It's a well-known phenomenon in behavioral economics that our financial incentives greatly influence the way we think and behave. So, for example, if you ask a tradesman for an opinion on an issue in your home, or an automotive technician to look at your car, it's highly likely that their diagnosis of the problem and the solution they recommend will be shaped by their desire to get paid. As Warren Buffett once put it, "never ask a barber if you need a haircut."

The investing industry works the same way. Indeed, it was this discovery that set Mark Hebner on a journey to found Index Fund Advisors. When Mark sold his nuclear pharmacy business for a large sum in 1985, he hired a broker to advise him on how to invest the proceeds. Almost every week, his broker would recommend buying some asset or other.

Mark thought little of it for the next 12 years or so, but then he started learning how to invest himself. To his amazement and annoyance, he discovered that if he'd simply invested the money in low-cost index funds he would have been around $30 million better off.

"I'm not saying (my broker was) a bad person," Mark explains in this video. "But he was in a system and business model that required him to do that, so he could make an income and so the firm could make an income.

"99% percent of this industry is designed to get people to trade. It's a commission-based, transactional business, and there's a long list of people who are just waiting for that salesperson to initiate the trade so that everybody can take a little piece of that trade. That's what this industry is all about. It's the largest casino in the world."

 

"Purposeful Inertia"

A new book provides some fascinating insight into why financial professionals think and act in the way that they do. It's called Inertia: Purposeful Inefficiencies in Financial Markets, and it was written by Yuval Millo from the University of Warwick, Crawford Spence from King's College London, and James Valentine, the former director of the Applied Investment Management program at Marquette University in Milwaukee.

The book is based on off-the record interviews the authors conducted with 70 investment professionals in the U.S. and the U.K., mainly active managers. The authors highlight the persistence of what they call "an epistemic inertia that characterizes the active fund management community in the face of a seemingly existential threat". That threat is the rise of passive investing and the growing realization among investors that they are better off avoiding active funds and using index funds instead.

The authors explain how the epistemic regime of active fund management — in other words, the intellectual reasoning behind it — is "long-standing and institutionally embedded". "In a theoretically efficient market," write Millo, Spence and Valentine, "this regime would have been swept away and replaced by ideas that encourage better resource allocation."

Why, then, does the active fund industry remain so powerful? The answer, the book claims, lies partly in the strong social bonds that exist between the different groups — fund managers, analysts, brokers and so on — that make up the current system. These different actors share a clear financial incentive in maintaining the status quo and work hard to do so.

Here are the some of the ways in which the authors say the active fund community seeks to preserve the current state of affairs:

• It strongly resists change, even in the face of overwhelming evidence that passive investing tends to deliver better returns for most investors. It continues to adhere to established practices and frowns upon those who "rock the boat".

• It creates and sustains a system of knowledge that justifies its existence. This includes claims of superior stock-picking ability, the necessity of active management for price discovery, and the idea that active managers can provide better governance over corporations.

• It uses rhetorical strategies to defend active management. For example, it    - claims that passive investing leads to market inefficiencies and price distortions that only active managers can correct; it positions active management as the only way to engage in sustainable, or ESG, investing; and it argues that active management is more effective in bear markets, despite the evidence that active funds tend to underperform in markets downturns as well as in bull markets.

What Active Managers Say In Private

Interestingly, Yuval, Spence and Valentine found that, although the fund managers they interviewed were keen for active management to retain its dominant position, they spoke with remarkable candor about the rise of passive investing and their own views in index funds.

What struck the researchers most was the information the professionals volunteered, without even being asked. Many conceded that investors are better off using index funds than active funds, and others even said they wouldn't invest their own money in the funds they were managing.

Ray, a sell-side analyst in New York, for instance, admitted during his interview: "All my own money is in index funds." When the interviewer suggested to him that this was a contradiction, Ray replied: "It is, right? Isn't it interesting? … I will come across as cynical. It's a good thing it is confidential and off the record."

Active Management Is Not In Terminal Decline

Despite the anxieties they encountered within the fund industry about the future of active management, the authors are far from convinced that it's in terminal decline.

In the conclusion they write: "It is tempting to view the active fund management community as a population on the verge of collapse, its members diminishing in numbers as the ecosystem surrounding them becomes less and less bountiful. However… history is full of bad or outdated ideas that manage to persist despite their shortcomings having been well recognized.

"Active management," they conclude, "continues to grow in terms of absolute assets under management globally, even if it is losing market share," and "remains remarkably successful in carving out a role for itself and convincing investors to place their faith in it."

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Robin Powell is the Creative Director at Index Fund Advisors (IFA).  He is also a financial journalist and the editor of The Evidence-Based Investor. This article reflects IFA's investment philosophy and is intended for informational purposes only. 

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