Last time on How to Win the Loser’s Game.
Nobel Prize-winning economist Eugene Fama says: “If you’re paying big management fees, the accumulative effect of that, given the way compounding works, is enormous.”
Merryn Somerset Webb from MoneyWeek says: “You know, almost all fund management is a complete rip-off. I mean, we know that. We only have to look at the 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 one’s retiring with a comfortable pot. It’s the fund managers who are becoming millionaires and billionaires because of those profit margins.”
Of course, the fund management companies could justify high fees and making large profits if they added significant value. Unfortunately, the performance of actively managed funds is consistently very poor.
Fund managers aim to maximise investment returns. Over time, markets deliver returns on their own. They’re what we call the market return. We pay managers to deliver more than the market return. In fact, after costs, they rarely do. One well-known sceptic of fund management famously described it as an industry built on witchcraft.
Jack Bogle says: “We have the most prevalent rule that applies to fund managers everywhere, and that is reversion to the mean. A fund that gets way ahead in the market falls way back behind it. It’s witchcraft in the sense that it’s managers hovering over a table thinking that they have the answer. The intellectual basis for indexing is (as I’ve said), is gross return minus cost equals net return. Period. What is the intellectual basis for active management? I’ve never heard one. The closest I have come is a manager saying ‘I can do better’. They all say ‘I can do better’. 100% of them say I can do better than the market. But 100% don’t. Probably about 1% of managers can beat the market over the very long term.”
That figure of 1%, you may recall, is consistent with the findings of the Pensions Institute report. And that study found that even those 1% of managers kept for themselves the value of any outperformance in fees. Several other studies have reached a similar conclusion.
This is an independent report commissioned by the UK Government into the Local Government Pension Scheme - one of the biggest public pension schemes in Europe.
As you would expect, some active managers used by the LGPS have outperformed. But the report found “there is no evidence that, in aggregate, the Scheme has outperformed regional equity markets”.
In fact, in many cases active funds were trounced by passive ones. For example, over ten years, passive North American equity funds delivered average returns of 2.6%, as opposed to 1.7% delivered by active funds. Passive Japanese equity funds recorded average returns of 2.6%, compared to 2.0% for active. What’s more, these returns do not not take into account the impact of investment charges.
The report found that in 2012, asset management costs for the scheme amounted to £790m - the vast majority of which was paid to active managers. Switching from active to passive investing would save the tax payer a staggering £660 million a year - and deliver similar, if not better, performance.
Michael Johnson is a public policy adviser with a specialist interest in pensions. He says the LGPS report is a wake-up call for the whole investment industry.
Michael Johnson says: “I think it’s a seminal moment in the history of investment management or fund management because it really lifts the lid on what is essentially an industry that adds no value to anybody. Essentially, very few people enter that industry with the express purpose of enriching others, and they’re good at what they do, which is enriching themselves.”
Alan Miller was a successful fund manager. But over the years he became disillusioned with the industry, and particularly with the poor performance that managers were delivering year after year.
Alan Miller says: “It used to be that the institutions had a big advantage. They would see the company first, they would see the management, if they were asked sensible questions they would get information before other people. This does not happen anymore. There is something called the internet. There is something called information given to everyone and, therefore, to have an edge it’s much harder. It’s a bit like companies drilling for oil in the middle of nowhere, where no one’s drilled before. It doesn’t mean they’re not going to discover oil, but the vast majority are probably just going to discover fizzy water. The marketing budgets within the big retail companies are millions and millions of pounds, and they’ve created this image whereby the customer thinks that these big brands are nice and safe, nice and solid, and they think they’re getting something better. They’re actually getting something worse. This is the irony. If you were to sum it up, less is more. The bigger the institution, the bigger the brand, normally the more you pay and normally the worse the performance.”
Michael Johnson says: “In a nutshell you have an industry of fund managers who are trying to out-compete one another in a giant negative-sum-game. Not a zero-sum-game, but a negative-sum-game, because whilst they’re doing this, they are extracting charges and fees on an annual basis which erode the capital of savers. In this competition of trying to out-compete one another, there are bound to be winners and losers every year, and there are some that claim that they add value, i.e they win more often than they lose, but if one actually examines the data, as I and others have done, it is nigh impossible to work out who is going to outperform the rest on a consistent basis. For virtually all investors, making a decision as to which active fund to invest in is a pure lottery.
And that’s more or less what the Nobel-award winning economist Eugene Fama has been saying for more than 50 years.
Eugene Fama: “There are lots of studies of persistence and performance. I had one of my students do a very famous thesis on this. He ranked the funds based on five years of past returns and did this every year, and examined whether that predicted future performance. No, it doesn’t. There is very little persistence in performance. But if I take all of the funds and look at them over their entire histories, then you’re going to see that some of them did extraordinarily well, and books get written about those managers, but in fact that distribution is pretty consistent with chance."
We asked several of the largest fund management companies to talk to us about performance, but had no success. But the trade body, the Investment Management Association, did agree to give us it’s point of view.
SITV says: “What evidence do you have that active fund management actually works?”
Daniel Godfrey says: “OK, well over long periods of time, active managers pick stocks that they believe will go up more than the market. But, of course, as a group, as a whole, we are the market. So, that’s why you will quite often see reports in the press saying that active fund management doesn't outperform the market. Well, the fact is that active kind of is the market - and passive obviously is the market too - so, as a group, they can’t outperform the market. What people are trying to do is find mangers that do outperform the market over a long period of time and, in fact, most people are quite successful at doing that because what you’ll find is that the managers that demonstrate an ability to outperform the market reasonably consistently, have the bigger funds and ones that don’t contract quite rapidly. So the lion’s share of new money and switching money goes into the funds of people who do outperform."
But Michael Johnson is unimpressed.
Michael Johnson says: “That is mathematical nonsense. How can you suggest that the majority of money is successful? How can the majority be outperforming the minority? Doesn’t make sense. This is an industry that is a genius at obfuscation and bamboozlement, with terminology that is utterly meaningless. And it needs to be challenged.”
So, what are the implications of all this for the investor? Well, the system needs active managers to set prices - to ensure we all receive value for value for money. But that doesn’t mean every investor has to pay for their services.
Indeed, the high cost of active management combined with its dismal track record - and the near impossibility of identifying the next star performer - should make the average investor extremely wary.
But, before investigating alternative approaches, we’re going to find out what the academic evidence says about investing - and how best to go about it.
Next time on How to Win the Loser’s Game.
Professor of Economics Jean-Michel Courtault says: “The expectation of the speculator is zero, because when you buy something you expect that the price is going to rise, but if you buy something, someone else has to sell it and this other person thinks the price is going to go down.”
Professor of Finance John Cochrane says: “When you think about Eugene Fama and efficient markets, don’t think about Einstein and some big theory that no one can understand. Eugene’s theoretical framework is quite easy to understand: competition means that prices reflect information.