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Speech by SEC Staff:
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This was prepared for presentation as an Address to the Pennsylvania Association of Public Employee Retirement Systems Forum in Harrisburg, Pennsylvania on April 12, 2007. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. |
It's a great pleasure to speak at the Pennsylvania Association of Public Employee Retirement Systems Forum. While I am currently serving in Washington, D.C. as Chief Economist of the Securities and Exchange Commission, I have been a Pennsylvanian of longstanding. I began my doctoral studies in economics at the University of Pennsylvania in Philadelphia in 1975 and have been a faculty member at Carnegie Mellon in Pittsburgh since 1979. I appreciate the opportunity to pull together my thinking about indexing and active and passive investing, which have strong implications for the investing of public employee retirement funds. For concreteness I'll largely focus my remarks upon the mutual fund landscape. My own expertise as an academic is closely related as a significant portion of my academic work has addressed topics in personal finance—asset allocation and taxes, mortgage financing, trading and arbitrage—issues that I have been thinking about over much of my career.
At the onset of my remarks, I first want to emphasize that the views and perspectives that I am expressing today are my own, and not those of the Commission or my colleagues on the SEC staff, and second I wish to thank the organizers for giving me the opportunity to speak in today's forum.
Initially, I'd like to emphasize the role of costs. This is a concept that is crucial to investment decisions in mutual funds. Costs can result in a significant diminution of the investor's value. To consider a set of simple examples suppose first that the manager's cost of investing the assets is exactly 1/100 of the total return. Arguably this is not grossly unrealistic; suppose hypothetically an asset had a 10% return and the costs of management is only .1%, as it is for some index funds. In this case 99% of the overall value is working for the investor and just 1% is the long-term present value of the costs. Now we consider a second example—suppose that the cost of managing is now exactly 1/10 of the total return. In some cases this is not unrealistic either—the average active equity mutual fund has a fee level in excess of 1%. In fact, according to the Investment Company Institute Handbook (2006) the average fee level paid on stock funds in 2005 was 1.13%, including an expense ratio of .91%. In this case only 90% of the value works for the investors and 10% is the long-term present value of the costs. Notice that in the first example the investor receives 99% of the benefit of his funds, rather than 90% in the second example. Hence, the effective return over time is 10% larger in the first example than in the second example since 99%/90% = 1.1. My illustration could actually substantially understate the point since many funds with excess costs also have substantial selling loads, which are not directly reflected in my illustration. Such selling loads are potentially re-incurred each time the fund is sold and another purchased.
I also should note that I am not arguing that it is in an investor's interest to simply select the lowest cost manager cost in all circumstances. For example, some types of assignments cost relatively more than others; for example, equity portfolios often are more expensive to manage than fixed-rate accounts and emerging market accounts are more costly than domestic accounts. I myself served on an institutional committee in which I supported allocations of funds for specific assignments whose fee levels somewhat exceeded that of other perspective managers, but frankly was willing to do so only when convinced that the managers would meet the burden created by their higher cost level. I'll have more to say about that burden later.
Focusing upon mutual fund costs, some of the cost differences across products reflect differences in management costs, but also reflect differences in trading costs within the product and differences in the costs of acquiring the product itself. It is sometimes suggested that certain products are "sold" rather than "bought"—this often is associated with the nature of the selling commissions on these products and the lack of direct interest by the investor in purchasing such products. "Whole life" life insurance is sometimes viewed in that manner as are mutual fund products with significant up-front loads. In my judgment it is important to ask how is your outside financial adviser or the person recommending a particular product being compensated. Does he or she have a financial interest in selling you one product over another or is the agent's incentives aligned to simply offer the best advice? While my instinct is that index funds without a selling commission and annual expenses of 10 basis points (or .1%) annually are often excellent products, advisers often do not recommend those types of products. I think it is important for investors, including retirement systems, to understand the consequences of how their advisers are compensated. Advisers often receive strong compensation for selling some mutual fund products, but not others. Obviously, this will potentially distort in a significant fashion the recommendations of these advisers. Indeed, that's the goal of a fund offering a selling fee to an adviser or broker. Analogously, homeowners who indicate a willingness to suitably compensate a broker who brings them a property's buyer are much more likely to have their homes shown by brokers. Now imagine that a homeowner announces that he is willing to pay a commission above the prevailing rate. Such homeowners could be especially well positioned to attract referrals from brokers. The financial interest of one's agent can dramatically depart from the interests of the underlying principal or investor. Agency conflicts are important in the process of distributing mutual fund products as they are in other aspects of the asset management business.1 This is not to suggest that product distribution is an inappropriate activity any more than is home brokerage. In home brokerage there is a significant economic matching problem that a broker often helps resolve. In my view the search problem is relatively more modest in identifying mutual funds—especially those with low expenses. The role of matching detailed characteristics is much less than for home ownership, but still at least some investors may need assistance.
As investors in mutual funds or other asset management vehicles we often do not focus directly upon the economics of the asset management business, but understanding the basic incentives of the fund are extremely useful for investors considering fund investments. The asset management business benefits from tremendous economies of scale reflecting the scalability of decision-making. The key to the success of mutual fund products in attracting funds is their past track record. These firms compete in many product spaces, including both those occupied by relatively more and less sophisticated investors. Within some niches the pricing is quite competitive, but in others the fund managers are much less aggressive as the asset managers earn substantial rents at the expense of less sophisticated investors purchasing actively managed funds. Of course, to the extent that these actively managed funds are generating superior performance on a discernible basis a priori, then competitive theory emphasizes that the resulting rents or excess profits should flow back to the owners of the scarce resource—superior management—rather than the owners of competing capital, a large number of whom would like to have truly superior performers. The mechanisms by which the superior managers can potentially capture such rents are by greater flow of funds from investors to manage in addition to potentially higher fees. Of course, the larger funds being managed by superior managers potentially reduces somewhat their returns because of a limited set of superior ideas and the greater price impact when one seeks to trade larger positions.2
There has been considerable study by finance professors of the structure of mutual fund returns. While mutual fund performance on a gross return basis is difficult to predict, expenses are highly persistent, i.e., funds that incurred high expenses last year are very likely to incur similar expenses this year. Consequently, net returns—i.e., gross returns less total expenses are predictable, because of the persistence of expenses. In looking at broad mutual fund returns, net returns are somewhat predictable as a result of the persistence of poor net returns of high expense products, though there is not much other evidence of the predictability of relative performance. Frankly, it is very difficult to predict superior performers. The variability in returns implies that very long return histories would be necessary to potentially detect superior performance and superior managerial skills.3 In this sense focus upon recent returns or very limited statistical information as illustrated by the required SEC disclosures can lead investors astray and do not offer accurate signals about the future. Gross returns and the basic value created by managers are hard to predict because of the extent of variability or noise in returns over time. Of course, in some related contexts—such as with respect to fund expenses—the fund disclosure can be quite informative because of the limited variability and considerable persistence.
To further illustrate the limitations in return disclosure, I also want to note that reported mutual fund track records may not be representative of the returns that an investor would actually earn. Currently published return histories reflect "survivorship bias," so the investor is only examining the track records of relatively successful funds that continue in operation. Some fund complexes have created the opportunity for a number of managers to run small pools to develop their expertise and identify the potentially superior performers. This incubation process obviously will bias track records in the spirit of survivorship.4 Analogously, when I was a member of an institutional selection committee the track records we saw in the presentation and selection process far exceeded the relevant benchmarks and also far exceeded our ultimate experiences with the managers that we selected. A good track record is essential to attracting substantial investments despite the important limitations of such records due to the issues that I have highlighted of (a) noise and statistical power and (b) survivorship.
One of the broad debates in portfolio management concerns the value of selecting active managers vs. passive managers for managing one's assets. I view the issue as relating to the degree to which active products being recommended produce statistically reliable evidence of superior returns net of fees. This is a very difficult standard for most active fund managers to be able to achieve. Nonetheless, many small plan sponsors focus upon actively managed products—I view that as a reflection of the distribution of these products and the extent to which active products are often "sold" rather than "purchased" and the broad agency problem in recommendations made for mutual fund products. In my view a key source of potential advantage of the passive funds are their dramatically lower expenses ratio and substantially lower turnover and attendant trading costs such as price impact, commissions and in the case of taxable accounts potential investor capital gains taxes. As a result of these advantages, I tend to advocate personally the use of low-cost passive and index investment products. While I believe that there are a small number of funds who might outperform passive vehicles, such funds are not easy to identify. Some critics of indexation have pointed to what I would term the "paradox" of indexation—i.e., if all investors follow index strategies, then wouldn't some investors do better since relative prices of assets wouldn't reflect fundamental information.5 That seems to be a sensible critique of a hypothetical economy in which all investors followed index strategies, but is relatively far removed from our actual economy.
Recently, a number of commentators have observed that the portfolio performance of "actively managed" funds with high expenses, except for the cost differences, has a fair amount in common with index products. Such active products are said to be "virtually indexed." In other words, much of the effective economic exposure of such seemingly actively managed products reflects the underlying movement in the relevant index. For example, this is almost inevitable if one is managing a portfolio of very large scale in large-cap equity. Backing out the fee for the truly active component of the return stream produces fee levels that are very high, by some calculations even larger than the fee levels for hedge funds.6 This provides another way to illustrate how costly is active management.
While almost all of my comments reflect a favorable attitude about low-cost index investing, there are a few features that I do not regard favorably. In particular, some index funds regard their objective as maximizing the R-square between the fund and the index as potential investors use that as a metric for the basis risk and accuracy of the index fund—but this objective, which helps deal with agency problems, can also potentially contribute to a fund's execution costs. While broad-based indices whose composition is relatively steady over time are often attractive investible assets, at least some indices can be inefficient because there is a lot of turnover within the index.7 For example, in some indices, such as the Russell 2000, assets whose value increased considerably no longer meet the criteria for inclusion in the index.
In preparing for this presentation I engaged in introspection about how finance professors invest their own funds or advise others to invest. What's striking to me from that is the emphasis on low-cost passive investing such as low-cost indexation, though in at a least a few instances also engaging in strategies that leverage a faculty member's specific skills.8 This emphasis on low-cost investing is striking compared to the distribution of costs in the marketplace. For uninformed investors low-cost passive strategies are very sensible given the competition within the marketplace and efficiency of the capital market.
In most of my remarks this morning I took the type of investing as given and focused upon the potential benefits and costs of passive strategies. Of course, you are involved in investing for retirement plans that have a specific structure to their liabilities. To the extent that your plan's liabilities are fixed in nominal terms, nominal fixed-income assets would be particularly appropriate investments. In particular, the plan liabilities are often contractual so that equity returns would not cover the liabilities in low return states of the world. In other word, while equity is sometimes selected because it has higher expected returns there can be a risk issue with respect to the fit to the liabilities. On the other hand, equity investment may be relevant for hedging plan liabilities to the extent that benefits are linked to the future success of the economy and wage growth.9
In my remarks I have highlighted the incentives of financial advisers and how that can influence the advice they provide with respect to selecting mutual funds. The difficulty in detecting statistically superior out-performance due to the cross-sectional variability in returns has been emphasized along with the importance and persistence of fund expenses for mutual fund selection. My overall judgment is that low-cost indexation and passive investing is an excellent choice for most investors as relatively large rents may be earned from unsophisticated customers purchasing active mutual funds.
I welcome your questions.
Berk, J. and R. Green, 2004, "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy 112, 1269-1295.
Biais, B., P. Bossaerts and C. Spatt, 2006, "Equilibrium Asset Pricing and Portfolio Choice Under Asymmetric Information," working paper, Toulouse University.
Chen, H., G. Noronha and V. Singal, 2006, "Index Changes and Losses to Investors in S&P 500 and Russell 2000 Index Funds," Financial Analysts Journal, July/August, 31-47.
Evans, R., 2006, "Does Alpha Really Matter? Evidence from Mutual Fund Incubation, Termination and Manager Change," working paper, Boston College.
Grossman, S. and J. Stiglitz, 1980, "On the Impossibility of Informationally Efficient Markets," American Economic Review 70, 393-408.
Investment Company Institute Handbook 2006, Washington, D.C.
Lucas, D. and S. Zeldes, 2006, "Valuing and Hedging Defined Benefit Pension Obligations: The Role of Stocks Revisited," working paper.
Miller, R., 2007, "Measuring the True Cost of Active Management by Mutual Funds," Journal of Investment Management 5, 29-49.
Office of Economic Analysis, Securities and Exchange Commission, 2006, "Power Study as Related to Independent Mutual Fund Chairs."
Spatt, C., May 2005, "Conflicts of Interest in Asset Management," Keynote Address at the "Hedge Fund Regulation and Compliance Conference." http://www.sec.gov/news/speech/spch051205css.htm
Van Nieuwerburgh, S. and L. Veldkamp, 2005, "Information Acquisition and Portfolio Under-Diversification," Stern School of Business New York University working paper.
http://www.sec.gov/news/speech/2007/spch041207css.htm
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