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Investment Management

Defining Events

From the date the Massachusetts Investors’ Trust emerged in 1924, recognized as the first open-end mutual fund, the industry matured and career paths within the field became more clearly defined. The modern financial markets as they exist today began taking shape. What were some of the defining breakthroughs that made all of this possible?

Government intervention in the 1930s created the foundations of the modern financial system, picking up the pieces after the stock market crash in 1929 and the economic depression that followed, hitting bottom in 1933. The creation of the Securities and Exchange Commission (SEC), the passage of the Securities Act of 1933, and the passage of the Securities Exchange Act of 1934 taken together put in place safeguards to protect investors: mutual funds were required to register with the SEC and to provide disclosure of risk in the form of a prospectus.

The Investment Company Act of 1940, called the “truth in securities” law, laid out the standards by which mutual funds (though not hedge funds) price securities and promote their funds. Investors in a mutual fund don’t directly own stocks, bonds, or other securities; they own shares in an SEC-registered company (an investment company) that in turn holds positions in various securities. The lawmakers’ intention was preventing conflicts of interest when mutual fund shares are offered to the public.

The Employee Retirement Income Security Act (ERISA) enacted in 1974 was another watershed event, both for investors and for investment professionals. The ERISA law was enacted to deal with a growing problem: under-funded or poorly managed corporate pension plans, a problem of such magnitude that it threatened the stability of the U.S. corporate pension system.

Among other things, the ERISA law: 1) required plan sponsors to disclose information about the financial health of the plan to plan beneficiaries; 2) held plan sponsors to a fiduciary responsibility in selecting money managers to invest plan assets. In practical terms, this meant that a plan sponsor couldn’t simply hire his brother-in-law to manage the investment portfolio. He had to follow a formal selection process, issue a request for proposals, review the proposals from asset managers, and make a recommendation to plan trustees.

Since most plan sponsors didn’t have the time or the resources to screen 5,000 equity managers (if an equity manager was needed) they turned the business of selecting managers over to an independent professional—the pension consultant. These pension fund consultants became the indispensable middlemen standing between the plan sponsors and the community of investment managers. The process of selecting managers became more streamlined and efficient, effectively giving money managers access to a much wider universe of corporate, multi-employer union sponsored and government sponsored pension plans.

401(k) Defined Contribution Plans and IRA Accounts—The Individual Market Opens

Four years after enactment of the ERISA law, government intervention—this time in the tax reform act of 1978—once again opened up an entirely new market for investment managers to tap into—the individual investor market. Benefits consultant Ted Benna discovered a loophole in the ’78 tax law, an obscure provision that he thought might allow a company’s employees to save more for retirement—independent of the corporate pension plan—through tax-deferred contributions into a company sponsored savings plan. The U.S. Internal Revenue Service provisionally approved Benna’s idea in 1981. The first 401(k) accounts, named after enabling section of the tax code, were opened later that year.

Federal legislation in 1981, the Economic Recovery Tax Act, broadened the market for another popular savings plan, the Individual Retirement Account (IRA) by allowing anyone under age 70 ½ to make tax-deferred IRA contributions regardless of whether they were participants in a company sponsored retirement plan. (Roth IRAs, expanding the self-directed retirement account still further, were introduced in 1997. Roth IRAs allow earnings to grow tax-free.) These developments prompted individual investors to focus on long-term savings and spurred the formation of a private pension fund market. Defined contribution plans such as 401(k) plans and similar 403(b) plans in the nonprofit world caught on fast with employers eager to lower their employee retirement costs.

During this period, the investment industry attracted many new start-up firms and became more fragmented and competitive. “Specialist” firms formed to manage individual and institutional assets or focus on a particular market niche, such as high-net-worth individuals. Many specialists responded to an expanding market by adding product offerings and marketing their new services and capabilities.

This competition added extra dimensions to the asset management industry. Investment skills, of course, remained critical. However, relationship building, marketing, and the professional presentation of money management teams became crucial for success.

Mutual funds became popular investment choices in the growing IRA and 401(k) market. The funds had been around for decades, but they generally were only used by financially sophisticated investors. This changed in the 1980s as fund companies greatly expanded their menu of fund offerings and ramped up marketing to individual investors. Asset management firms began heavily marketing mutual funds as a safe and smart investment tool, pitching to individual investors the virtues of diversification and other benefits of investing in mutual funds.

Individual investors also had more information at hand to analyze and compare competing mutual funds. Fund rating agencies such as Lipper (founded in 1973, now a part of Thomson Reuters) and Morningstar (founded in Chicago in 1984) increased investor awareness of portfolio performance. These rating agencies publish reports on fund performance and rate funds on scales such as Morningstar’s five-star rating system.

With more and more employers shifting retirement savings responsibilities from pension funds to the employees themselves, the 401(k) market grew rapidly. Consumer demand for new mutual fund products—the preferred choice in most 401(k) portfolios—exploded.

Competition among fund providers stirred up a wave of consolidation and globalization as mutual fund companies and investment firms acquired other firms and expanded their distribution channels to Europe, South America, and Asia. Brand recognition and advanced distribution channels (through brokers or other sales vehicles) became key success factors for asset management companies.

More than ever, asset management companies are focusing on more than investment research and stock picking. Marketing, compliance reporting, client servicing and technology integration all play a vital role in the success of investment management firms. Those developing a career in this field have many options to look over besides those in the investment side of the business.

Mutual fund marketplaces such as Charles Schwab’s, appeared starting in the early 1990s, making it much easier for individual investors to pick and choose no-load mutual funds (funds with no sales charge or brokerage commission) for a large number of mutual fund families. Fund distributors—led by Schwab, Fidelity Investments, and TD Ameritrade—also gave investors free analytics to track investment returns and buy, sell, or trade funds as needed.

Alternative Investment Styles Become Mainstream

During this period, roughly since the 1990s and continuing to the present day, alternative investments (and alternative investment strategies) became mainstream investments, accepted by more sophisticated individual investors and large institutions (pension funds, endowments, etc.) as a necessary enhancement to an investment portfolio.

Alternative investments, in short, have become more accepted by wealthy individual investors over the last decade or so. Not only are they more popular today, there are many more alternative products available, so these types of investments are within the reach of a much broader universe of investors than, say, 15 to 20 years ago.

Wealthy investors moved aggressively into alternatives in the decade starting in 2000, a period when inflation adjusted equity returns in the broader stock market—the Standard & Poor’s 500 for instance—were mostly flat to negative. Hedge funds that shorted the equity markets in the 2008-09 recession (selling stocks expecting prices to fall) did exceptionally well in a very turbulent market.

What are alternative investments? Any investment product other than stocks, bonds or cash (traditional investments) is usually classified as an alternative investment. Some of the most common alternatives are limited partnerships, managed futures, private equity, real estate investment trusts, and venture capital. The alternatives are favored by institutional investors and accredited high net worth investors (individuals with at least $1 million in investable assets, excluding real estate) looking for asset diversification and protection against market volatility.

Alternative investments are in demand because they usually don’t move in lock-step with the broader equity and fixed-income markets; when the broader equity markets are caught up in a market correction (falling prices), the alternatives tend to go their own way. Investment pros say the alternatives—hedge funds, private equity, venture capital, etc., have a low degree of correlation with the broader equity and fixed-income markets.

This doesn’t always happen, of course, and there are no guarantees the alternatives will produce positive investment returns every year. But for an investor with a five to 10 year investment outlook, holding small amounts of alternative investment products has been demonstrated to produce higher investment returns while dampening the effects of up and down market swings that give investors a dose of anxiety whenever the stock market is in free fall. This extra cushioning alternative investments offer comes at a price, namely a longer holding period and higher management fees paid out to the investment manager.

Over the past decade or so, a growing number of traditional mutual funds behaving much like hedge funds, so they can claim to offer positive returns in both up markets and down markets. Some examples are the long/short funds and the 130/30 funds. The 130/30 fund has a mandate that says the portfolio must be 30 percent short, and use those “borrowed” funds, to purchase an additional 30 percent of stocks, making the long position 130 percent. Examples of 130/30 funds include the Vanguard Emerging Markets Bond Fund, Weitz Partners III Opportunity Fund, and Guggenheim Alpha Opportunity Fund. (While a long-short fund’s mandate gives it the ability to short-sell, the fund has no obligation to do so. One analyst working for a long/short product stated: “We haven’t been short a stock in over a year.”)

Still, traditional fund companies are clearly migrating toward alternative strategies. “Over the past decade, new alternative vehicles and new platforms have become available to the high-net-worth retail sector, including feeder funds that aggregate smaller investors, money funds with alternative strategies and non-traded interval funds, which make periodic repurchase offers to their shareholders,” according to an article about the trend at CNBC.com.

Compared to traditional investments such as mutual funds, alternative investments are less regulated. Hedge funds, which are essentially commingled private investment pools, don’t have to follow the same rules as mutual fund investment companies so investors receive less information. Larger hedge funds must register with the Securities and Exchange Commission, a requirement added by the Dodd-Frank Act, the financial reform legislation enacted in 2010. These added disclosures make the hedge fund world more visible to the investing public, or as investment pros like to say, more transparent, than was the case only a few years ago.

For a sophisticated investor, alternative investments can be a prudent addition to the portfolio over the longer term. But they aren’t for everyone. These investments typically have higher management fees, compared to traditional investments, and are more illiquid. They are harder to unload if an investor has a sudden need to sell securities.

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