High pay for asset managers makes the world poorer

Many asset managers don’t invest their own money. They invest the money of mutual funds, banks, insurance companies or pension funds. In those cases asset managers are typically rewarded with pay-for-performance schemes (bonuses), which are meant to incentive asset managers to outperform the market. As the substantial bonuses are added to an already impressive base salary, the job of asset manager is among the best paid world-wide.

On the face of it, this all makes sense, as it is both extremely difficult to outperform the market and extremely lucrative if it is pulled off. The promise of outperforming the market is then the sole justification for the generous remuneration of asset managers. If asset managers could not beat the market, then the only thing they basically would have to do is diversifying their portfolio to avoid idiosyncratic risks. That certainly requires some training and experience, but it is essentially a clerk’s job, and could be paid accordingly.

“Even if some asset managers individually outperform the market that does not necessarily imply that bonuses are good for society at large.”

The crux of the matter is that the average investor can’t outperform the market –for the market is the average investor. Collectively investors are thus not adding value. The gain of one investor is the loss of another, so asset management is ultimately a zero-sum game. In fact, collectively asset management is a losing game, as the average return minus costs is by construction lower than the market return (which equals the average return). Society as a whole loses, just like gamblers collectively loose (though individual gamblers may become incredibly rich).

Now, it is sometimes claimed that a societal benefit of asset management is its so called price discovery function. By constantly trading shares and bonds, the “correct” price of securities is determined. There is something to that, but not that much. Share and bond markets are second-hand markets. The trading of securities does not provide companies with new capital. One could then argue that the price discovery function helps determining the “correct” price in case companies issue new shares or bonds. But it is unclear why that is helpful. In any other market, the price for a good or service is determined in the market itself where supply meets demand. Non-financial markets function without second hand markets signalling prices to the original market.

Of course it still makes sense for individual mutual funds, pension funds and banks to reward investors who beat the market –who wouldn’t want to become incredibly rich. But collectively large bonuses make the world poorer. Gambling’s number one rule is that in the end the house always wins. In financial markets asset managers always win, as they receive extreme salaries for a clerk’s job.