Murder on the Orient Express: The Mystery of Underperformance

Evidence increasingly shows that a “crime” of extensive underperformance has been committed in mutual funds, pension funds, and endowments. In a pattern reminiscent of Agatha Christie’s famous novel Murder on the Orient Express, an investigation leads to a surprising, if inevitable, conclusion: The usual suspects—investment managers, fund executives, investment consultants, and investment committees—are all guilty.Evidence shows that investment results for institutional investors—pension funds, endowments, and mutual funds—are below market. Although analysts, portfolio managers, broker/dealers, and consultants continue to enjoy high personal incomes and profits, we need to understand the causes of the disappointing performance. High incremental fees—relative to the value added over and above low-cost index funds—are one surprisingly major factor. Correctly stated, fees for active management are not “1%,” but 75–150% of the actual benefit. Although still “secret,” this specter haunts investment management.A surprisingly large majority of professionally managed funds fall short of their chosen benchmarks. And the magnitude of underperformance far exceeds the magnitude of outperformance. The shortfall hurts the ultimate clients of institutional funds. So, who is at fault?Active managers are obvious suspects. As markets have become increasingly professionalized—and thus increasingly efficient—competition has made it harder and harder for any manager or any firm to get ahead of the formidable competition. Suspicions mount when we see business disciplines and “asset gathering” increasingly dominate the values and priorities of the profession at investment firms.Investment consultants are surely suspect. Their business model focuses on getting and retaining clients, so their normal strategy is to urge clients to hire many different managers—diversifying the consultant’s “manager risk” but increasing costs to clients and adding complexity to manager management—firing laggards, hiring via “speed dating,” and, however unintentionally, coming between managers and clients rather than helping them build strong, “shared-understanding” working partnerships.Fund executives are certainly suspect. Disparagingly called “gatekeepers,” they are often understaffed and inexperienced with investments. Not empowered to make major decisions, they seem to serve only to facilitate hiring and firing decisions by powerful seniors on investment committees.Investment committees are obvious suspects. Most committee members are not experts on the intense challenges of contemporary investing. With the guidance of investment consultants, many investment committees misdefine their role as management—listening to presentations, hiring and firing managers, and so on—rather than concentrating on the important work of governance. Doing too much of the former and too little of the latter, they are unable to see that, ironically, their activities do more harm than good.Although all the suspects—active managers, consultants, fund executives, and investment committees—are contributing to the “crime” of institutional underperformance, the real fault is not with these performers but, rather, with the whole process of institutional investment management.The high costs—estimated at $10 billion to $20 billion a year—will continue until the process is changed. Until then, the process will be controlled by the agents whose incentives are not aligned with those of the principals.