Professional money managers can trace their lineage to the advisors of pharaohs and ancient kings. Although the title has changed many times over the centuries, money managers are primarily concerned with helping people produce a good return on their capital. In this article we will look at the development of the money management profession in the United States and how it impacts professional money management today.
The Prudent Man Rule
Early money managers in the U.S. were mostly employed in maintaining estates and trusts - there were no mutual funds for small investors. The money management guidelines for the U.S. were set by a court case in the 1800s. John McLean of Boston died in 1823 leaving an estate of $50,000 – a handsome sum at the time – to be held in trust for his wife. Upon the death of his wife, the remaining amount would be split between Harvard and the Massachusetts General Hospital.
When Mrs. McLean died in 1828, the disappointed recipients found the estate had lost almost half its value because the trustees invested in dividend-paying stocks rather than more conservative bonds. Harvard and Massachusetts General sued the trustees, demanding that they pay the difference. In 1830, Judge Samuel Putnam ruled in favor of the trustees because he saw money management as a venture where the manager must be free to act as long as he acts in what he honestly believes to be the best way. This became known as the prudent man rule and it was the base upon which American money management was built.
The prudent man rule was a Boston decision and Boston money managers read the rules as an encouragement to make money for their clients. Boston money managers were considered the guardians of old money, while the New York banker was seen as the creator of new wealth. Benjamin Franklin's will donated two large lump sums to both Philadelphia and Boston to be managed locally for 100 years and then dispersed. The Boston endowment tripled the performance of its Philadelphian brother. The difference was that Philadelphia sought to preserve capital whereas Boston, adhering to a liberal view of the prudent man rule, both risked and gained more. The moral was that, with good managers, more freedom means more risk-taking and potentially higher reward. Boston's freer view of money management made it the center of innovation in money management, including the creation of mutual funds.
Cabot and State Street
Money management grew with the explosion of the stock market and trusts. Fraud abounded as average people were sold on closed-end trusts and other blind investments that acted as a dumping ground for garbage securities. The public was being lured in by sensational promotion and then defrauded. Paul Cabot was one of the few money managers who publicly denounced these money managers and their practices. His State Street Investment Corporation, one of the first mutual funds in America, set high standards for money managers in the post-crash backlash of the 1930s. Cabot focused on stocks more than bonds and his career record ranks among the all-time best. He went on to lead Harvard's endowment, taking it from about $200 million in 1948 to more than $1 billion in 1965.
Money managers all over the country imitated Cabot's techniques, if not his morals. As the market recovered and people returned to mutual funds, public interest in managers' performance grew. The media began following the successes and failure of money managers, and this trend would eventually lead to the performance cult thinking decades later.
SEC Changes the Game
Under the prudent man rule, a money manager faced no personal risk or professional requirements when handling a client's money. This basic precept was shaken when the SEC introduced the federal Investment Advisors Act (1940). The act mandated that anyone managing money for more than 15 people must be registered and that a public disclosure be made. The act gave the SEC broad powers to prosecute money managers and encouraged states to set their own additional regulations.
Thirty years later, the Employee Retirement Income Security Act of 1974 (ERISA) made more significant alterations to the prudent man rule. Now money managers were expected to conduct themselves "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."
The phrase, "familiar with such matters," suggested that money managers needed a specific education to be protected under the law. Furthermore, it encouraged a comparison to other managers in an "an enterprise of a like character and with like aims." Some took this to mean that the money manager could be sued for underperforming a peer and many rushed to get insurance against such suits.
Dirty Harry Guns Down an Industry
Although it was published in the 1950s, Harry Markowitz's portfolio theory came to the forefront in the uncertainty of the '70s as a way to protect investors and professionals. By balancing for beta, managers could satisfy questions about risk and their investors could count on the safety of diversity. Many pension fund managers piled into early index funds for legal reasons as much as for guaranteed market returns. However, when these funds were opened to the public in 1976 managers were hogtied. If they ventured too far from index fund betas to beat the market, they invited legal problems along with extra risk and reward. If they went the other way and became index huggers, then their investors were better off owning a low-fee index fund.
Money managers were essentially required by law to diversify in order to reduce risk. They had to buy many investments even if they were only able to fully research and be confident in a few. This led to the birth of the safe lists that all fund managers began to buy from, consequently leading to a standardization of mutual funds that reduced the diversity investors thought they were getting. Money management became a form of legislated mediocrity where investors saw meager returns and paid generous fees.
The dissatisfaction of investors grew even as the economy recovered. To avoid losing clients, money managers sought to provide funds that fit various investors' risk tolerance. This allowed them to step around the prudent man rule – they were legally protected as long as they followed the investing strategy laid out in the fund's prospectus. The responsibility was placed on the individual clients to make sure the fund met their investing objectives and financial needs.
With the prospectus and portfolio theory providing a legal umbrella, funds could differentiate themselves once more. For this to work, investors needed to educate themselves about risk. For example, high-beta portfolios aren't necessarily bad, they simply race ahead of the market during a bull, and do worse than the market in a bear. The money-management profession was just starting to stabilize again when the efficient market theory and the random walk theory appeared to shake up the profession again.
EMH and Random Walks
The two theories suggested that a professionally managed portfolio and a randomly selected portfolio with the same beta – that is risk characteristics – will tend to have the same results. Another way to look at it, the money paid to a money manager in fees guarantees you'll do worse than if you randomly selected your own portfolio. The market was so efficient and so many rational investors were looking at the information, academics reasoned that it was impossible to outperform the market consistently – this was the efficient market hypothesis (EMH).
This has led to a compromise where investors' funds are split between passive and active management. It is impossible for all funds to be passively managed because blind indexing would necessarily lead to a long-term bubble of stocks on major indexes without active managers buying and selling to maintain prices. Simply put, too much passive management would actually cause the efficient market to run inefficiently. This would swing the pendulum back towards active managers able to profit from the inefficiencies. Investors hedge the risks of EMH and Random Walk Theory by placing investments on both the active and the passive side of the argument.
The Bottom Line
The history of money management is one of evolving responsibilities. Money managers went from being expected to act in good faith to being specially educated, to being measured against beta. The most important rule today is that money managers and clients understand each other. Investors who jump between managers excessively are partially to blame for their mounting losses from fees, but managers also bear responsibility to make sure the client understands their investment strategy – whether outperform in bull markets, protect against inflation, focus on dividends, etc. Although the rules have changed, the basic need for honesty in the investor and money manager relationship has not.
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