Jack Bogle recently predicted the demise of active investment management in the next 25 years. Will he be proven correct? It doesn't matter. In the debate over active versus passive investing, we're missing the larger point.
Today we focus on short-term excess return over a benchmark, but the discussion should focus much more on the long-term value investment professionals bring to society.
Our industry is undergoing a slow death brought on by a combination of investor apathy and invasive regulation. Regulators are under political pressure to get involved in our business. If we don't reform ourselves, they will. As financial professionals, we need to explain and prove much more carefully the long-term value we are delivering to clients. The way our industry is currently structured — encouraging professionals to push products rather than selling the service and value they provide — makes it all the more challenging.
After all, financial professionals advertise the one thing we know to be unsustainable: quarter-over-quarter outperformance of a benchmark. After fees, this is less than a zero-sum game. What about meeting clients' long-term investment needs?
OBSESSED WITH BENCHMARKS
Our industry is the poster child for short-termism, obsessed with quarter-over-quarter benchmark performance that we know will mean-revert. Investors, as a result, have become self-medicating; they see little use for financial professionals and have less desire to pay for their advice. The rise of passive
investment vehicles and robo-advisers is a testament to this trend. The recent 2015 World Wealth Report revealed that nearly 50% of high-net-worth investors would consider using automated advisory services.
Passive investing is thriving in part due to financial professionals' inability to explain the value they bring to clients and to society. Ironically, by making markets more efficient through the expensive process of price discovery, active managers are creating an environment where index funds are appealing.
But once you change your investment time horizon from short term to long term, you change the nature and range of the factors you need to consider in your investment process. The more we can focus on the long term, the better we will connect with the aspirations of our ultimate clients.
MORE BENEFITS
This is where active security selection and
portfolio management have some noticeable advantages, as they produce deeper and more pervasive benefits for individuals and society. Active managers catalyze value generation in the real economy by helping direct savings to those projects with the best longer-term returns (both financial and social). Active asset allocation helps meet a client's investment objectives and creates positive social impact, connecting those who need capital with those who are willing to provide it.
An actively traded market also ensures that security prices are fair and provides much-needed trading liquidity for all, which, in turn, offers the potential for better risk management for individual investors.
Ultimately, active investment management provides value — in the form of personal attention and professional advice — to each individual investor in a way that passive investing, as much as it tries, can't emulate. This emphasis on value generation needs to be at the crux of investment advisers' sales pitches to prospective clients.
Despite the protests about it, the rise of passive investing is actually a positive for the overall industry because it increases transparency and reduces product margins, forcing advisers to focus on selling service instead. This is a true value-add in developed markets, where it is becoming increasingly hard to add value through security selection.
If we can't make this transition, we are destined to lose clients and face increasing regulation. There will no doubt be short-term pain, but ultimately a healthy rebalancing of activity will take place.
We should also remember that the more money that is placed in passive investments, the more value the shrewd will find in active investment. But this process could take an awfully long time and carry many of us out with it while it works its way through.
I see the industry of the future dividing into three areas: Low-cost product manufacturers, where there is no size constraint on product; high-cost product manufacturers, such as hedge funds and small-cap managers, where there will be capacity constraints; and investment advisers who sell investment advice made up of product blocks built on the first two categories, with no size limit. Investment advisers generally will have an open product architecture and will appeal to both institutional and retail clients.
OFFERING OUTCOME INVESTING
The first two areas are really zero-sum games. The third is about outcome investing: how to meet client needs over the long term. By understanding and taking an interest in each client and his or her financial goals, advisers can better showcase the value they provide over robo-advisers and other potentially cheaper alternatives. It becomes a case of serving your clients' needs first versus serving your own by pushing products that will net higher fees but move clients further away from their long-term goals and from us as professional advisers.
The question that must be asked, unfortunately, is whether the investment advisory industry has the capabilities to make this value-emphasized approach work. How can we get our clients to
trust us to serve their needs if we don't expect more from ourselves?
The amount our industry spends each year on training is very low, and we need to do much better in this area if we are to demonstrate to clients the seriousness of our intent. Our profession often appears to be involved in a race to the bottom as far as standards are concerned. The industry, hand-in-hand with regulators, is determined to drive educational standards to as low a level as possible because it worries that if it raises the standards too high, many of us will be out of a job. This is not a sustainable business model, and eventually regulators, under pressure from a disaffected public, will put a stop to it. Can we reform ourselves before this comes about?
There needs to be a more established linkage between running a profitable, long-term sustainable business and possessing a well-trained workforce. You need high-quality personnel to succeed in today's brave new world.
Ultimately, to thrive as a profession, we need to better demonstrate what it means to be a profession by putting our clients' interests before our own. We can do this by promoting the highest standards of education, competence and professional conduct.
Paul Smith is president and chief executive at the CFA Institute.
