The need for an Apex Allocator

If you want to make money, work with money. Don't horse around making light bulbs. - Bruce Lee

I have seen the future of the OPM business and it involves a whole lot more fee compression. I recently learned how some "zero-fee" ETFs operate. There are different models. Some charge no management fees, but charge a performance fee. Others charge nothing in the first few years, but plan to charge eventually. Another model is to earn fees by engaging in securities lending of the ETF's holdings (ie facilitating stock borrows for short-sellers in exchange for interest payments). I wasn’t aware of this third approach, it shows how every little edge is being exploited by cost leaders.

Then there are commission-free brokers. They have five sources of revenue (interest on cash balances, margin lending, securities lending, payments for order flow and forex). Robinhood in the US is a pioneer in this field. It got to 2 million clients without doing any digital marketing. It simply decided to instigate a price war in its industry. It got a lot of PR and had a strong referral program.

And now, there's a credible zero-fee robo-advisor in the US, SoFi (aka Social Finance). What's the model behind it? There's no revenue model. SoFi's core operation is lending (student loans, personal loans, etc.). They simply offer free investment management as an adjunct product for existing customers or conversely, as a loss-leader to attract new ones. SoFi has raised more than $2 billion in funding. It has signed a deal for the naming rights to a football stadium for a rumoured $500 million. It is lead by the former CFO of Twitter (and Goldman Sachs alum). SoFi has close to a million clients for its main products. But it has only gotten 26k clients for its robo service and $106m in AUM as of mid-2019. The Globe would probably call that a super flop.

I can fearlessly predict that robo-advising will eventually go to a flat subscription price model that may well approach zero. Pricing based on account value (aka ad valorem pricing) makes no sense. It's a tax on wealth. I certainly don't think anyone will be able to charge 50 bps for it long-term.

The broader investment management industry is by and large not responding properly to these threats. The Globe provided a very good example of this in its Wealthsimple takedown: the Investors Group Mackenzie Dividend Fund charging 2.4% MER vs 0.67% for a comparable Horizon ETFs - despite weaker performance. (The higher fee and weaker performance are probably two sides of the same coin). That fund has $12.5 billion in AUM.

Of course, even a single dollar allocated to a dividend fund is misallocated, regardless of fees, since a dividend yield is a superficial indication of the investment merits of a company. Jeff Bezos keeps saying it's Day 1 for the internet revolution. Similarly, I think the investment world still has strong elements of astrology within it. This week, I saw the inexplicably high readership numbers of a macro newsletter that publishes typical macro garbage: commodities, Federal Reserve conspiracy theories, words ending in "flation", etc. Many of the clients presumably read this on company time. This is just one example of many of the people working in OPM also being a major misallocation of human capital. Present company excluded, obviously, I'm not an animal.

Many funds are like North Korea - they’re a cult of personality where some delusional leader exploits a populace deprived of the right information. The march of progress through education, technology and business model innovation will address such economic inefficiencies, as it has in other aspects of life. If you have a spare bedroom, you can monetize this underused asset through Airbnb. If your car is spending most of the day parked, there's Uber. There are now companies to auction off unsold first-class seats in planes. But I believe the greatest opportunities are in the OPM business. A good investment manager with poor marketing is like a hotel with unsold rooms. If your capacity is $5 billion AUM and you only have $500m AUM, you have excess capacity that goes to waste every day.

Did you know that the New York Times stock has outperformed Apple in the past 5 years? I think the newspaper industry is much further along in its evolution than the money management industry. That is, in sorting out survivors vs zombies. I am confident that sooner or later, these inefficiencies in OPM will be sorted out (though there will always be a minority of investors interested in gambling). Businesses like Airbnb and Uber are trivial compared to the potential of an entity intent on re-organizing the misallocations of capital between investors and investment products. I don't believe anyone currently has a model that combines all the necessary elements of marketing savvy, customer-centricity, investment rationality and cost-cutting. Spending half a billion on a stadium deal doesn't cut it.


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