Why The Performance of Money Managers is Designed to Make Them, Not You, Rich

At this point, the enduring popularity of high-paid money managers is a mystery. People trust them to manage their money, paying them handsomely to beat the market. But they rarely do. After accounting for fees, money managers’ picks often underperform much cheaper funds that simply and passively invest in a benchmark index.

This fact perhaps wasn’t as well documented back in 1940, when Fred Schwed wrote his classic sendup of Wall Street, “Where Are the Customers’ Yachts?” But it’s clear that Schwed was onto something. That, and his delight in roasting Wall Streeters, may explain the resurgence of his book in recent years.

Where Are The Customers’ Yachts?

In his book, Schwed tells the story of an out-of-town visitor who is being shown Lower Manhattan, when his guide points to the yachts in the harbor and says they belong to brokers and bankers. The tourist then asks, “Where are the customers’ yachts?”

Possibly apocryphal, the anecdote reflected sarcastic and cynical Wall Street humor regarding the nature of the business and who benefited most, and Schwed used the quip as the title of his book, which was published in 1940.

Schwed questioned the value of the advice the financial services industry gives to its customers and insinuated, like Gordon Gekko in the film “Wall Street,”  that money managers simply throw darts at a board.

“The principle of ‘managed’ investment trusts is absolutely sound, granted only one premise…. there are somewhere people of such experience and insight that they can predict with some sort of accuracy the future behavior of securities,” Schwed wrote.

Money Managers Paid Regardless

In most industries, failure to consistently deliver objectives is punished. Active money managers, on the other hand, continue to get paid higher rates than those running passive funds, even though it’s been well documented that active managers don’t outperform passive funds. That’s why no less than Warren Buffett says the average investor should simply put their money in an exchange-traded fund (ETF) that tracks the S&P 500 index.

Active or passive, most money managers are paid regardless of performance. The typical fee structure is to charge a percentage of assets. That means their income is tied to the amount of money they manage rather than how well they manage it.

It could be argued that the amount of money invested in the fund will only grow if it performs well. True or not, the latest figures indicate that investors seem to be catching on to the futility of active management. In 2024, for the first time ever, assets in passive mutual funds and ETFs surpassed those in actively managed funds.

Misaligned Incentives

The way active money managers are compensated can encourage mediocrity over taking risks to actually try to beat the market, which is what they are paid to do.

Being conservative ensures a steady pay rise while minimizing the risk of a tarnished reputation. Marketing is key to bringing in new capital, and a steady return is easier to market than losses. This all helps explain why many money managers hug indexes.

At the same time, managers are pressured to be active and differentiate themselves from the market they’re tasked with beating. This, too, can work to the detriment of investors. Making the right picks is extremely difficult, and each move incurs transaction costs, which investors pay for and also eat into returns.

On paper, mediocrity can be painted in a positive light. However, the returns advertised are often an illusion. Subtract the fees, and the result is disappointing. And even a run of good luck is no guarantee of future success.

The Bottom Line

Wall Street money managers have long been accused of being more concerned with lining their own pockets than their customers’. The idea of having a “pro” handle your money is comforting. The problem is beating the market, the task they advertise, which is extremely difficult, and the money managers’ quest for fees rarely aligns with their clients’ quest for superior returns.