we have ourselves to blame.  We want to believe that money managers are good stewards of our savings.  When they tell us they can discern the future, we believe them.  When they claim they can beat the markets, we trust them.  We fall for their marketing pitch each and every time.  For example, when a stroke of good luck produces a wee bit of good performance, which money managers heavily market, we tend to throw huge amounts of money at them.  And when performance lags or markets swoon, we withdraw our money.  Our instincts are completely wrong. 

We should be highly skeptical of money managers when times are good, and open to invest (albeit still skeptical) when times are tough. As the credit bubble inflated, investors fed the frenzy by wiring money into their investment accounts.   Money managers, in turn, quickly put the money to work in financial stocks and all sorts of high yielding mortgage products.  When the bubble burst, we lost confidence and asked for our money back.  At the very point that there was an opportunity to buy securities at attractive prices, we were withdrawing capital from our accounts and, therefore, the markets.  Pension plans and endowment professionals probably think I am writing about retail investors.  No, pension plans and endowments made the same mistake.  In other words, we feed the bad practices of money manager and tolerate their lax practices. The short-term mentality of the money management industry is reinforced by the behavior of investors.

Some industry critics will insist that money managers provide more disclosure (the old adage that “sunshine is the best disinfectant”).   The mutual fund prospectus and annual reports are already hundreds of pages, and the files of institutional investors are already crammed full of information.  At least in money management, more disclosure isn’t going to change anything.   In my view, investors have to hold managers accountable for their investment decisions, their fees, and their results.  If investors continue to be passive with their active money managers, you can expect money managers to remain passive when it comes to research and analysis.  They’re happy to collect their fees and avoid responsibility.  If investors are unwilling to step up, they ought to put their money in index funds and avoid taking on the responsibility.

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