Wednesday, August 27, 2014

How to Win the Loser's Game

"Part 1 of a new documentary about investing.

The City of London… The centre of the financial world.

It’s here that some of the finest minds in global finance ply their trade.

The pressures are huge - with salaries and bonuses to match.

London’s financial sector encompasses a whole range of commercial activity - from banking and merchant banking to insurance and accountancy. But central to it is the fund management industry.

It’s fund managers whom the vast majority of us entrust with our long-term investments.

They choose which stocks and other assets to invest in on our behalf - and decide when the time is right to buy and sell.

And yes, they’re very well remunerated.

In fact pay has risen sharply in the last few years.

One manager, Richard Woolnough at M&G Investments, was paid £17.5 million in 2013 - 600 times the average UK salary.

Research by the FT shows that, in the same year, pay per employee in the sector outstripped even investment banking.

At one fund management company the average annual salary was £436,000.

The standard line from the industry is that it needs to offer such large financial rewards to attract the brightest talent.

But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.

For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency.

Typical of the reports produced on this subject is this one by the Pensions Institute, based at Cass Business School in London.

Researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1% of managers were able to produce sufficient returns to cover their trading and operating costs.

But even those managers pocketed for themselves any value they added in fees, leaving nothing for the investor.

The remaining 99% of managers failed to deliver any outperformance - either from stock selection or from market timing.

In case you’re wondering whether those managers were simply unlucky, the researchers found the vast majority weren’t; they were “genuinely unskilled”.

While a tiny number of “star” managers do exist, they are, to quote the report, “incredibly hard to identify”. Furthermore, it takes 22 years of performance data to be 90% sure that a particular manager’s outperformance is genuinely down to skill.

For most investors, the report concludes, “it is simply not worth paying the vast majority of fund managers to actively manage their assets”.

If you’re shocked and appalled by those findings, so you should be.

The Pensions Institute report is a damning indictment of the fund management industry which is completely at variance with the image that most of us have of the City as a centre of investment expertise.

Since this is only the latest in a long line of reports that have said more or less the same thing, it also begs the question, why are so many ordinary investors completely unaware of this scandalous situation?

In fact there are many reasons.

This a hugely powerful and largely self-regulated industry, which lobbies hard to protect its interests.

It also spends a fortune on advertising.

And the financial media, which is largely funded by those adverts, has an insatiable demand for stories, which the fund management companies are only too happy to provide.

But ultimately, actively managed funds still hold sway over cheaper, passive investments such as index funds, because investors continue to buy them.

We think we’re paying for better performance; that greater skill will produce superior results.

But investing almost always works the opposite way round. The less you pay, the more you get back.

Yes, it’s counter-intuitive, but it’s true.

In the course of this programme, we’re going to be looking at just how much investing costs us; and at the performance that fund managers deliver.

We’ll be exploring more than 100 years of academic research into asset pricing and how markets operate.

And we’ll be examining long-term investment strategies that have been shown to work.

Investing has famously been called the loser’s game, and for most people, it is. We’re going to who you how to win it.

Next time..

Nobel Prize-winning economist Eugene Fama says: "If you're paying big management fees, the cumulative effect of that, given the way compounding works, is enormous."

Merryn Somerset Webb from MoneyWeek says: "Almost all fund management is a complete rip-off. We know that. We only have to look at prices relative to the performance."

Gina Miller from the True and Fair Campaign says:"The very people who are being prudent and saving and investing are not the ones who are retiring with a comfortable pot. It's the fund managers who are becoming millionaires and billionaires because of those profit margins."

hat tip Michael Johnson


Anonymous said...

You have just figured this out now?.

I always wondered why you wasted your time on obsessing about your pension.

There are two issues :-

Company bosses should be paid in stocks, to be vested in 3,5,7, 10, 12 years, this way they are thinking about the future growth of the company. If the company goes bust e.g. Woolworth's the company bosses get nothing. The current high salaries of company directors, them no incentive to think about the long term.

As for fund managers. I agree with the issue raised.

With my small investments, the returns are nearly 0%, but the big PLC companies managing the funds are raking in bumper profits in fees. How can they be making big profits, when they have done nothing for me?

The way fund fees are charged works against the investor. For instance if my fund was worth £1,000. The fund management would take 2% of the "entire lot". Whether or not it made a profit or a loss (%2 of the entire fund is £20 for that year). So my fund is now worth £980. Even if the gains were zero. So they could just sit on their backsides and keep counting the cash.

However, if the fund management could only take their fees based on any 'increase' in fund value, then they have more incentive to seek out profits. Lets say, the fund manager, got a 10% return for that year and you made £100 (based on £1000). The fund managers should charge 20% on the gains i.e £20. But you are a winner because you fund in now worth £1080 (less their £20 fee). So they earn on the 'increase in value' rather then taking money out of the fund.

John Gray said...

Hi anon

I have actually been banging on about this rip off for quite some time.

Not sure if I am "obsessive" about pensions but guess that I don't like seeing people who have worked all their lives die in poverty. But maybe that is just me.

Share incentives are better than cash but still cause problems since managers will take unnecessary risks to maxmise share price. We need a different model of ownership on 30 year plus time horizons.

There are a few funds out there already which are largely performance fee driven but the better way of investing is index funds.

There is no evidence that fund managers do better than index funds - so why bother?