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29 August 2015

Managing Money

Tag(s): Business, Politics & Economics
They say you should sell in May then go away and they were certainly right this year. Stock markets all round the world have taken a pasting, triggered by a massive correction in China. The Shanghai Stock Exchange Composite Index is still 35% ahead of this time last year but has lost all the gains made in 2015. It was on a ridiculously bullish run fed by retail investors, apparently borrowing money to buy their shares. The government has tried to intervene to correct the trends but had to realise that markets are markets and can’t be corrected by communist dictat. Why Western markets should react so negatively to this nonsense is beyond me but then I have long known that markets are not rational. The background noise to this is that the rate of growth of the Chinese economy is slowing down. For three decades it averaged about 10% per year taking it to the level of the second largest in the world. This rate of growth was not of course sustainable, not least because Chinese labour costs were rising and some of its export markets were starting to buy from other cheaper sources like Vietnam. But the Chinese economy is still growing at a rate that more developed economies can only envy. So as an economy it is still larger every year, is still building new million inhabitant cities, numerous airports, miles of high speed rail etc.

Coming back to the stock markets at times like these retail investors like you and me face difficult options. First it is obvious that the efficient-market hypothesis – the idea that markets ‘price in’ data- is not valid. If they did we would not be seeing this emotional reaction to the overdue market correction in China. If markets did work efficiently then it would be difficult for individual investors to beat them and so the logical consequence would be to track them passively and that idea may indeed have a lot of merit.  However, most of us it seems still prefer to hand over our money to professional fund managers to invest on our behalf. How do we get on?

Not very well. Research shows that as many as 85% of fund managers can’t beat the Stock Exchange Indices. One analysis over the period 2009-2012 showed that only 70 out of 224 (31%) active UK all-companies funds with a three-year record  managed to equal or better the FTSE 100 and FTSE All-Share indices, according to Morningstar, the data firm. Over the three years from June 2009, the FTSE All-Share rose 38.1%, the FTSE 100 was up 36.4% but the average UK fund was up just 35.9%. Over the last twelve months of that period 183 out of 240 (76%) active funds underperformed. And that is before charges.

But these active funds charge much more than the passive funds they are trying to beat. The stated annual charge on actively managed funds is typically 1.5%. However, a more representative figure is the total expense ratio (TER), which includes extras such as legal and audit fees. The average TER is 1.7% but more than 100 funds charge at least 2%. By contrast the average TER for a tracker fund is 0.8% and some charge as low as 0.25%. The compound difference of these charges is massive over time. If you invested £10,000 through an ISA in a fund with a TER of 2%, you would have £18,061 after 20 years, assuming annual growth of 5%. If you chose a tracker with a TER of 0.5%, you would have £24,117 – an extra £6,056, outperformance of 33%.

Some fund managers do perform well but as every financial product advertisement says, past performance is no guarantee of future performance. The problem is exacerbated by the huge number of funds to choose from. “There are too many investment funds, most of which take similar charges whether they deserve them or not – and most of which underperform.”[i] There are about 3,000 funds for investors to choose from and this can make it difficult for investors to identify which fund managers are delivering superior long-term performance, as opposed to investing in a particular sector that is enjoying some short-term upswing.

I have referred to the TER as a useful point of comparison but according to Alan Miller, a former star fund manager with Jupiter Asset Management who went with John Driffield to set up New Star Asset Management in 2001, the TER is “complete and utter nonsense.” It doesn’t include some of the costs of running funds such as dealing fees. Some fund managers routinely take a cut of any interest on their clients’ cash; some take a commission on currency exchanges when they buy foreign stocks for clients; some make a large part of their margins from broking commissions; and some do all three. Fund managers have “basically been allowed to lose sight of the fact that that it is not their money" according to Miller.

So what about Absolute Return Funds (ARFs), are they the answer? After all they promise to maintain a positive (absolute) return in all market conditions. Typically they offer you the money market cash rate ‘plus x%’, for example. The appeal is obvious in volatile markets when most investors want to protect their capital as much as make big returns from it. So are they delivering? According to Informed Choice, a consultancy, only three out of 51 funds were worth investing in, looking at performance, consistency and charges. The biggest problem again seems to be charges. Alan Miller reviewed 28 ARFs and concluded that, on average, 38% of gains over a three-year period were eaten up in fees.

Perhaps for these reasons many investors, big and small, have turned to hedge funds for better results. The idea has grown up that hedge fund managers can systematically deliver superior returns, so-called alpha, by spotting opportunities for arbitrage in derivatives or other complex instruments. This is another myth. The Oxford-Man Institute of Quantitative Finance examined 18,382 hedge funds between 2007 and 2011 and found that 40% mislead investors by routinely revising historic performance data. This is possible due to the secrecy of an industry that is largely unregulated compared to listed equities or registered mutual funds. Because mandatory, audited reporting of performance has not been required of them, hedge funds have typically self-reported monthly performance figures to public databases in order to attract further investment.  A similar paper by US academics concluded that, after fees, hedge funds deliver risk-adjusted returns of essentially zero.

Again the problem is charges. The common fee structure, in which hedge-fund managers keep 2% of assets as a “management” fee to cover expenses and 20% of profits generated by performance, has made many managers rich, but not their clients. Simon Lack spent 23 years at JP Morgan selecting hedge funds to invest in but became disillusioned and has written a book on the subject.[ii] He calculates that hedge-fund managers have kept around 84% of profits generated, with investors only getting 16% since 1998. He even thinks that the disastrous dive of equity markets after the Lehman crisis in 2008 may have wiped out all the profits that hedge funds have ever generated for investors.

So are there any ways left for us to invest in stock markets? Well, perhaps yes, if we can follow some of the lessons of legendary investors like Sir John Templeton.[iii]
  1. Don’t let your emotions ruin you. Don’t let yourself be distracted by the flow of news and the siren call of brokers who want you to trade –you’ll only increase your costs and damage your overall returns. And never panic. If the market crashes, don’t rush to dump everything. The only reason to sell is if better opportunities have arisen elsewhere.
  2. It’s risky to take no risk.  If you take no risks, you might sleep well, but you’ll never make decent money. Inflation is its own risk. At a rate of 4% a year it will reduce the buying power of £100,000 to £66,500 in just ten years. To grow your money you need to beat inflation and add a bit on top. Low risk cash and fixed-income government bonds won’t do that.
  3. Be contrarian. You can’t outperform the market if you’re just buying the market. So the trackers won’t do it unless the stock market is going to do very well over the long term. But boom and bust have never been abolished and never will be. The same goes for stock market cycles.
  4. Investing takes effort and time. Blindly trusting share tips or snapping up hot initial public offerings without double checking the data is simply dart-throwing.
  5. Monitor your portfolio regularly. The winners and losers – even among the biggest companies – change surprisingly rapidly. Thirty of the Fortune 100 in 1983 had dropped off the list by 1990 because they were taken over, went bust, shrank or went private. So rebalance your portfolio once a year to ensure you don’t get overexposed to any single stock, sector or asset class. I do it twice a year.
In 2009 a company in South Korea organised a competition between 11 investors. Ten were professionals of long standing. Their rival was a four-year-old female parrot called Strawberry, which picked stocks at random with its beak. The parrot came third.


[i] Patrick Connolly, an adviser with AWD Chase de Vere.
[ii] The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True Simon Lack Wiley 2012.
[iii] How to Invest Like Sir John Templeton  Tim Bennett. The Week. Prosper



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