|Paul G. Haaga L’74, WG'74|
By Jenny Chung C'12
On the evening of Tuesday, November 15, this year’s Law and Entrepreneurship Lecture drew an audience of students, faculty, and members of the public to the Law School’s Levy Conference Room to hear Paul G. Haaga L’74, WG'74, Chairman of the Board for Capital Research and Management Company, speak on the topic of “Life in Long-Only, Objective-Based, Active Money Management.”
Haaga, a prominent spokesman for the mutual fund industry and current chairman of the Penn Law Board of Overseers, opened the lecture, which was sponsored by the Institute for Law and Economics, by dispelling “myths” central to investment practices and financial markets, encouraging his audience to remain critical of popular opinion. “The most successful people are those who ask the right questions and listen to the answers,” he said.
Invoking 2011 statistics appearing to indicate that indexing invariably yields higher returns than active management—with between half and two-thirds of active managers failing to beat their indexes—Haaga contested the prevailing view that index funds guarantee higher yields than active funds.
He maintained that factors other than the type of fund must be considered when determining yield, such as the frequency of withdrawals. “The really important thing [to selecting a fund] is what people’s timeframes and objectives are,” he explained.
To further discredit the notion of index funds beating active management funds in every instance, Haaga cited a study of the hundred largest equity mutual funds conducted from 1997 to 2002. By the end of the five-year period, it found that Vanguard’s two index funds were in the ninth and tenth deciles, having been beaten by 90 percent of active funds.
“An index fund can never have less volatility than the market, an actively managed fund can,” he explained, adding that it is also possible for actively managed funds to produce a “higher dividend yield than the market,” while index funds cannot.
Haaga then proceeded to examine the destabilizing effects of investors’ efforts toward obtaining the highest yield possible.
Because the inflationary climate of the early 1980s had permitted high yields, he said, when interest rates fell significantly investors had “developed an incredible taste for yield” and were reluctant to forgo high yields in spite of being financially better off.
“Funds were writing covered call options to get an extra one to two percent yield—we invented a mutual fund that could go down but not up,” Haaga explained. When the market changed, he said, “investors lost 20 percent by trying to get an extra one to two percent while yields were down.”
Fund managers, who had relied primarily on models to determine the security of writing covered call options, were “caught off guard” as a result of unprecedented market conditions which modeling could not anticipate.
“Most bad things happen in the investment world when people try to get more out of investments than the investments themselves are capable of paying,” Haaga said, naming the recent mortgage crisis as a prime example.
Further, he explained, overreliance on the “myth of modeling” is ill-advised as the value of modeling rests on the flawed assumption that “market participants will always do what makes economic sense under the model.”
Haaga named “performance” as another myth surrounding the mutual fund industry.
“We aren’t allowed to use the term ‘performance’; the reason for that is that performance is inward-looking,” Haaga said. “Investing isn’t fantasy football—it’s other people’s money. Treating it like it’s all about you and what numbers you can generate is wrong.”
In answer to an audience member’s question regarding the ideal method by which to compensate those who make investment decisions, Haaga articulated support for “measuring people against the long-term, keeping bad years [relevant to compensation calculations] to discourage them from ‘shooting the moon’ and calculating bonuses based on external factors instead of performance relative to peers.”
When asked shortly thereafter to name the biggest challenges facing the industry, Haaga opted to identify the most promising opportunities first.
“The biggest opportunities in mutual funds and active management space will be for those who find a way to educate 411 investors,” he said, adding that “other winners” will include entrepreneurs who design products providing income guarantees with “long tails” that enable individuals to continue drawing funds well into old age.
According to Haaga, challenges will likely result from failing to address the above two needs and sacrificing long-term stability for short-term profit.
“If we continue to try finding more ways to make more money than there is, we’ll continue to have crashes and disappoint and lose generations of investors,” he said, emphasizing the dual necessity of encouraging investors to “manage expectations [and] accept moderate returns” and of ensuring that firms deliver the returns investors expect.