Don’t Hate The Player, Hate The Game- Part 2

We once wrote, "Don't Hate The Player, Hate The Game".  A recent study reinforces the idea that the "game" is broken.  The game we are speaking of is the financial services industry and the study was conducted by the University of Notre Dame and a securities law firm, measuring industry professionals attitudes towards unethical behavior.  You would think that seeing their company brands getting tarnished over the past several years might cause some introspection about how investment professionals view such behavior.  Think again:

“On an individual level, 32% of professionals with less than a decade in the business would engage in insider trading if they could get away with it. That’s [more than] twice the figure (14%) for employees with more than two decades in the industry,” Thomas explained. “What does this mean for the future of the industry, and how will it impact the fragile confidence of investors?”

The poll, which included 925 Americans and nearly 300 British respondents, also finds that nearly one-fourth of financial professionals, or 23%, believe that their colleagues likely “have engaged in illegal or unethical activity in order to gain an edge,” the report says, “nearly double the 12% that reported as such in 2012.”

Overall, nearly one in five professionals feels it is at least sometimes necessary to bend or break the rules to get ahead in the field, the study shows. Plus, 32% say compensation structures or bonus plans “pressure employees to compromise ethical standards or violate the law,” according to the report.

One question I don't know the answer to is whether the industry creates this type of behavior in people OR these people have always been this way and are just attracted to this industry?  One thing I know for sure is that major reform would have the potential to solve the problem, no matter what the cause.  When we started Greenspring we thought long and hard on how a firm should be designed to prevent this behavior.  Here is what we came up with:

  1. Remove bad incentives- can an advisor get paid differently based on his/her recommendation to a client?  If so, this is a horrible incentive that should be eliminated.  Charging a fee only for advice, directly from the client, and not receiving compensation for selling a certain product is the best way to remove these incentives.
  2. Eat your own cooking- the lead up to the financial crisis was clear evidence of this.  There are countless stories of firms selling products to their clients AND betting against the same products they peddled to clients.  Firms should not be investing their own money in a way that is different from their recommendations to their client.  If you wouldn't buy it yourself, don't sell it to your client.
  3. Firm structurewhen a firm has shareholders to satisfy and wall street estimates to hit, client needs may take a back seat. Shareholders of the company that are purely focused on profit create a real ethical dilemma for officers and executives- do what is best for shareholders or do what is best for clients?  We believe a partnership, not beholden to outside shareholders, where the advisors and the employees are the owners removes some of this conflict.  This, in combination with the first two suggestions helps eliminate the bad behavior coming from trying to balance shareholder and client needs.

At the end of the day, you can't regulate morality.  Everyone of the professionals in this study know better and should be behaving appropriately.  One of the great things about capitalism is that the market has a tendency to regulate itself.  Clients are not dumb and the trends are clear.  In a recent report by Cerulli, they estimate that Registered Investment Advisor (RIA) firms (ones that embrace many of the reforms I mentioned above) will grow their market share be 40% over the next four years while wirehouse firms (the big firms represented in the study) will see their market share decline by 5%.  Whether or not regulation gets passed, it seems as if economics may force the industry to reform.

Hedge Funds Close Up Shop

The New York Times has a story about hedge funds closing their doors over the past year or two.  When asked why, many claim that the hassle of dealing with investors or regulations is just too cumbersome.  Instead, they'd rather just manage their own money and not deal with all the red tape. Here is an excerpt:

Others are more direct. For Gideon King, of Loeb King Capital Management, running a hedge fund had just become "too cumbersome."  Mr King, who has been managing money for 21 years, informed his investors in a letter in January that he would be closing the doors.

All three have chosen instead to invest their vast personal wealth through so-called family offices, which means fewer regulatory hurdles and compliance costs. As a family office, each will not have to register with the Securities and Exchange Commission.

And if you believe that, I have a bridge to sell you.  Regulations and compliance costs are a drop in the bucket when it comes to hedge fund revenues.  Think about a fund managing $1 billion.  In a traditional 2% of assets and 20% of profits setup, in a good year, that fund might generate $20 million in asset management fees plus $20 to $40 million in performance fees.  Does anyone really believe they can't handle the "cumbersome" regulation with that kind of budget?  So why would anyone want to kill that golden goose?  The likely reason…they aren't earning those types of fees.  The dirty little truth that most won't tell you is that hedge fund managers often take extraordinary risks, and if those risks don't result in profits they will shut their fund down.  Why?  Because they can't make any money.  Investors pull their money which limits their ability to earn asset management fees.  In addition, their lack of performance negates any substantial performance fees.  When that happens, yes regulation and compliance costs do become an issue, solely because of the fact that their is so little revenue to pay for it.

So why is this an issue now?  Mainly, performance has been so abysmal that the fees I mentioned above have been decimated.  During the last 10 years (ending 4/30/2015) the HFRX Global Hedge Fund Index has returned 1.21% per year.  As you can imagine, it is hard to generate huge fees from returns as small as these.  As an investor there is no reason to take these kinds of risks and pay these kinds of fees with your money.  Put the odds back in your favor by minimizing costs and broadly diversifying.  It is a much better strategy than trying to pick a winning hedge fund.  

Another Reason Why Global Diversification Matters

One of the arguments I have heard over the last several years is whether investors truly need global diversification.  The argument goes like this:  nearly 50% of the revenue from the S&P 500 comes from overseas, so aren't I getting diversification to other countries by owning the S&P 500 since globalization is just so much more prevalent these days?  It is not surprising that this argument has surfaced after 5 years of significant outperformance from the US stock market over both foreign developed stocks and emerging markets.  Investors tend to make arguments suggesting why a simple investing theme no longer applies AFTER it has been out of favor (think about the late 1990s when many argued that earnings didn't really matter anymore).  

Nevertheless, it is an interesting thesis and to some extent is correct. Things are more global these days.  Multinational companies sell all over the world.  But recent research from Credit Suisse (via suggest that global diversification is still valuable for another reason:

just as industries can be concentrated within a few countries, so countries can be dominated by a handful of industries.” For example, “the weighting of the three largest industries accounts for at least 40% of country capitalization for 42 out of the 47 countries; for at least 50% for 33 countries; for at least 60% for 21 countries; and for 70% or more in 15 countries.

While the US is much more diversified across industries than other countries, we still have our overweights:

The U.S. is among the countries least concentrated by industry, but we still have “a heavy weighting in technology (17%), high weightings in oil and gas, health care and consumer services, and lower weightings in basic materials, consumer goods and telecoms.”

Some countries just tend to be more focused on specific industries either due to natural resources, country demographics, education, or history.  Focusing your portfolio on  one country (or handful of countries) may be targeting a smaller group of industries that could have been available to you had you invested in a global portfolio.  While a home country bias probably makes sense for most investors, that doesn't mean you should ignore the rest of the world.


Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.