In his paper, “The Nature of the Firm”, Ronald Coase proposed that firms exist because there are transaction costs to organising economic activity through the price mechanism such that when they exceed the benefits of market transactions, it becomes cheaper to organise certain economic activities within a firm, where they are coordinated administratively, rather than in the market. One can apply this framework to understand why active asset managers have had their pricing power, in the form of fees, eroded over time.
The Steady Erosion of Pricing Power
That same logic explains why passive management funds exist: asset managers face enormous transaction costs in attempting to create a diversified portfolio of stocks that can outperform the broad market, from research costs to trading costs and commissions and the tax implications of trading. Passive management funds exist because their broad diversification, and lower trading frequency and the scale they can achieve, allows them to capture the broad market return, while eschewing the transaction costs of active management. Active managers are at a disadvantage because they have higher transaction costs and are less likely to achieve market returns for clients even before they deduct for fees.
The paradox of investing is that it is essential for the preservation and growth of wealth, and yet, most investments fail to preserve wealth or beat their benchmark. Economic losses, rather than profits, define investing, not merely because they are more probable, but also because losses impact portfolios more profoundly than gains. Indeed, such is the nature of risk that, in the long run, even in a fair game1, wealth is destroyed. Daniel Bernoulli called this, “nature’s admonishment to avoid the dice”. I noted in a discussion on future S&P 500 (market-weighted) returns, that,
In his earthquake of a paper, “Do Stocks Outperform Treasury Bills?”, Hendrik Bessembinder found that, between 1926 and 2017, four in seven U.S. stocks had lower compound returns than one-month Treasuries. In terms of lifetime dollar wealth creation, he found that just four percent of public companies generated the net gain for the entire U.S. stock market, with the rest earning returns that merely matched Treasury bills. In “Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks”, Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, found that this positive skewness of stock returns was a global phenomenon. Between 1990 and 2020, 55.2 percent of U.S. stocks and 57.4 percent of non-U.S. stocks, had lower compound returns than one-month U.S. Treasury bills. In terms of lifetime dollar wealth creation, they found that just 2.4 percent of the 64,000 firms they studied generated all the net gain of the global stock market. Ex-U.S., just 1.41 percent of firms generated $30.7 trillion in net wealth creation. The implications seem clear: an active manager is more likely to create a portfolio that underperforms one-month Treasuries, than outperforms it.
In a study of the cost of using active managers, “The Deadweight Loss of Active Management”, Moshe Levy studied the Sharpe ratios of U.S. active equity funds against that of the S&P 500 -as a proxy for the market-, using the CRSP Survivorship-Bias-Free Mutual Fund Database for the December 1991 to March 2021 period. The results are shocking: 92.1% of funds underperformed the S&P 500 and investors incurred total annual losses of $235 billion, due to $186 billion for inefficient portfolio allocation, and $49 billion in fees. When firms outperform the market, that outperformance is typically modest, whereas when they underperform the market, the results are often cataclysmic. So, while the S&P 500 had a Sharpe ratio of 0.288, and the average Sharpe ratio of active funds was 0.192, the best Sharpe ratio among active funds was 0.392, an outperformance of only 0.104, while the lowest Sharpe ratio among active funds was -0.475, an underperformance of -0.763.
Yet, people must invest, and for most of the modern era, they have relied on active managers to do so. In his paper, “Exposition of a New Theory on the Measurement of Risk”, Bernoulli gave the world’s first mathematical argument for the benefits of diversification, saying that “it is advisable to divide goods which are exposed to some danger into several portions rather than to risk them all together”, so that the geometric return of the portfolio approaches its arithmetic return. For investing, nothing is a greater testimony to the power of diversification than passive funds. A mass of stocks, most of which fail to beat the humble Treasury bill, are together able to generate positive returns in excess of those of Treasury bills, and such that their geometric mean approaches its arithmetic mean. As passive funds are more diverse than active funds, with, for example, the S&P 500 holding 500 stocks, or the Russell 3000 holding 3000, their chances of capturing the excess returns available on the market are far higher than for more concentrated portfolios held by active funds.
Since the advent of passive investing instruments, active managers have been battling two powerful forces: firstly, that they face greater information costs in attempting to find that slice of the market that generates excess returns, and secondly, that given the unlikeliness of this, they are more likely to generate inferior returns pre-fees, than passive funds, although William F. Sharpe believed that active managers can match market returns pre-fees and that it is fees that are the source of inferior active management returns. Empirically, studies of active US large cap funds have found that pre-fees, the odds of outperformance are a coin flip and post-fees, the odds crash toward zero. Data from S&P Global’s SPIVA, which measures the performance of active managers against the S&P 500 and other indices across the world, shows that in the last fifteen years, 87.98% of Large-Cap active managers have underperformed the S&P 500, and only 12.02% have outperformed it. Morningstar’s research found that real estate is the only category in which the 10-year success ratio for active managers exceeds 50%. However, outside of US large caps, Dr Alex Beath of CEM Benchmarking found that,
…the average fund in the CEM database has outperformed their benchmark by 67 basis points (bps) gross of costs and 15 bps net of costs. It is reassuring to note that the evidence shows that large institutional investors are able to add value over long periods, even if more than 75% of the gross value added is eroded through costs.
The United Kingdom’s Competitions and Market Authority (CMA) noted that
…‘buy-rated’ products outperform their respective benchmarks on a gross of AM fees basis by approximately 23 bps per quarter, on average. These results are highly statistically significant. This is also true however for all the AM products in our sample regardless of their rating, which are also found to outperform their respective benchmarks albeit by a smaller margin (17.4 bps per quarter, on average).
156. Once we take into account AM fees, we find that recommended products continue to outperform the market though only by 4 bps per quarter on average. These results are no longer statistically significant. In other words, because of the variability in the net active returns of ‘buy-rated’ products in the data, the observed outperformance against their benchmarks may be attributable to chance.
2At scale, a sliver of outperformance may be enough justification for institutional investors to continue to use active managers. In fact, passive instruments make up just over half of US long-term funds, and 39% of the global funds market, and represent just 23% of global assets under management (AUM). Nevertheless, the effect of these forces is to create downward pressure on fees so that they now approach those of passive managers, a pressure that is likely to continue.
Given that few active managers have succeeded in fundamentally reducing their information costs and earning extraordinarily high long-run returns, the typical active manager has to accept declining fees. Quite simply, active managers do not have meaningful “pricing power”. A study by McKinsey tells us that revenue-weighted pre-tax operating profit (NOPBT) margin declined three points between 2019 and 2023, while revenue compounded by 3.3% a year, and costs by 4.3% a year. Similarly, in that period, model portfolio constituent, Diamond Hill, experienced a fall in its NOPBT margin from 61.9% to 50.3%, as a result of the confluence of revenue compounding by an anemic 0.018% a year, while adjusted operating expenses compounded by a margin-eating 3.7%.
In her 2023 letter to the shareholder, Heather Brilliant, CEO of Diamond Hill -whom I have written about here and on SumZero-, said,
And, of course, costs have been rising for asset managers — including distribution costs, growing product suites and the related data and technology to support them, operational and IT costs, and the ability to retain top investment talent to deliver strong results for clients. At the same time, rising revenues over the last 15 years have enabled a lack of cost discipline to persist within the industry. With revenues now slowing, the industry is starting to see the implications of higher cost structures.
This is the fundamental reality and challenge facing active managers. The other reality is an opportunity and it is that, not only must people invest, but some people want to earn returns greater than those available in a passive investing instrument and will continue to be attracted by active managers.
Conflicts of Interest Are Endemic to Active Management
In Coase’s theory of the firm, he argued that firm size is a function of rising marginal costs of organisation, so that a firm will stop growing when the marginal costs of organisation equal the marginal benefits. The active asset management industry suffers from diseconomies of scale. It is ironic, for example, that just as Warren Buffett became recognised as a kind of prophet of a secular religion, Berkshire Hathaway was approaching diseconomies of scale. Buffett himself observed that his best period was in the 1950s, when he “killed the Dow”. Increasing scale reduces the investable universe, focusing attention on larger and more widely understood opportunities -eroding any information advantage, i.e; increasing information costs-, and carries the risk that large block trading negatively impacts the strategy3. Michael Jensen’s agency theory views the firm as a “nexus of contracts” tying stakeholders together, wherein a principal delegates decision-making authority to an agent in a relationship of asymmetric information. Conflicts of interest arise when contracts and financial incentives do not align an agent’s self-interested desire for wealth and leisure with the shareholder’s need for wealth maximisation. Yet, as Chengdong Yin discovered, active fund managers are paid more as the size of fund assets increase, even at the risk of hurting fund performance. Thus, typically, there is misalignment of interests in the typical investor-fund manager relationship, with firms policing their size as much as is needed to maintain style average performance. With compensation linked to both fund performance and fund size, a manager who cannot earn market-beating returns is rationally obliged to continue to grow fund assets, because what counts is the total compensation package, not the share attributable to performance or size.
- That is, one where one has an equal chance of winning and losing. ↩︎
- The SPDR® S&P 500® ETF Trust has a net expense ratio of 0.0945%. ↩︎
- Renaissance Technology, a firm that enjoys pricing power, found that in commodity markets their trading activity directly impacted market prices. ↩︎