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Rekenthaler Report

The Fund Industry’s Brain Drain

It’s not an entirely bad thing.

In Demand
I know a recent college graduate who majored neither in business nor engineering. Common wisdom says that such students struggle to find work. Common wisdom is wrong. It applies, loosely and with many exceptions, to ordinary students, but not to the extraordinary. Excel at the SAT, gain admission to a top university, and then excel again, and the corporate gates will open.

This young man accepted an offer from a fund company, to assist with its active portfolio management, at a salary of $120,000. The decision to enter the fund industry was against the trend. In 2006, 46% of Princeton seniors who had jobs lined up when they graduated chose finance. Many joined mutual fund companies, to work in research or investment management. However, because of the 2008 financial crisis and the success of index funds, the percentage of top grads entering the fund industry has slipped.

Glory Days
The heyday for mutual fund employment was from the late 1980s through the mid-1990s, when technology startups were just beginning to become glamorous and when star mutual fund managers were household names (at least, to upper-income households). At that time, fund companies sat atop the recruiting food chain, vying with the elite management-consulting firms, the investment bankers, and a handful of other industries for the top graduating talent.

The brightest of the industry's stars were at Fidelity. And why not? The company was the largest mutual fund manager, with more than 100 billion dollars in its U.S.-stock funds and more assets coming in daily. It hired young, on the theory that it was better to teach an adept but untrained mind than to attempt to retrain an experienced investment professional. (As far as Fidelity was concerned, any experienced applicant needed to be retrained, because by definition that employee's previous company was inferior.) New hires would not only be well paid and possess jobs of true responsibility, but might also be rapidly promoted.

The advancements could be quite swift. If all broke right, a 22-year old college grad could be managing one of the company's sector funds three years later, and then a newly created diversified-stock fund two or three years after that. If he (almost always a he) succeeded at those tasks, he could be promoted to managing one of Fidelity's large, established stock funds shortly after his 30th birthday. Less than 10 years out of college, and a career already made.

The process worked. Fidelity's efforts to track down the elite, and pay them accordingly, were fully justified by its results. The stock market circa 1990 was mostly efficient, but there were cracks. The biggest institutional investors, such as Fidelity, had data and computational advantages. They could buy databases that others could not afford and could crunch the numbers faster. They also enjoyed better information from CEOs than is possible today, as the SEC has since cracked down on behind-the-scenes "guidance" from corporate managements. Fidelity succeeded, through better information, better technology, and the best available personnel.

A Clear Pattern
Let's see the evidence. The chart below shows the trailing three-year total-return percentiles for Fidelity's "growth" and "growth and income" funds, as they were called at the time, relative to other funds in their Morningstar Category. The randomly selected date is Jan. 31, 1991. For purposes of illustration, I reversed the usual Morningstar approach of putting the top fund in the first percentile and the bottom fund in the 100th. For this chart, 100 represents the best performance. The bigger the bar, the better the relative return. 


  - Source: Morningstar

Of the 12 Fidelity funds, eight placed in their category's top quintile. The lowest performer landed in the 55th percentile--barely worse than the category average. In the early 1990s, buying a Fidelity stock fund meant the possibility of outstanding relative returns with little downside. It is no wonder that, although Vanguard and DFA had started to become major industry presences, Fidelity's U.S.-stock funds held considerably more assets than did their indexed rivals.

The Pattern Disappears
The times have certainly changed. The next chart portrays the same information as the first, using the same scheme (bigger bars are better) for a similar group of Fidelity funds, through Oct. 31, 2017. The picture is altered. The previous dominance has been replaced by randomness. By and large, the typical Fidelity large-company U.S.-stock fund behaves like the typical large-company U.S.-stock fund from other houses. Some are better, some are worse. Most are somewhat in the middle.


  - Source: Morningstar

Fidelity is but one example; the pattern holds across the industry. Once, many mutual fund companies, in many investment categories, boasted consistently good numbers, such that one could reasonably believe that they enjoyed a competitive advantage. Nearly all those outperformances are gone. It is not that those previously successful companies reverted to the mean and were replaced by new winners. It is instead that the winners have disappeared, because of an increase in competition that has leveled the playing field. Fund companies these days don't hit .400.

Which returns us to the brain drain. Because the markets have become more efficient, the payoff to fund companies for investing in their research teams has shrunk. Also, most active funds are losing shareholders rather than gaining them, such that even an active fund that performs strongly might not receive new assets. That also means limited chances for promotion for aspiring young researchers. Put that all together, and it means that today's fund companies can't and won't attract as many high achievers into their investment-management groups as in the past.

The Bright Side
While the market's higher level of efficiency isn't necessarily a boon for fund investors, or for those seeking portfolio-manager careers, it does have positive social effects. The more efficient the financial markets, the better the capital allocations. In addition, some economists (and Warren Buffett) have long argued that finance shouldn't be employing the nation's best and brightest. They should be instead working in more-productive industries, at companies that do more to improve people's lives--such as  technology.

Such critics will be happy to hear that my young friend no longer works in investment management. He works for Uber--and I don't mean driving. 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.