The Agency Problem: The Difference between an Investment Firm and a Marketing Firm

Wall Street Journal's business columnist Jason Zweig frames the agency problem in a remarkably different light: the fiduciary duty of finance managers.

Excerpted from Mr. Zweig’s excellent speech entitled “Putting Investors First”, as published at his website (hat tip Tim Price) [bold mine]

How do a marketing firm and an investment firm differ?  Let us count the ways:

-The marketing firm has a mad scientists’ lab to “incubate” new funds and kill them if they don’t work.  The investment firm does not.

-The marketing firm charges a flat management fee, no matter how large its funds grow, and it keeps its expenses unacceptably high.  The investment firm does not.

-The marketing firm refuses to close its funds to new investors no matter how large and unwieldy they get.  The investment firm does not. 

-The marketing firm hypes the track records of its tiniest funds, even though it knows their returns will shrink as the funds grow.  The investment firm does not.

-The marketing firm creates new funds because they will sell, rather than because they are good investments.  The investment firm does not.

-The marketing firm promotes its bond funds on their yield, it flashes “NUMBER ONE” for some time period in all its stock fund ads, and it uses mountain charts as steep as the Alps in all its promotional material.  The investment firm does none of those things.

-The marketing firm pays its portfolio managers on the basis not just of their investment performance but also the assets and cash flow of the funds.  The investment firm does not.

-The marketing firm is eager for its existing customers to pay any price, and bear any burden, so that an infinite number of new customers can be rounded up through the so-called mutual fund supermarkets.  The investment firm sets limits.

-The marketing firm does little or nothing to warn its clients that markets do not always go up, that past performance is almost meaningless, and that the markets are riskiest precisely when they seem to be the safest.  The investment firm tells its customers these things over and over and over again.

-The marketing firm simply wants to git while the gittin’ is good.  The investment firm asks, “What would happen to every aspect of our operations if the markets fell by 67% tomorrow, and what would we do about it?  What plans do we need in place to survive it?”

Thus you must choose.  You can be mostly a marketing firm, or you can be mostly an investment firm.  But you cannot serve both masters at the same time.  Whatever you give to the one priority, you must take away from the other.

The fund industry is a fiduciary business; I recognize that that’s a two-part term.  Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits.  And that’s as it should be.  In the long run, however, you cannot  survive as a business unless you are a fiduciary emphatically first.

In the short term, it pays off to be primarily a marketing firm, not an investment firm.  But in the long term, that’s no way to build a great business.  Today, tomorrow, and forever, the right question to ask yourselves is not “Will this sell?” but rather “Should we be selling this?”  I will praise every fund company that makes that choice based on what is right for its investors, because I believe that standard of judgment is the right standard.

Amen.

But don’t expect the fiduciary role to be adapted by the sellside industry who predominantly embraces the "marketing" aspect as their core function. That's because most of them seem as adherents to JM Keynes' sound banker principle:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.