May 2010
If you are that smart why are you trying to beat the market?
Economists can always prove us wrong but, in general, smart people tend to be better off. This group, or HNWs in the modern politically correct age, have a lot of calls on their time whether related to work or leisure. The best way to quantify that worth is to express it as an hourly rate. Bearing in mind that the minimum wage is £5.80 an hour a wealthy individual should be valuing his time at a large multiple of that, say 10 fold, thus making each hour worth over £50. If this person’s time is so valuable why would he want to waste it doing something that adds no value, and in fact probably detracts value, from his net worth; like managing his own money?
Consider a wealthy individual with an equity portfolio of £100,000 that he manages himself. Let’s assume his portfolio outperforms a comparable index fund by 2% a year, every year. In his first year the market rises 10% and his portfolio rises 12% so he has added £2,000 to his net worth. The question to be asked is how much of his time did it take to achieve that? If he devotes an hour a week to the task over a year and assuming he takes a few weeks off over Christmas and the summer it is reasonable to suppose he devoted 50 hours. That means he made £40 for each hour devoted to his portfolio. That is about £10 less than his market rate.
Implicit is these assumptions are three crucial factors. First that he always beats the market and secondly, that he does it on a net basis after his dealing costs and thirdly that his return is achieved at no higher risk than a tracker fund. If his superior return is only 1% more than the market his one hour a week drops to a net value of £20. Even to achieve that net return he will probably have to achieve an additional gain of 0.2% to cover dealing costs and stamp on the assumption he trades once a month and to cover the fixed costs for his brokerage account. More worrying is the risk he has incurred. Higher returns, especially from small portfolios, are usually generated by taking more risk. In a down year that means his losses are likely to be worse than a tracker fund. If he suffers one down year in five then his average rate per hour falls 20% or possibly more.
An hour a week is not much time to research the stocks, place the trades and update his records, even using the Internet and a high degree of automation. An even bigger assumption is that an hour a week, or even two, is all that is needed to beat the market. Most professional money managers’ work considerably more than the normal working week of 40 hours and only one third of those manage to beat the index in any one year and a lot less over multiple years. If he spends twice as much time his hourly rate falls to £20 and it drops to the minimum wage if he devotes 8 hours a week to it. Hardly a good use of his time one would think. If he is average he will only beat the market one year in three. So that hourly rate should be reduced by a further 30%.
The trump card of course is that of scale. If his portfolio is worth £500,000 rather than £100,000, then his hourly rate jumps fivefold. Surely the exercise is worth it to make £200 an hour? The answer is yes only if he can always beat the market by a net 2% a year every year at no extra risk. An additional return of 2% over and above the index on a portfolio of £500,000 is worth £10,000. No one would argue that is not worth achieving but, as is already clear, that return is by no means guaranteed. Moreover, holding all your assets in one asset class, UK equities, is perhaps not the best idea. A portfolio of that size should at least have foreign shares and some fixed income. Would our DIY investor be able to manage those securities as well in his allotted hour or two a week?
On these numbers then it looks as if the private investor with between £100,000 and £500,000 in investable assets has probably got better uses for his time than hunched over his PC for a few hours a week.
If that logic applies to the private investor is it not also relevant to the investment adviser or private client fund manager? Does it really make sense for him to research stocks or active funds to enable his client to get a better return than the market? Take an adviser with funds under advice of £50m.This collection of securities will be more diverse than the pure UK equity portfolio of our DIY enthusiast. Holding fixed income and maybe structured products will make it that much harder to deliver superior returns than the index over many years. A consistent excess return of a net 1% would be excellent and would deliver an additional £500,000 over and above the asset class returns to his clients. His clients would doubtless be very grateful, but unless he is a hedge fund manager with a performance fee his only reward would be the additional £5,000 arising from the 1% annual charge on the increased asset base. If he can achieve that, on a consistent basis, for an input of 50 hours a year his time has been rewarded at £100 an hour. While that is not to be sneezed at it is probably less than he charges his clients on an hourly basis. So is he really adding value? Surely his time would be better spent on prospecting for new business?
Those figures only make sense if he consistently adds value, at no, or little additional risk. Any year that he underperforms the index is he taking value out of his clients and of his own advisory business. That is hardly a good business proposition. Like the DIY enthusiast in the spare room his time is more valuable than that. Rather than going to conferences listening to fund managers giving their views of a particular stock, sector or economic trend he would be financially better off simply buying a tracker fund and prospecting for new clients to grow his business. It might be interesting hearing a talk about the prospect for the UK economy or oil prices but, for the adviser, it is time badly spent.
There is one last point to bear in mind for the adviser. Only one third of active managers beat the index so how does a prospective client identify an adviser who can pick this subset of the cohort? It’s the same exercise again and is a game where the odds are against the adviser using active funds. Conversely, the adviser using a passive approach with tracker funds can guarantee delivering the bulk of the returns of the markets each year every year. That is a simple pitch to the client, and allows both of them more time to go fishing.