More Organizational Resources Do Not Translate into Higher Returns

In recent decades, a shift toward increased participation in financial markets has been observed. It moves from a relatively small number of individual investors to more widespread exposure to financial markets, through investment funds that manage individual savings. Small investors entrust their capital to professional managers who take care of investing it in the financial market. To have an idea of ​​the magnitude of the phenomenon, institutional investors in the United States control approximately 70% of the stock market; among them, mutual funds control a third of market capitalization.

These asset management companies currently employ hundreds of thousands of people in the aggregate, as financial analysts and for doing portfolio research and management. Despite such deployment of human resources, well-established academic literature and common knowledge among industry players suggest that medium-term investment performance of funds yields returns, net of commissions, that are significantly worse than those of passive benchmarks, i.e. portfolios which can be reproduced almost automatically. Why, therefore, do they employ such a large number of employees?

This question is the basis of a study I recently conducted with Lenny Kostovetsky of the Carroll School of Management at Boston College. Based on a sample of more than 10,000 RIAs, Registered Investment Advisers, we have analyzed which clients, asset classes, and strategies require larger amounts of human capital, as well as the added value of human capital itself in investment management.

Our results indicate that a larger number of employees does not appear to be correlated with better performance, controlling for size of investment portfolio managed by the company. Conversely, a higher number of employees in a RIA firm appears to attract a larger volume of capital flows. The stronger business would therefore justify the higher costs (for example in terms of salaries) incurred by RIA firms. Our analysis also suggests that RIAs with large number of employees tend to exhibit a so-called closet-indexer behavior: their investment portfolios keep close to the asset composition of passive benchmarks, in spite of the fact that RIAs state they follow active investment strategies.

In other words: a larger staff does not guarantee higher returns on investment; actually this translates in investment strategies that individual investors could play by themselves at more limited cost, for example by purchasing Exchange-Traded Funds (ETFs). This suggests that some asset management companies are conscious of their own limitations in generating yield (the so-called alpha), and therefore choose to steer their efforts towards attracting clients, rather than defining original investment strategies. From the point of view of the shareholders of asset management companies, this is not a bad thing: they still make profits. From the point of view of savers, however, there is what economists call an agency problem, linked to the possible conflict of interest with asset managers who, while declaring they have an active management of investments (and hence extract higher commissions), actually follow a passive strategy.