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December 19, 2017

Think Twice About Becoming a Portfolio Manager

This morning I saw a job posting for a Global Equity Portfolio Manager role in Toronto. The base pay was $200,000 with total compensation ranging up to $600,000.

Let me repeat that: Total compensation was up to $600,000. Per year. Every year.

What are the requirements for such a prestigious role, you ask? The ability to convert water into wine? The answer to the meaning of life? Or perhaps a more reasonable track record of outperformance versus a benchmark?

Nope. None of the above.

The right candidate simply needed 10+ years of experience in a similar role managing money. In other words, the person needed to be experienced, but perfectly average against their peers.

The posting didn’t ask for someone who has an above-average track record because this would dramatically restrict the pool of candidates, thus increasing the expected compensation well into the 7-figure range. The outperforming investment manager is an expensive unicorn – a unicorn that happens to revert back to the mean 9 times out of 10. So, instead of searching for a unicorn, the asset management firm hires for average.

Portfolio management departments of asset management firms are filled with such people - experienced, but perfectly average investment managers and research analysts. These folks are smart and knowledgeable, but they tend to lack any credible evidence that they can deliver on their mandate in any way better than their colleagues or an index. So you are left with a department filled with average managers and analysts eating up millions of dollars in salaries, research software and travel expenses.

Staffing an asset management shop is expensive, however asset management revenues (received via management fees) continue to shrink. Management fees are shrinking for a multitude of reasons, none of which paint a good picture of the exalted portfolio manager: 1) Forecasted market returns are lower, thus management fees must decline to somewhat compensate, 2) new cheaper investment products are available to all (i.e. index funds), and 3) a quarter century of research shows that it is almost impossible for anyone to outperform the market after costs on a consistent basis.

Today, the model is still profitable, but as pressure on fees intensifies something will eventually break.

The rift between revenues and expenses will widen, but only one of those things can be controlled by the company. Cost cutting will be critical to the survival of asset managers over the next decade and portfolio management and research is one of the fattest parts of the business, especially when evaluated in terms of contribution to investment performance.

When people get too expensive for the value they create salaries decline or machines move in. This is precisely why manufacturing is more capital intensive in Japan and America than in China or Mexico. Already, algorithms and artificial intelligence (AI) are taking the place of humans in the asset management business. Some firms are spinning this as a novelty, while other asset managers have used some form of AI at the core of their operations for years.

Still, the vast majority of investment management is performed by fallible, underperforming human beings. The avalanche has yet to start, but all it takes is a single snowflake to trigger motion that will change the landscape forever.

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