We need adventurous investors, not reckless conservatives
Institutional investors, with some honourable exceptions, have an insatiable appetite for worrying about the wrong things. At present, their highest priority seems to be safety. They want to invest with the largest and best established managers, either through managed accounts or via regulated funds. These vehicles, they say, offer not only safety but also (among other favourite cant words and phrases of our time) better corporate governance and greater transparency.
Any investor whose highest priorities are the shape of the corporate organogram and the detail of the portfolio reports is focusing on what can be measured rather than what matters. In fact, it is not reckless to predict that the growing popularity of regulated alternative funds will in the long run prove to be no more than an expensive form of beta. They are the tribute intermediaries exact from the institutional faith in over-priced active equity management.
Institutional investors who believe regulation is a sensible alternative to doing their own due diligence (or paying someone to do it for them) are choosing to believe in contradictions. They hope leverage and shorting (but not too much) might help them beat their chosen benchmark net of costs. They also believe that they can obtain these benefits and retain a high degree of liquidity at the same time.
Hedge fund managers cannot be blamed for responding to this environment. As the primary source of innovation in investment management, they understand that corporate governance, transparency and depositary banks do not produce performance but eat it. But if investors do not want the higher performance promised by less liquid and less transparent investment vehicles, hedge fund managers will manufacture for them a different sort of investment vehicle which can guarantee them the under-performance they obviously prefer.
The industry should not delude itself that institutional investors are adopting anything other than a wilfully uninformed and unambitious approach to investing which it is beyond the ability of conventional financial analysis to explain. Its origins lie in the organisational dynamics of institutional investment institutions. Managers of large pools of institutional money are never going to risk their careers by straying too far from the conventional. In fact, measuring managers against a benchmark has an obvious appeal to this mentality.
The investment consultants - which retain a mystifyingly unbreakable stranglehold over the investment allocations of pension funds in particular, despite a growing conflict of interest with their own investment management businesses- are equally useful to the large class of unimaginative investors. They provide a means of abdicating responsibility for lousy investment performance, without ever having to do anything awkward, such as fire a fund manager (or even hold consultants accountable for the quality of their advice).
A marketplace in which investment consultants are competing with the asset management industry, but with an unfair advantage in terms of captive clients, cross-subsidised services and self-reporting of the results, is not one in which the best fund managers are going to get the largest allocations. The consultants know their clients are not going to challenge their decisions, and they too have no incentive to do anything other than recommend the biggest and the dullest managers, where they are not tempted to appoint themselves.
The market in fund management mandates is not open and, as a result, it is certainly not working properly. Unowned and under-managed pools of institutional money are not the responsibility of competent management but the playthings of investment consultants and superannuated financiers riddled with conflicts of interest that make open competition for capital to manage impossible.
The results are predictable. Institutional investors are paying far too much for indifferent investment management performance. In some parts of the business, they are taking all of the risk and seeing a share of the rewards that bears no relation to that risk. The people who should be angry about this are either bamboozled by investment consultants, or too busy managing their own conflicts of interest to make a serious contribution to reform.
Regulation in this area is worse than useless. It encourages a culture of safety-first, smothering innovation in pettifogging rules, while encouraging managers of institutional money to believe that someone else will always pay for their mistakes. It is an approach to investing which combines conservatism with irresponsibility. It is hard to think of a surer recipe for investment under-performance, and it will continue to deliver exactly that as long as it is allowed to persist.