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Investment management in the U.S. has always been a well-heeled endeavor. As an industry, even in troubled times investment management usually has been prosperous. But beginning in the 1970s, investment management became an even more lucrative business, in many cases leading to fabulous wealth.

Several factors contributed to the formation of what has become an investment management bubble: Mass-media marketing caused a broader slice of the U.S. population to view the industry's services as helpful if not necessary. More clients meant more assets under management. And more fees. The mutual fund industry experienced explosive growth. Institutional endowments also saw tremendous growth including from favorable demographic changes. And inflation and periods of increasing stock market values helped mask the investment manager's "take."

These factors and business norms - the perceived unseemliness of negotiating fees below "customary" levels - significantly alleviated pricing pressure on investment managers' fees.

But no more. Recent events indicate the accelerating deflation of a forty year bubble in the profitability of investment management. A golden era is beginning to experience a "perfect storm" of four converging factors.

The first factor is academic research revealing that the cost of active investment management is unjustified by performance. Today, the revelation is nearly incontrovertible. In the 1990s and early 2000s, that wasn't so. Back then, it wasn't difficult for full-price investment managers to dismiss as a fluke 10 or even more years of investment history indicating that broad-based, low cost index funds performed better on average, after costs and taxes, than investment approaches and vehicles more lucrative for managers. The stock market breaks of 1987, 2000, and 2008-2009 facilitated dismissal including by making comparisons not straightforward.

But accumulated data since the 1976 launch of the first index fund causes a similar dismissal - today -- to sound hollow. ("It is difficult to get a man to understand something when his salary depends upon his not understanding it." - Upton Sinclair.) Managers and consultants continue to be creative in their explanations of why the better performance of a low cost, index strategy is still a fluke after all these years. Here's a very recent explanation: "[w]eve been in a period of non-selectivity in the markets. An index in that environment should do better." See Are State Pension Funds Paying Wall Street Too Much?, August 15, 2012.

The second factor is competition from new entrant investment managers challenging name brand incumbents. Many of these incumbents are tarnished by their but-for-the-bailout failure during the 2008-2009 financial crisis, furthering the new entrants' competitive advantages. Firms such as AssetBuilder, Portfolio Solutions, and Wealthcare Capital represent the future via their low costs and academic underpinnings. Technological innovators such as MarketRiders, Personal Capital, and Betterment are examples of a second wave of low cost new entrants. These new entrants likely will multiply and grow and, as the winners sort themselves out, take meaningful market share from incumbents. (For an in-depth view of the newly competitive environment for investment management please see Private pursuits (The Economist), May 19, 2012).)

The third factor is today's ultra-low fixed income yields. Today's yields leave investment managers little room to maneuver to minimize the long-term effects of their fees.

The fourth factor is that the investment management costs of public pensions are starting to become a political issue. Electorates don't grasp easily that public pension underfunding, to which high investment management costs contribute significantly, eventually is borne at least in part by taxpayers. That fact is not yet a front-and-center issue for two main reasons: the lag times involved -- for example between fees to managers paid currently and underfunding that manifests itself in fiscal distress years later -- and the many factors besides cost that bear on net investment returns. But it's only a matter of time before high investment management costs become a signature issue for political candidates.

The campaign of Ron Elmer, who earlier this year ran unsuccessfully for Treasurer of North Carolina, is an example. Here's Mr. Elmer's response to a candidate questionnaire:

What do you see as the most important issues facing the Treasurer's office? If elected, what are your top three priorities in addressing those issues?

The biggest issue facing the Treasurer's office is the $3 billion hole in the state pension fund [the state retirement system] caused by poor investment management. For the first time since 1998 our state pension is underfunded.

The single biggest impact the State Treasurer can have on North Carolina is by increasing the investment returns within the $75 billion pension fund. We can reduce the burden placed on state taxpayers and still secure the rightful benefits earned by our faithful public servants.

First, I will stop and reverse the current flow of funds into the very high cost alternative investments such as hedge funds and private equity.

Second, I will massively reduce the exploding annual cost of investment manager fees of $300 million that is paid to external managers that essentially funds 3,000 high-paying jobs outside our state. I will "in-source" these investments at a fraction of the cost of the current policy of out-sourcing the investment management. We can save hundreds of millions of dollars each year and create a few investment jobs right here in North Carolina.

Third, I will increase the use of low-cost passive indexing as an investment strategy. At $75 billion, our pension fund is the 10th largest in the U.S. The fund is so large that once we add up the portfolios managed by the 200 external managers, the pension fund looks a lot like a very expensive index fund.

In summary, by eliminating or reducing Wall Street's $300 million drain on our pension fund, the state Treasurer could easily reduce the burden to the state by more than $1 billion over the course of a four-year term. There is not another public official that has the ability to increase state coffers by $1 billion without raising a single tax or cutting anyone's budget except the state Treasurer. But, it will take an experienced investment manager to do that. I am the only candidate in the race with any true investment management training and experience.

Mr. Elmer also noted that his election opponent held a successful fund-raiser on Wall Street.

***

Due to these four factors, the sun is setting on a golden era of U.S. investment management. As an investor, you're well advised to buy low cost, broad-based index funds. But if you're addicted to individual stock-picking, then at least steer clear of publicly-traded U.S. investment managers.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: The Bursting Bubble Of Investment Management Riches