The Economics of Active Management

Pension fund management needs improvement. Robert G. Snigaroff

he pension fund and institutional investment purchasers of asset management services frame the debate of active or passive management in philosophical terms, using such phrases as I believe (or dont believe) in active management. Then they hedge their bets by deciding what percentage of their funds should be passively managed. Academicians debate market efficiency using language like the semistrong-form of market efficiency hypothesis, and produce research attesting to the general folly of active management. Investment management firms simply want the job of managing someones money. Of course they believe in active management, or at least those who arent cynics do. A more formal approach to the way pension fund buyers of asset management services think about the active management market and the way they apply their thinking could not only help clients improve their operations, but could also impact the market for those services.

SUPPLY, DEMAND, AND THE ALPHA PRODUCTION POSSIBILITIES CURVE

ROBERT G. SNIGAROFF is chief investment officer of the San Diego County Employees Retirement Association in San Diego (CA 92101-2427).
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For purposes of illustration, the supply of active management is drawn in Exhibit 1 as relatively flat, or elastic. Factor inputs to active management suppliers, such as the salaries of investment professionals, systems, and infrastructure, are net, fairly constant regardless of quantity supplied. Such inputs may even fall with increased output, resulting in a downward-sloping supply curve.
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It is very difficult, however, for buyers to find and to distinguish suppliers with talent from those without it. Because of this, suppliers build distribution franchises resulting in significant hurdles for new entrants. Generally, the firms that provide active management have high margins after they are successful in attaining scale. Buyers of active management are willing to pay a premium to firms that are able to add value, as they may employ talented professionals or have a valuable intellectual or operational franchise. Marginal costs for suppliers are relatively low after fixed costs are met. Whatever the shape of the supply curve, buyers of active management create a demand curve for active management that impacts the production of alpha. The supply and demand curves represented in Exhibit 1 portray a monopolistic competition. Buyers can influence both the demand curve and the alpha production possibilities curve in order to improve their prospects in actually producing alpha. The production of excess return, or alpha, can be modeled as an alpha production possibilities curve (hereafter alpha curve), as shown in the bottom half of Exhibit 1. As the supply of active management rises, there is a

EXHIBIT 1 SUPPLY OF ACTIVE MANAGEMENT

Q2 Q1

D2

D1

Region of Managed Value Reduction to Pension Funds

Quantity of Active Management Supplied

corresponding increase in the aggregate dollars of produced value; i.e., the dollar amount of value that is added to buyers of active management increases with the amount of assets employed to produce it. At point A, the curve reaches its highest point; that is, the continued addition of active management supplied results in a maximum dollars of produced value. After point A, there begins a reduction in produced value for buyers. Transaction costs grow with supply. Although transaction costs are outside the alpha curve (by definition, alpha is produced value after transaction costs), the fact that they grow with trade size contributes to a value decline. And of course the market, if its trading with itself, cant beat itself. Even if we allow that there is alpha available to the entire universe of active management because of its role as providers of liquidity to the market or because of non-wealth-maximizing market participants, there is a maximum dollars of produced value. There is also a unique alpha curve and maximum dollars of produced value for each subset of active management buyers. Ideally, the pension fund buyer subset, in the aggregate, would like to be positioned at point A on the alpha curve. It may be, however, that these buyers are instead positioned at point O, oversupply. If pension fund buyers are positioned on the alpha curve at point O, they are failing in their business efforts to produce alpha they are, in fact, in the region of managed value reduction. At point O, the demand curve intersects supply at Q2 in Exhibit 1. If buyers of active management are not as informed as sellers, then the demand curve would: 1) likely have a steeper slope; i.e., demand is inelastic, and 2) be positioned farther out on the supply curve (buyers buy too much active management).1 The demand curve would look like D2 in Exhibit 1. On the first point, the fact that the percentage of pension fund assets managed actively and the fees sellers charge buyers have both remained constant suggests demand inelasticity.2 On the second point, uninformed buyers would tend to overestimate the actual size of the alpha curve and so overbuy. Much research suggests an inability to add value by the average supplier of active management, hinting at oversupply, hence the intersection at Q2. Consistent with this research is new work by Ambachtsheer, Capelle, and Scheibelhut [1998] arguing that, on average, the pension fund buyers of active management are in fact reducing value for their pension fund stakeholders.
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Dollars of Produced Value

Price of Active Management

THE ECONOMICS OF ACTIVE MANAGEMENT

THE PRINCIPAL-AGENT ISSUE

EXHIBIT 2 SHIFT IN CURVES FOR ACTIVE MANAGEMENT

Demand curve D2 is consistent with the presence of a principal-agent problem for pension fund organizations, where agents are not acting to meet the objectives of principals (maximization of risk-adjusted returns).3 In the pension fund context, the principals include both the funds beneficiaries and the plan sponsor. The beneficiaries are principals as the fund exists to make current, and future, payments to them in retirement. The plan sponsor is a principal because it reaps the benefit, and assumes the risk, of any asset-liability mismatch. (Here we are considering the economic principal-agent definition, and not the legal.) Lakonishok, Shleifer, and Vishny [1992, pp. 374375] posit an agency problem in pension fund management, and suggest a possible source of the problem as the desire of the treasurers office (i.e., pension fund management) to look similar to other funds (reduction of maverick risk) and to retain its own empire. They even suggest that employees in the treasurers office may be frustrated stock pickers, or perhaps excessively risk-averse and in need of a good story to explain poor performance to their superiors inside the sponsor organization. Assignment of blame is, in fact, a cultural feature of pension funds. OBarr and Conley [1992] observed the behavior of pension fund managements and find culture to be a more important decision driver than economics. To say that the pension fund communitys business practices are a result of culture, though, is simply a dead end. Ascertaining how funds obtained this culture and whether it can be changed is what is important for pension funds and the active managers they hire. For this, we can apply economic reasoning. Principal-agency issues can be addressed by pension fund organizations. Ambachtsheer, Capelle, and Scheibelhut [1998], for example, argue that pension funds with higher scores for optimal organizational layering and clarity of delegation have better performance. In effect, what they are arguing is that agency issues can be successfully addressed, and that the segment of the pension fund community that has better business practices has in fact addressed them and so has grown its particular alpha curve. The entire pension fund community can, in fact, grow its alpha curve with business practice improvements. This is shown in Exhibit 2, where A2 is shifted upward
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Price of Active Management

S Q3 Q1

D3 D1

Dollars of Produced Value

A2 A

Region of Managed Value Reduction to Pension Funds

Quantity of Active Management Supplied

and to the right, allowing a corresponding shift in the optimal demand curve to quantity Q3. This is the preferable solution for suppliers of institutional active management. A move to Q3, however, means that there is a corresponding erosion in someone elses alpha curve. The game becomes, how we, the pension fund community, can carve into the alpha curve of, say, the buyers of mutual fund active management. Can we, the pension fund community, use our economies of scale and infrastructure to our advantage? In fact, we have already done so. For example, pension funds have succeeded in gaining tax exemption. Tax exemption is more than avoidance of confiscation of a portion of the alpha curve to pay taxes. It allows the expansion of the alpha curve for market participants who can exploit their tax-exempt status through the consideration of additional alpha production strategies (e.g., higher turnover strategies, or dividend preference strategies when income is subject to higher taxes than capital gains). Also, corporate pension funds and many public funds enjoy a prudent investor standard with respect to the building of their investment portfolios. Del GuerTHE JOURNAL OF PORTFOLIO MANAGEMENT

cio [1996] has shown that market participants who are held to another standard cause market segmentation distortions by tilting portfolios toward investments that fiduciaries could defend as being prudent. (Del Guercio looks at a prudent man standard where investment vehicles are viewed as suitable only when viewed in isolation and not in a total portfolio context.) Also, pension funds build transported alpha portfolios using derivatives to give the alpha of one asset class (presumably less efficient and with a higher expected information ratio) to another. This last case does not expand the alpha curve through preferential regulatory treatment, but rather through an application of the pension funds infrastructure. Pension fund managers can separate the asset class return from the production of alpha, and find the best sources for alpha production. This exploitation of market segmentation is much more difficult for individuals. Creating strategies for alpha curve expansion is desirable for the pension fund community (buyers and sellers), but such strategies do not solve the principalagent problem.
THE PRODUCTION OF ALPHA

If alpha production is similar to any other product the corporation (or public entity) might wish to produce, why do so many funds fail in its production? I believe it is due to a principal-agent problem that pertains in many pension funds and that has not been successfully addressed. I dont believe the problem is empire-building by fund managers; in fact, just the opposite. Ambachtsheer, Capelle, and Scheibelhut [1998] are on to something when they write about the importance of pension fund governance and layering and delegation. For example, there is a surprising lack of resources devoted to the pension funds internal management. The top pension fund governing body (or the board), which spends as much or more than 50 basis points of aggregate fund assets in external asset management fees, rarely spends more than 2 basis points on its own internal management. Fund managements, as a result, are staffed by executives who are poorly compensated, aspire to careers on the sell side of asset management, have short average tenure, are compensated without regard to whether alpha is actually produced, and are delegated very little authority.4 Boards often retain the authority to hire and fire active management suppliers themselves (in almost every
4
THE ECONOMICS OF ACTIVE MANAGEMENT

case in the public pension fund arena). In other words, the boards of institutional pension funds, which enjoy significant economies of scale in retaining a professional management effort in order to produce alpha, not only do not pay enough to attract top talent in order to succeed, but also end up trying to produce the alpha themselves. If a board committee decides how to produce alpha, it not only has to select superior asset management products, but it also needs to address complex issues that dont lend themselves to solution by what is usually a part-time committee composed of non-investment professionals.5 The first is that asset management firms usually have an economic incentive to grow beyond the most effective trade size for their clients. Second is the need for the optimization of alpha production. That is, it is the overall fit of a particular product or strategy within the aggregate portfolio that matters, not the effectiveness of the strategy in isolation. Third, research indicates that past performance matters little in forecasting future performance, and past performance is the very information that committees heavily rely on to add or retain service providers (along with a short presentation by the service provider).6 Fourth, a committee must wade through an astounding number of investment offerings and understand the strategy of product proliferation that asset management firms use to reduce their own business risk (not necessarily with active management skill, but rather by offering a range of products; see Ennis [1997]). Finally, firms that should no longer be in business stay in business through their marketing by association. (They exploit active management buyers lack of knowledge, weak management structure, and personal and political connections.) Persson and Tabellini [1999] have something to tell us about authority delegation. In the political world, they find strong and robust support for the prediction that the size of government is smaller under presidential regimes. This research provides an interesting corollary for the pension fund community. The authors find that a parliamentary government, with its diffuse form of decision-making and accountability, increases politicians positive rents for themselves (government is bigger and more expensive). This, they contrast with governments with a presidential regime, i.e., a regime with more authority and visible accountability that is associated with less government and expense. The delegation of authority is also consistent with the general change in the practices of U.S. business in
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recent years: the pushing down of authority to frontline employees. Many pension funds (especially public funds) are practicing a centralized business model that fewer and fewer of the companies they invest in continue to practice. Finally, the hypothesis that there is a pension fund principal-agent problem as opposed to sellers with monopoly pricing power is evidenced by the structure of the asset management industry. Active management sellers do not have a monopoly; there is too much industry diffusion and too much fluctuation in market share. There are 392 active managers each managing more than $1 billion in tax-exempt assets. Only six have 2% or more of total market share, with the one manager maximum just over 4%. The Herfindahl index of industry concentration for all active managers is 120 for 1998, nowhere near the 1,000 index level the Justice Department uses to define overconcentration. Contrary to much current commentary, industry concentration has actually decreased; the Herfindahl index was at 132 in 1989.7 Even so, suppliers demonstrate pricing power. They have adopted what Ennis [1997] describes as an adaptive strategy of product proliferation resulting in less well-informed buyers paying the same levels of active management fees to a revolving set of suppliers. Sellers are adapting to the market in active management. Buyers are not.
Path-Dependence

Given that a principal-agent problem exists, how did the pension fund community get to where it is? One reason is that the asset management firms, the consultants, and other service providers are provided incentives to help boards focus on whats not important. Service providers simply want to sell a service, and to make the sale they need to show their wares. They therefore supply inordinate amounts of information testifying to their skill. They also spend significant resources in marketing by association to the buyers of the services. Simply by providing the enormous amount of information, and by marketing, sellers move the focus from the pension plan balance sheet and total fund managed value-added to investments and investment providers. Buyers of active management, if they are the board, spend a great deal of time on the evaluation of active management service providers, instead of evaluating the overall (and far more important) pension fund balance sheet issues. The tendency of the active manWINTER 2000

agement buyers to be dazzled by the mystique of the market and the money masters is reinforced by sellers trying to make a sale. This view only moves the question back one step without explaining how the pension fund active management industry arrived at its current condition. For this, we need a brief dose of history. Through the 1970s the asset management industry looked different; bank trust departments dominated the management of pension fund assets. Before the mid70s, all assets were actively managed. Pension fund assets grew dramatically through the 1980s and 1990s. During the 1980s banks failed to reconcile the need for highquality professionals and their compensation schemes (a problem related to the current pension fund dilemma of quality management and inadequate compensation). They then lost their most important asset, skillful professionals. The stand-alone asset management firms were formed in great numbers after these professionals recognized that they could capture the high margins associated with asset management themselves; talent is, after all, beneficial to asset management buyers. Two general trends are occurring in asset management today. The first is that some asset management firms are cashing out: selling their businesses back to banks or other large institutions that want an equity stake in the business and that have enough capital to continue the expensive marketing of products. The second is rapid product proliferation by which suppliers hope to have a reasonable chance at offering benchmark-beating products. As the level of complexity in the institutional funds management market has grown, so too has the complexity of investment vehicles and strategies that pension funds use to try to succeed in alpha production. Organizational design within pension funds, however, remains as before. During the 1970s, an external entity (the bank trust department) chosen by the board had oversight over the pension funds entire pool of assets. Now, in the banks stead, the board of the pension fund very often assumes oversight of the aggregate fund, and as it selected the bank trust departments, it still often chooses to select the asset management service providers. Following enactment of the Employee Retirement Income Security Act and gradual acceptance of portfolio theory, boards now have a far more complex task: building a portfolio with portfolio theory and a slew of specialized active managers. Frequently a board brings in a consultant to offer support. The board often accepts the advice of the increasTHE JOURNAL OF PORTFOLIO MANAGEMENT

ingly product-focused active management sellers, sometimes preferring it to their own managements.8 Both at corporate and public pension funds, boards tend to neglect planning for and evaluation of management and infrastructure in order to produce alpha. For example, the career track for a corporate pension fund investment professional is often a return to the corporate treasury department.9 At public funds, managers are not given much authority, and they administer board directives as opposed to initiating their own. Often managers are merely an additional screen for active management suppliers to overcome in selling their product to the board. Boards arent conscious rent-seekers, as there is relatively little rent, or self-benefit, in the continuation of their current business practices. They simply arent offered a better way of practicing business by the industry that offers them products. Pension fund industry structure is thus path-dependent, a result of its particular history that locks the industry into inefficiency.
Changing the Path

Both corporate fund and public fund governing bodies need to make improvements if they want to: 1) create value for their stakeholders, 2) keep plan sponsors from forcing change, and 3) avoid possible legislative action concerning their business practices. Sooner or later, plan sponsors and beneficiaries will begin to realize the success, or lack of success, of their pension fund efforts to produce alpha. Likely, the realization will come from the plan sponsor, as the beneficiaries are, in the parlance of public choice economics, rationally ignorant.10 In 1985, the Financial Accounting Standards Board issued FAS 87, which requires that unfunded pension liabilities be moved to the balance sheet. Ideally, this increases the visibility of the pension fund to the corporate plan sponsor, but on the down side, FAS 87s reliance on defensible asset return assumptions allows corporate funds to use historical returns, which have been high recently. Generally, expected future returns are not discounted to compensate. Corporate funds can, in fact, thus double-count asset return assumptions. Many pension fund active management buyers show a desire to evaluate their alpha production businesses. A significant number accept Ambachtsheers contributions to pension fund governance, including participation in the cost effectiveness management sur6
THE ECONOMICS OF ACTIVE MANAGEMENT

vey and use of the risk-adjusted net value-added, or RANVA, performance metrics, which is the pension fund equivalent of the corporate economic value-added measurement.11 Some use the information ratio performance measurement for evaluation of actual returns as compared to their policy returns. The active management industry is capable of material change. Think about the change in the brokerage industry after the deregulation of commissions in 1975. Since 1975, average institutional commissions for listed shares have dropped by as much as 80%, as asset management firms in both the pension and mutual fund active management segments have demanded unbundled (from research) commissions at lower cost. What helped foster this change was an economic alignment that properly motivated agents to act in the best interests of their principals; reduced commissions result in an improved active management product to gain or retain market share. Pension funds would benefit similarly from an improved principal-agent relationship in order to advance alpha production activities. Specifically, boards need to delegate responsibility to management, build suitable infrastructure, align compensation of management to recognize success in attaining their goals, and make management accountable for results. Finally, boards need to design their organizational structures so that management becomes the primary voice in the formulation of business strategy. For suggestions on how boards can improve their overall oversight of pension funds, I recommend Ambachtsheer and Ezra [1998]. Given a desire for individual pension plans to attempt to produce alpha, there is a tendency for the pension fund community in the aggregate to slide down the alpha curve from point A toward point O in Exhibit 1. Widespread adoption of performance-based fees paid to asset management firms could alleviate this problem. Pension funds would need to manage the moral hazard of giving asset management firms and the managers of the pension funds an asymmetrical bonus payment, as presumably neither would accept a penalty if they were to underperform. For this, pension funds need to adopt well-designed risk audit programs.
SUMMARY

Active asset management is a zero-sum game. Buyers who want to produce alpha in a zero-sum game have to be better than their competition. For pension
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funds, competition includes all other participants in active management, including mutual funds, individual investors, endowments, bank trust departments, institutional funds trading for their own accounts, hedge funds, and even each other. Pension funds do not now plan their alpha production efforts using strategies to exploit their competitive advantages. In fact, the pension fund community has a principal-agent problem that makes it difficult to even see whether the fund is successful in producing alpha, and the design and execution of alpha production efforts suffers. The structure of the industry and the nature of the product contribute to the tendency for pension fund boards to be dazzled by investment advisors rather than conscious of management accountability and business issues. Research suggests the magnitude of the problem and confirms a need for improvement. Pension funds do not have to accept the inevitability of the culture. They can successfully address principal-agent issues. Some of them have, and the active management industry will adjust.
ENDNOTES
for example, Ambachtsheer [1998]. effectiveness measurement data show the U.S. pension fund average percentage of assets externally actively managed is at 63.1% in 1997 versus 65.1% for 1994 and that direct investment management costs are at 29.1 and 29.6 basis points for 1997 and 1994, respectively. Suppliers are also able, with their segmented fee structures, to practice multistage price discrimination to use the normative term favored by economists. Different prices for buyers with different demand can benefit buyers with more elastic demand and so reduce their prices. The offering of discounts to the largest buyers increases trade size, however, and can erode the ability to produce alpha for all clients (but not supplier revenues). For discussion of incentives for firms to grow beyond the optimum size for their clients, see Perold and Salomon [1991]. 3We could look at other objectives, but our focus is on pension fund alpha production. 455% of corporate and 47% of public fund executives next career choice is work in consulting or at an investment management firm (according to 1993 Survey of Plan Sponsor Backgrounds, Responsibilities and Career Plans, p. 16). These numbers are likely understated as they include some non-investment survey respondents who presumably have career aspirations other than consulting or with investment management suppliers.
2Cost 1See,

The 1993 Plan Sponsor Compensation Survey, p. 11, reports for public funds an 8.6% participation rate in bonuses with a 7% mean bonus yielding a 60 basis point average bonus. For corporate funds 73% of fund executives participate in bonuses, but for only 27% is the bonus linked to fund performance. 5In corporate pension plans, boards are often made up of senior corporate treasury personnel whose expertise is corporate finance. In public plans, boards often include political appointees and representatives of current and future beneficiaries. 6See, for example, Kahn and Rudd [1995]. 7Index calculated using data as reported in Pensions & Investments (May 17, 1999). Data are for tax-exempt asset management firms market share for all active management firms. The Herfindahl index is: H = S2 + S2 + S2 + + S2 , where 1 2 3 n Sn equals the percentage share of the n-th firm in the market. See Gwartney, Stroup, and Studenmund [1995, p. 615]. In the market share for just top ten and top one hundred firms we see slight decreasing percentages of the total active management market. 8Consultants generally are capable firms that can offer sound advice, but they come with their own principal-agency burdens: the selling of research and advice both to pension plans and money managers, directed brokerage, and so on. The best business design calls for an accountable management as opposed to a joint management-consultant effort reporting to the board. Pension fund boards could consider outsourcing all their alpha production efforts to an outside service provider. This would be desirable for the funds that have difficulty meeting market compensation rates for management or for small funds that want to produce alpha but have diseconomies of scale. 9The 1993 Survey of Plan Sponsor Backgrounds reports 48.8% of corporate plan sponsor respondents foresee remaining at their current job between one and five more years (p. 29). 10Beneficiaries are most interested in the level of their benefits, and the cost of monitoring the efforts of the pension fund is not worth the effort. Even if the pension fund fails in its alpha production efforts, the reduction in its funded ratio happens slowly over time, and is not material for a single beneficiary. Some pension funds have constituent retiree groups that have organized themselves and monitor pension fund activities. This type of activity will likely increase with improved communication via the Internet. Still, its the plan sponsor that is on the hook for any asset shortfall. 11Ambachtsheer and Ezra [1998] define two pension fund RANVAs: a policy and an implementation RANVA. The implementation RANVA measurement would be applicable to a funds ability to create value above its policy benchmark, and would be the appropriate measure for evaluation of alpha production.
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REFERENCES
Ambachtsheer, Keith P. Todays Financial Food Chain: Getting the Customers on Top. Ambachtsheer Letter #150, June 30, 1998. Ambachtsheer, Keith P., Ronald Capelle, and Tom Scheibelhut. Improving Pension Fund Performance. Financial Analysts Journal, November-December 1998, pp. 15-21. Ambachtsheer, Keith P., and D. Don Ezra. Pension Fund Excellence: Creating Value for Stockholders. New York: John Wiley & Sons, Inc., 1998. Del Guercio, Diane. The Distorting Effect of the PrudentMan Laws on Institutional Equity Investments. Journal of Financial Economics, 40 (1996), pp. 31-62. Ennis, Richard M. The Structure of the Investment-Management Industry: Revisiting the New Paradigm. Financial Analysts Journal, July-August 1997, pp. 6-13. Gwartney, James D., Richard L. Stroup, and A.H. Studenmund. Economics: Private and Public Choice. Orlando: The Dryden Press, 1995.

Kahn, Ronald, and Andrew Rudd. Does Historical Performance Predict Future Performance? Barra Newsletter, Spring 1995, pp. 1-20. Lakonishok, Josef, Andrei Shleifer, and Robert Vishny. The Structure and Performance of the Money Management Industry. Brookings Papers in Microeconomics, 1992, pp. 339-391. 1993 Plan Sponsor Compensation Survey. Callan Associates Investments Institute, 1993. 1993 Survey of Plan Sponsor Backgrounds, Responsibilities and Career Plans. Callan Associates Investments Institute, 1993. OBarr, William M., and John M. Conley. Managing Relationships: The Culture of Institutional Investing. Financial Analysts Journal, September-October 1992, pp. 187-193. Perold, Andr F., and Robert S. Salomon, Jr. The Right Amount of Assets Under Management. Financial Analysts Journal, May-June 1991, pp. 31-39. Persson, Torsten, and Guido Tabellini. The Size and Scope of Government: Comparative Politics with Rational Politicians. Discussion Paper No. 2051, Centre for Economic Policy Research, London, 1999.

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