Image Credit: Christophe Vorlet
By Jason Zweig | May 13, 2016 11:53 am ET
Earlier this month, eight pension funds appeared in a full-page ad in The Wall Street Journal asking asset-management firms to sign a code of conduct that commits them to treating clients fairly.
The effort, 10 years in the making, says a lot about how far the investment business has yet to go. Introduced in 2006, the Asset Management Code of Professional Conduct, sponsored by the CFA Institute, a nonprofit association of financial analysts, asks investment firms to be prudent, honest and ethical.
Who could possibly be against that? So far, about 1,300 firms have adopted the code worldwide. But tens of thousands more haven’t.
One reason for the hesitation is that investment firms often don’t see the need to comply with a voluntary set of standards on top of the mandatory disclosures and other requirements already imposed by regulators.
But some of the biggest investors in the world still think standards need to be raised.
“If you have a firm that is adhering to the code, all else being equal, you’re less likely to have ethical missteps and systemic problems there,” says Michael McCauley, senior officer for investment programs at the $170 billion Florida State Board of Administration, another signatory.
A recent survey of more than 3,800 investors in North America, Europe and Asia found that only 51% of individual and 41% of institutional investors were “very” or “extremely” likely to recommend an investment firm to others.
“The underlying reason is that the person on Main Street does not believe in the pit of their stomach that the industry is set up to benefit them,” says Paul Smith, president of the CFA Institute.
It’s high time that individual investors had their own equivalent of a Bill of Rights. Here is a start:
Asset managers shouldn’t overcharge. Today, asset-management companies often earn net profit margins in excess of 25%. According to Morningstar, the investment-research firm, only 7.3% of U.S. stock funds charge 0.5% or less in annual expenses; 56.7% charge more than 1%.
In 1960, more than three-quarters of all stock funds charged no more than 0.5% in annual expenses, and fewer than one-tenth charged more than 1%. Yet asset-management companies still ran an average net profit margin of 18% back then — so they can certainly afford to cut fees from today’s levels.
As investors continue to pull money from overpriced mutual funds in favor of cheap, market-tracking index funds, cutting fees isn’t just the right thing to do for investors; it may well be a matter of survival for asset managers, as well.
Asset managers shouldn’t outgrow their capacity to do a good job. Investment firms tend to promote their funds hardest just when returns are hottest. In such areas as small stocks, high-yield bonds and emerging-market securities, where trading costs are high and large lots of bargain-priced investments may be hard to find, a sudden influx of capital into a fund can make it all but impossible for the manager to match its past performance. So firms should stop taking in new investors when an investment strategy becomes too popular too fast.
But that isn’t easy, says John Montgomery, chairman of Bridgeway Capital Management, a $6 billion investment firm in Houston that has closed several funds to new investors over the years. “Your marketing people will say, ‘We’ve got a fund that’s shooting the lights out, and you want us to do what?!’ It’s like running a clothing store and locking the doors as soon as word finally gets out among all the customers in town that your stuff is really good.”
Firms shouldn’t launch new portfolios without announcing, in advance, how much money they can manage efficiently in that strategy. Once they reach that level, they shouldn’t take in new money anymore.
Firms shouldn’t “backtest” with abandon. In “backtesting,” asset managers try many different strategies to see what would have worked best in the past. Then they roll out a portfolio based on whichever approach happened to prevail, without disclosing how many others they tried.
Simply by testing enough possibilities, the researchers can be almost certain — by chance alone — to come up with one that “worked.” Since clients have no way of knowing how many different approaches the manager sifted through before settling on a final choice, they have no way of evaluating whether the strategy is just a statistical fluke.
Firms should never offer backtested portfolios without listing how many other strategies they considered but rejected, as well as which data and time periods they used for their tests.
Finally, asset managers shouldn’t market portfolios they wouldn’t invest in themselves. Does the investment world need exchange-traded funds specializing in organic-food producers, developers of drone technology or marketers of products with special appeal to millennial consumers? How many ETFs do we need speculating on whether volatility will go up or down?
Along the lines of the ethical acronym “WWJD” (What Would Jesus Do?), I propose this rule of thumb: “WWMB” (What Would Mom Buy?). If an investment manager wouldn’t want his or her mother to buy a new portfolio, then it has no business being sold to the investing public, either.
Source: The Wall Street Journal