Is Active Fund Management a Market for Lemons?

Prior to being awarded the Nobel Memorial Prize in Economic Sciences, economist George Akerlof authored the seminal paper: “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (1970). The piece focused on the used car market in the United States with a central contention that an information asymmetry existed between buyer and seller, which led to low quality cars (lemons) being overpriced and high quality vehicles under-priced; the consequences  for the market were considered as follows:

– Withdrawal of higher quality vehicles.

– Reduced size of market.

– Reduced average quality.

– Reduced average willingness to pay.

Though the ‘information asymmetry’ term is somewhat oblique, the core concept is simple – where the seller knows more about the product than the buyer, this can be used to their advantage.  Whilst the prospective purchaser can make a general assessment of a car’s qualities, they are likely to have limited knowledge of its detailed history.  In the absence of this information, it is difficult for the buyer to differentiate between cars of contrasting quality except by judging headline factors such as appearance.  This leads to a price convergence between low and high quality cars as buyers are unable to accurately distinguish between options, and a subsequent withdrawal from the market by those offering higher quality vehicles.

I previously held the view that the active fund management industry was consistent with the ‘market for lemons’ concept, but, on reflection, whilst there are certain echoes, the impact of quality uncertainty in active management is distinct.  Most notably, in Akerlof’s example, the condition is created by a significant disparity in the awareness of a product’s quality between buyers and sellers – the aforementioned information asymmetry.  However, in the case of active management, doubt over the quality of the product is true for both buyers and sellers – neither party is certain that skill exists. Although there may be an informational edge held by asset management groups regarding the underlying quality of their active offerings, this is likely to be marginal and often erroneous.

The central problem of the market for active fund management is the subjectivity around what constitutes quality (or skill) and the spurious use of past performance as an indicator of said quality.  From a buyer’s perspective, at the point of purchase it is difficult to know with certainty whether one has purchased a manager with skill or a ‘lemon’.   In addition to this, given the randomness of outcomes inherent in financial markets, even if a manager with skill is correctly identified – there is no guarantee that positive outcomes will be delivered.

In the majority of purchasing decisions – a washing machine or TV, for example, – there is a reasonable level of clarity over what the key indicators of quality are and how they might influence the product’s cost.  In the case of active fund management, it is far more difficult to ascertain what characteristics define quality and how they should be valued.  Given this uncertainty the temptation is to depend on past performance as the best indicator of quality / skill; a situation which allows many ‘lemons’ to masquerade as high quality active funds merely due to good fortune.

The reliance on past performance as the primary marker for quality also leaves investors vulnerable to a distinctive aspect of the active fund management market –  ‘evidence’ of historic high quality (strong past performance) may actually increase the probability that future outcomes will be of a lower quality (poor performance through mean reversion).  This is a perverse situation, akin to a scenario where a hotel that has received consistently five star reviews on TripAdvisor is more likely to deliver disappointing holidays to future guests.

Given the majority of active funds producing sustained underperformance will close or be subject to manager change; we are left with a pool of active managers, most of which will have delivered outperformance for certain periods, some through luck, others skill (and a combination of the two).  Within this collection of managers the quality will inevitably vary significantly, and it is the challenge of differentiating between these (for both buyers and sellers) that gives the market for active management its most distinguishing features:

– Proliferation of active strategies / Reduced average quality:  The subjectivity around what constitutes quality and the randomness of performance (particularly over shorter-time horizons) means that a vast number of low quality / unskilled active strategies can exist, creating a bloated market.

– Homogeneous pricing:  The problem of discerning between different levels of quality leads to minimal distinction between active fund costs.  Active funds with no evident skill (which should cost zero – at most), are priced under the assumption that they do possess skill; whilst the highest quality offerings may struggle to charge a ‘premium’ price to the wider market because the buyer is uncertain over their true quality.

– High average price relative to average quality: The entire market is priced as if skill is pervasive.  On balance, there are a greater number of lower quality funds overcharging, than there are higher quality funds ‘undercharging’; thus, the average price for active management is skewed upward.

– Withdrawal of highest quality operators:  This is perhaps a factor at the margins, with certain high quality operators moving away from the mass market and into (even more) rewarding fields, such as hedge funds.  This move, however, will also be attractive to unskilled participants, who wrongly believe they possess skill.  Overall, the market is currently sufficiently lucrative for the majority of participants to remain.

In essence, the structure of the market for active management is defined by a cocktail of random markets and our own behavioural frailties.  Our focus on the short-term, obsession with outcomes and susceptibility to compelling narratives serves to cultivate its core characteristics.  Whether these features are indelible or materially vulnerable to the changing investment management landscape witnessed in recent years, remains open to question.

Key reading:

Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 488-500.

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