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creative destruction
Wall Street Business Model Under Pressure

It turns out a Bernie Sanders administration wasn’t necessary to put the squeeze on Wall Street’s financial gurus. The market is doing that on its own. WSJ reports that hedge funds and money managers are losing market share as investors shift their money into index funds, which charge far lower fees and beat the experts more often than not:

Pension funds, endowments, 401(k) retirement plans and retail investors are flooding into passive investment funds, which run on autopilot by tracking an index. Stock pickers, archetypes of 20th century Wall Street, are being pushed to the margins. […]

The upheaval is shaking Wall Street.

Hedge-fund managers, the quintessential active investors, are facing mounting withdrawals as they struggle to justify their fees. Hedge funds, which bet on and against stocks and markets world-wide and generally have higher fees than mutual funds, haven’t outperformed the U.S. stock market as a group since 2008.

There are a number of factors behind this shift. First, new technologies have made capital more mobile and encouraged diversification. Second, according to the WSJ, low interest rates have led investors to scrutinize money management fees more closely than before (sometimes filing lawsuits against investment firms). And in fairness to Bernie backers, government has played a role—not by taxing or breaking up financial institutions, but merely by issuing regulations that encourage more fee transparency and enhance competition for investors.

To be sure, there will always be a role for active investment giants. Some investors will always aim to beat the market, rather than just match it, even if the odds are long. And without hedge funds and other financial institutions constantly assessing companies’ performance, stock prices wouldn’t accurately reflect their value.

As David Frum points out, passive investing “only works because someone else is doing the work of making the market efficient.” What is happening now is that the market is re-adjusting the optimal ratio of passively versus actively-traded capital, and putting to better use money that would otherwise be siphoned off by money managers.

This story is another reminder that competitive markets, when they function properly, don’t just hammer the little guy, as is commonly assumed. Higher levels of competition, innovation and transparency are pressuring threatening less-skilled industries, yes, but they are also putting Wall Street’s business model under pressure.

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  • Jim__L

    You know, if the fees of finance people were simply reduced to the point that they were at parity with other professionals with comparable education, the transaction costs of the market would be reduced in a very healthy way.

    It’s basic economics. =)

    • Matt B

      Yes, but if hedge fund withdrawals are this high, some of these folks could be facing a 50% pay cut. I don’t know how you can get by with a $10M bonus when you have been living on $20M.

      The winds of change are bitter indeed.

      • Jim__L

        … Somehow, my threshold for sympathy has not been met.

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