By DAVID MOON, Moon Capital Management
Despite the anemic returns in the stock market this year, investors continue
to pour money into their 401(k)s, almost all of it into mutual funds. Some
investors use this as rationale that stock prices must continue to increase,
since more money equates to more demand. There are other consequences of
this phenomenon, most of which are much more likely and influential.
Mutual fund companies don’t improve their profitability by producing better
investment returns. The most immediate impact to the bottom line of any
money management company results from an increase in new assets to manage.
New assets can come from two places: market appreciation and new deposits.
New deposits are usually a much more predictable source of increased
Since managers have a greater incentive to attract assets rather than improve
returns, they become more concerned with mimicking the returns of an index
(usually the S&P 500.) Relative performance is more important than absolute
performance, because three or six months of underperforming the index will
result in lost assets – and lost revenue.
Too many mutual funds companies are now marketing organizations, not
More managers migrate toward the same stocks that comprise the S&P 500,
concentrating greater assets into these securities. They have to,
otherwise their returns might differ from everyone else’s. A premium is
placed on short-term performance, creating an exaggerated move of money to
momentum driven portfolios.
While this is happening, the quality of the research produced by Wall Street
firms is also declining. Investment banking used to provide the primary
(and in some cases, the only) source of revenue for research departments.
With the admitted scandals in these research departments, a separation is now
supposed to exist between research and investment banking. Analysts who
used to produce hundreds of millions of dollars in investment banking fees are
now cost centers. Coverage is declining, and the research that is being
done is performed by people who expect less compensation – these are less
experienced, junior analysts.
Another factor diminishing the value of Wall Street research is SEC
Regulation FD. Back in the good ol’ days, public companies would basically
do the work of the Wall Street analysts. CFOs and investor relations
executives would “whisper” signals about upcoming earnings and changes in their
business. Reg FD eliminates that, forcing analysts to do something new:
The result of these changes is that more opportunities are available for
investors who are willing to be different. The ability to actually analyze
data and understand companies is now more valuable than in any time in the last
fifty years. The key is that investors must be willing to accept returns
that are non-correlated with the short-term movements in the overall
market. The unknowing sheep of Wall Street follow in the same path, afraid
to be different. As legendary investor John Templeton said, “if you want
the same returns as everyone else, buy the same securities as everyone
else.” That’s a guarantee of, at best, mediocrity.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).