There is a question which I find fascinating but which everyone else seems to treat as utterly banal: why do people operate mutual funds, hedge funds, real estate investment trusts, and other investment vehicles for the benefit of other owners and shareholders?
After all, if you really believed that a long/short market-neutral trading strategy will generate returns in excess of the market, why would you want to share those returns with anyone else? Moving from a 6% annual return to an 8% annual return will, over the course of a lifetime, make you phenomenally wealthy. What would motivate you to let anyone else in on your secrets?
But I listen to a lot of investing podcasts and what I find is not people modestly explaining how they became phenomenally wealthy investing on their own behalf, but rather a range of pitchmen trying to gather assets for this or that investment vehicle — explaining how they plan to use their genius to invest your money.
With that in mind, here are my four best explanations for why people run investment vehicles open to outsiders.
This is essentially the pitch that William H. Macy’s character in “Fargo” makes to his father-in-law: he’s got a sweet deal lined up for a parking lot (really sweet), but he doesn’t personally have the money to execute it. He wants his father-in-law to provide the money as a loan. His father-in-law, sensibly, answers that while he’s willing to pay Jerry a finder’s fee, he’s not going to loan him the money without an ownership stake — he’s not a bank.
This is a perfectly sensible reason to seek money from outside investors! Creative, energetic individuals raising money from the wealthy and indolent in order to pursue expensive, lucrative projects is just about as close to the heart of capitalism as you’re likely to get.
I like to say investing will make you rich in 30 years, while selling investing ideas to others will make you rich in 5 years. Investing in real estate is hard work; selling tickets to real estate investing seminars is easy work.
A $100,000 investment in an investing idea that returns 10% will double your investment every 7 years. A $100,000 investment to start a hedge fund that charges 2% of $5,000,000 under management will double your investment in a single year.
This is essentially the business of sales. The return on your investment doesn’t depend on the quality of your investing idea, it depends on your ability to sell the idea to others. If you’re a good salesperson it doesn’t matter how good an investor you are: you’re being paid to sell, not invest.
What if you had an investing idea you thought would probably, but not certainly, return more than the market? One thing you could do is split your capital between that idea and the market, limiting your total exposure to each. If you put up only $500,000 of a $1,000,000 investment, you can invest the other $500,000 in the market and hedge your exposure to your alternative idea.
I recently read Edward Thorpe’s excellent “A Man For All Markets” (review to come next week) and while he never says it explicitly, I gather this is an important concern for him. He thinks but doesn’t know he can beat blackjack and roulette. He thinks but doesn’t know he can earn excess returns through market-neutral derivatives trading strategies.
Since he doesn’t know he’ll outperform the market, or even have positive returns, he manages his risk by not managing exclusively his own money, but also the money of others.
Economies of scale
When Vanguard launched the First Index Investment Trust (now the Vanguard 500 Index Fund) in 1976, it charged a sales load of 6%. I can’t easily find definitive information about its expense ratio prior to 1991, but in that year the fund had an annual expense ratio of 0.2%. Today of course the Vanguard 500 charges no sales load and Admiral shares carry an expense ratio of just 0.04%.
What if Jack Bogle had kept his idea to himself, taken his severance package from Wellington and simply bought a market-cap-weighted basket of S&P 500 stocks? It would have been a disaster! He wouldn’t have been able to buy round lots, the tracking error would have been astronomical, and he’d be paying brokerage commissions every time he bought shares to rebalance his portfolio.
Taking the money of outside investors allowed him to build a more efficient machine for himself (and his investors) to pursue the investment strategy he designed.
I think many investment vehicles have this kind of basic logic to them. Even if you are technically able to implement your options trading strategy with your own money and an Interactive Brokers account, you probably can’t do so at the scale necessary to achieve perfect implementation. Even a perfectly designed strategy that’s guaranteed to produce excess returns across the entire market may fail if you only have the resources to implement it across a subset of that market.
I don’t know why Wes Gray runs Alpha Architect, why Jeremy Siegel runs WisdomTree, or why Meb Faber runs Cambria. Presumably it’s some combination of all four reasons I mention above, and others I haven’t considered.
But just listening to these guys talk, you’d come to the conclusion that they’re running these investment vehicles as a charitable contribution to the financial well-being of the American public!
The trouble is, if someone won’t tell you why they’re actually doing something, you have to figure it out for yourself — and you might be wrong. If you think Wes Gray got into the ETF business out of poverty, but he actually got into it out of greed, you may invest too much with him. If you think Jeremy Siegel invested in WisdomTree for risk management purposes but he actually invested for purposes of economies of scale, you may invest too little with him.
My point isn’t to warn you against these vehicles or recommend them to you. It’s that unless you know why someone is doing something, you have no basis to decide one way or the other whether what they’re doing is in your best interests or not.
So why would you invest with someone who can’t open their mouth without lying?