I was reading this lovely WEF report yesterday on the “Future of Long-Term Investing” when I stumbled upon the graphic below. While it’s very simple, I think it offers a neat explanation as to why some institutional investors are bringing assets in house. Simply put, it shows that if – and this is a very big “if” — an institutional investor can implement a sophisticated in-house program, the end result will be better alignment of interests between the asset owner and the ultimate investment decision-maker. Said more provocatively, a direct investment policy has fewer stops on the ‘chain of fools’.
I don’t mean to suggest that the intermediaries / links in the ‘chain of fools’ are themselves fools or even foolish. Rather, the injection of new incentives and motivations at each link of the chain can’t help but distort the original motivations of the asset owner in such a way that the final investment decision maximizes the utility of the intermediaries as much as the institutional investor (if not more so). That, in my view, is the foolish part. (In econojargon, this would also fall within classic principal agent problems.)
It’s a bit like the game “Telephone” I used to play when I was a kid. One child whispers an original message, which is then whispered down the line from child to child. The payoff occurs when the child at the end of the line says aloud what he or she thinks is the original message; hilarity typically ensues when it’s much, much different. For another example of what I’m talking about, check out this awesome “evolution of lines” video. Anyway, all this is to say that the more links in the investment chain, the more likelihood of it becoming a ‘chain of fools’ in which the outcome doesn’t match up with the original intent.
I would be remiss, however, if I didn’t raise the flip side of this coin: While investing directly may offer better alignment of interests, it creates countless new governance and management issues. In other words, in-sourcing assets can create just as many problems for institutional investors as the ‘chain of fools’. Consider yourself warned.