December 2010
The Tyranny of League Tables
Everyone loves league tables, especially the press. It’s a great way of creating a story and a fair few column inches to describe what’s hot and what’s not. But do they really help consumers?
In the case of motor cars it is perhaps interesting to know which car is fastest. However, most prospective car buyers would be more concerned with fuel consumption and insurance groups. They will be looking for the ones with the lowest of each not the highest.
Yet the world of finance is full of league tables ranging from the best analysts to the biggest banks. Rarely do they show the worst. Most of these tables are therefore irrelevant to the average investor save for the performance of collective investments and here the press really goes to town. Most financial magazines, and quite often the weekend press, will carry tables and features showing the ten best performing fund over the last year, or the five stocks you should have bought last month.
In reality this is about as useful as comparing family cars on top speed. In tells you nothing about what has been assembled to create a fund that beats everything else. As with anything there are tradeoffs. A fast car will have high fuel consumption and probably a high insurance rating. In other words it will be expensive to run.
The same applies to collective investments. In the short term a performance that has trounced its competitors will undoubtedly have taken more risks and, if it is an investment trust, may well have increased its gearing to amplify returns. While that is great in a rising market it is dismal in one that is falling. Yet how often do we see league tables of tracking error? Although a crude measure it does give some idea of the risk a fund is incurring. In the same way the press never publish tables of costs, either annual management charges (AMCs) or total expense ratios (TERs), nor do they rate funds on beta, alpha or information ratios.
The industry is obsessed with one figure and one figure only and that is returns however they are achieved. But even analysing that is more complex than it seems because the stock market is a bit like a chameleon; it is always changing. Sometimes it likes growth shares, sometimes value share, at other times resource stocks are in fashion and then it might be technology.
Other than a few specialist sector funds it is usually hard to discern what style individual funds have. Usually the fund manager will know, but that might not always be communicated to the investor. Nevertheless, if a fund style is out of favour in that particular market it will struggle to get a decent place in the rankings. Many people recall how value funds were shunned in the dot com bubble at the turn of the decade. Though that was extreme, those periods when one style is in favour still occur, albeit on a less extreme basis.
League tables take no account of style bias, so all funds are lumped together. In the last year or so mid-cap funds have done extremely well as the FTSE 250 outperformed the FTSE 100 by up to 14% at one stage. No matter how good a stock picker a manager was anyone who confined themselves to picking stocks from the big cap index was fighting a big headwind during that period.
Of course few houses or fund managers care to admit that their fund may not perform well in all circumstances. If some of them were to admit, that like a family car in the snow or a sports car trying to shift furniture, their funds were not suitable for some tasks then the process of selection would be easier for investors and advisers.
The problem with league tables is that they rate so few parameters. Performance over three years is not a whole lot more useful than over five years. What are needed are lots of tables assessing different parameters. Moreover, funds need to be subdivided into categories like growth and value. Most important of all tracker funds should have their own category. That way they can compete on a level playing field with other such tightly specified funds selecting and weighting stocks from a defined universe. At the moment they are compared to funds that buy other asset classes, foreign shares and even use derivatives. That’s a bit like a comparing cars and motorbikes in one table.
Ultimately long-term performance, say over ten years, does sort the fund management hares from the tortoises. But, that’s a long time to wait. After all, you don’t need to wait ten years to know that a V8 4x4 will depreciate more than a one litre city runabout. Engine size, weight and insurance group will tell you that right at the beginning even if the price doesn’t. The industry needs to lift the bonnet on funds, assess the processes and then tabulate the data so that investors can get a guide to what might happen rather than what has happened. Being roughly right about the future is more use than knowing precisely what the historic returns were.
November 2010
A softer approach to RDR
The RDR has taken on the form of Smaug, the dragon from The Hobbit. Even though it has yet to be seen it evokes fear and dread in the land of Middle Earth, that land of the ever open pub occupied by intermediaries and fund managers.
The main thrust of the RDR to tackle the problem of trail commission is simply to ban it. Many in the industry see this as a draconian solution to a problem that is not the biggest issue the industry faces and will impose collateral damage on many. Not least of which is the likelihood that many investors will be left with nowhere to seek advice except from the banks. And few in the industry think that is a good idea, apart from the banks of course.
At the heart of the debate is the need to separate the revenue generated from selling a product to revenue from giving advice. The simplest way to do that is make it easier to compare naked products shorn of all advice. That makes it easier for the consumer to distinguish between what it costs and the advice given to sell it.
The industry could go a long way to making the market easier for consumers to understand by providing greater information on each product. More data will help investors make their own decisions on what products to use. After all, these days many people eschew advice when choosing expensive cars, mobile phones or computers. All of these are complex products but the manufacturers and trade press provide so much information that it is relatively easy for consumers to choose for themselves. There is no reason why financial products should be any different. That leaves IFAs to give unbiased advice on such things as asset allocation and tax planning which the client can either execute himself or in partnership with the adviser.
So here are a few suggestions for the industry to consider as an alternative to banning trail commission. Underpinning them all is the concept that improved investor education will reduce the risks of consumers using the wrong product.
As a start the FSA could encourage funds to publish a full list of holdings, including derivative and short positions and any stock lent out, every month. There is no need to penalise those that don’t but, presumably, investors would prefer products that are transparent and not opaque.
Secondly, why not allow direct promotion of funds and financial products by providers? Is there any reason why detailed explanations of performance data and the reasons behind stock selection and relative weights should not be included in promotional material? If the industry treats its client base as know-nothings it shouldn’t be surprised when it is accused of miss-selling. Other industries bombard customers with technical information, why should finance be so different?
A relaxation of money laundering rules would make it much easier for investors to buy directly from product providers. The current system of checks and information gathering actively discourages consumers from shopping around and trying different products. Inertia is a big factor in deterring investors doing anything other than using their existing broker and platform. No one wants to go to the hassle of sending off all that data to again just to try a different product. Besides, how many money launders have actually been caught by all these rules and regulations?
A key difference between investment products and consumer durables is the need for the product provider to continue servicing it over an extended period of time. This contrasts with the sell and forget approach that is adequate for hard goods. Even so, the maintenance of the investment is the duty of the product provider and not the distributor who merely passes the data through to the client. If all funds were required to offer the product at a “factory gate” price it would clarify the difference between product costs and distribution costs.
Car manufacturers are obliged to publish fuel consumption figures to encourage more economical driving and persuade buyers to consider efficiency when choosing cars. In the same way if fund providers were required to publish risk and cost measurements such as alpha, beta, tracking error, information ratio, full TER and portfolio turnover it would help investors to take risk into account when selecting funds. That way they would be less likely to select on the single measure of performance. After all, few people pick a car just because of its top speed; insurance groups, mpg and crash test data are all important to drivers.
These requirements would be extended to include ETFs as well as OEICS and Investment Trusts.
More controversial would be this last idea. Why not abolish tax shelters such as ISAs and SIPPs? These tax wrappers can only be administered by intermediaries and platforms and are directly responsible for pushing individuals to using third parties instead of managing their own affairs directly. Removing the tax shield would encourage investors to buy products directly without the need for a third party. Eliminating stamp duty from investment products would partly compensate for the loss of these tax planning structures and work to encourage savings.
You might expect a loud chorus of complaints against such an idea because it would remove incentives to save. However, it shouldn’t be necessary for the government to point out the blindingly obvious. If people are going to work from the age of 20 to 66 and be retired for the next twenty years it doesn’t take a genius to work out that you will need to save something during those 46 years to live on for the following twenty. Administration of these tax shelters gives intermediaries a powerful lever to impose charges. Giving people the option not to pay those charges could substantially reduce costs. In any event the tax benefits of SIPPs are not as great as many might suppose because the pension they ultimately provide is taxed.
These proposals, if enacted, would improve consumer education. That alone would be a powerful factor to guide investors to lower cost products and help understand the difference between the cost of a product and fees for advice. Market forces would be a much more effective mechanism for doing this than legislation that could have many unintended consequences.
October 2010
How conventional index trackers make the stock market more volatile.
Conventional wisdom holds that the simple market capitalisation weighted index fund is about as safe an investment in equities as you can get. It may surprise some investors in such funds to know that they are in fact adding to instability in the market. Every now and then that instability manifests itself as a large correction but fingers are usually pointed at hedge funds as the culprits, not index funds. In fact it is the index funds that create the distortions and the hedge funds that restore normality. Usually, their actions are in the form of short selling, and that is facilitated by those self-same index trackers through stock lending.
In nature there are a number of combinations where seemingly incompatible forms of life coexist in a powerful symbiosis. The Clown fish of the Great Barrier Reef cleans the Sea Anemone and is protected by it from predators. Its own unique mucus prevents it from being killed by the animal it is helping. But the world of finance has created one of the oddest double acts. It is only the forces acting for good in hedge funds that can limit the evil impact of dumb money in cap weighted index funds. And the scary thing is that both need each other to survive.
Index funds are known for their low cost passive approach. But there is a cost to that low cost. They need the income from lending out stock to help keep their fees down. And the institutions that want to borrow that stock are the favourite bad boys of the media and the regulators; the hedge funds. But without them working to restore the correct valuations the stock market would gradually morph into a strange creature that had a few mega-companies at the top and a mass of small companies that had no access to equity capital at the bottom.
It is of course possible to argue that large overvalued stocks are an unfortunate, but necessary, side effect of the move to index funds. As long as they stay overvalued there is no problem. But they don’t. At some point reality eventually sets in and a stock price starts tumbling. If it was hugely overvalued to start with the fall can be precipitous. And that is when investors get worried. They assumed funds were being invested by sagacious men who looked at balance sheets, cash flow and business prospects. In reality it is simply computers saying that company A is twice as big as company B, so allocate twice as much money to it. That is hardly a logical way to allocate capital in the 21st century.
The problem is not just that index money is dumb money. The index is even dumber. Simply listing the largest 100 or 500 companies by market capitalisation to make an index is not actually very smart. The reason it is not can be called the “car park” problem.
Imagine a town where one car cark contains the 100 most expensive cars. No other measure like fuel economy, luggage capacity or number of seats is considered; just price. The chances are it will be full of Ferrari’s, Porches and maybe the odd Bentley. Suppose one of these cars leaves to drive to another town and the car park is obliged to fill the gap with another car. What are the chances of it being a seven seat people carrier, a van or a fuel efficient city runabout? Pretty much zero wouldn’t you say? No, it will be another German or Italian car of impeccable breeding and limited practicality. That car park is self-selecting on price in exactly the same way as an index selects a company on market capitalisation.
Even worse is that within that index the largest weighting then goes to the largest company. With that sort of mathematics it is easy to see why corporations are focussed on growing the size of their company by market capitalisation rather than any other measure. Takeovers are the quickest way to achieve that even though it is well known that many destroy value. That does not matter though if all executives want is the largest slot in the car park.
Fortunately owners and employees of hedge funds are smart enough to spot this. And, at the opportune moment, they can short the stock by borrowing it from index funds before everyone else realises that the flashy car is overpriced. It is that moment of price correction when the true instability of the market imbalances caused by price weighted index funds becomes apparent. And it can be rather upsetting. But it is wrong to blame the hedge funds for exploiting miss-pricing in the market. It makes more sense to point the finger at those who allocate capital on the basis of market capitalisation alone.
Of course that is not to say that hedge funds are the best solution to this problem. Their fee structures, limited availability and erratic performance do not make them suitable for the mass affluent. Surely it makes more sense to allocate capital to companies though the use of some fundamental measure rather than price. Taking price out of the equation for a tracker fund means it can construct a portfolio efficiently without the need for another agent, like a hedge fund, to periodically wrench valuations back into line with reality. The partnership of index and hedge funds does work, but it makes for a bumpy ride and is unnecessary when there are smoother alternatives.
September 2010
How stamp duty can distort investment decisions.
Most of us are familiar with the irritation of discovering how much tax we have to pay when we book a flight with a low cost airline. The annoyance is temporary though and, in the end, does not impact the decision making process. We know that if we fly on a full service airline we still have to pay it. The only reason that we know about the tax is that the actual cost of the airline ticket has fallen so much that the tax is now a large component of the total cost.
In the same way the falling costs of money management are now making the tax on investing a much larger, and more visible, component. It is getting harder for the new range of low cost funds to bury it. The gradual erosion of initial commission and the move from a bid offer spread to single pricing now means that any other costs are more obvious. It is for this reason that Vanguard imposes a 0.5% charge to cover stamp duty for investors in its low cost UK funds. That sort of pricing is likely to become more widespread as fund charges come down. However, unlike buying airline tickets the impact of tax is now starting to influence behaviour, something that taxes are not supposed to do.
In the case of investing the problem lies with stamp duty. It is bad enough having to pay it on houses at an exorbitant rate but the imposition of it on investing is ludicrous. No one is any doubt that the country faces a huge pension crisis as the erosion of defined benefit pension schemes moves the onus of saving for retirement onto the individual and away from the state and the employer. Added to that is the gradual decrease in mortality rates which is increasing the liability to be funded from a pension. The scale of this shortfall is vast and can only be solved by individuals making their own savings arrangements through ISAs, SIPPs and other pension schemes.
The investment time scale for pensions stretches over several decades and that will draw many savers to equities. You would think the Government would be keen to encourage savers and move the liability from the Treasure to individuals. But no, the Government takes 0.5% of your already taxed earnings as stamp duty before any money goes into an asset. As an upfront charge on say, a twenty year investment, that is pretty steep. Compound that at whatever growth rate you like and it will come to a substantial figure.
It is easy to see then why many investors are attracted to the concept of investing through ETFs, because they don’t incur stamp duty. In 2007 secondary trading in ETFs became exempt from stamp duty and this has led to a huge rise in their popularity. It is common now to read or hear someone advocating passive investment through the use of ETFs. Part of that is because of this favourable tax treatment.
However, there are substantial differences between a conventional OEIC and an ETF. Most OEICS are simple, long only collective vehicles where the underling stock is bought and held by the custodian under the watchful eye of the trustee. Stamp duty is incurred buying the stock and becomes part of the total expense ratio (TER), even though it is a one-off cost. Funds that have low TERs, which usually goes with low annual management charge (AMC), have less scope to hide the stamp duty. That is why Vanguard charges it separately. An ETF that doesn’t have that clearly has some attractions.
However, while ETFs started in the same way as “physical” or “in specie” funds that held stock there has been a trend towards “synthetic” or “swap-based” funds that guarantee to deliver the return of the specified index. Doing this obviously raises the question of who is providing the guarantee and whether that counter-party risk is acceptable. The events of 2008 demonstrated that counter-party risk can be a significant issue.
Dealing in ETFs is akin to dealing in ordinary shares and will probably involve a commission to a broker and there may well be a bid-offer spread in ETFs tracking smaller indices. Contrast that to the removal of initial commission on OEICs and the move to single pricing.
Liquidity issues mean that some ETFs do not fully replicate the index being tracked and that may result in a tracking error and/or a higher TER. Another factor to consider is the domicile of the ETF is also important as that can affect its tax status, especially in regard to dividends. Moreover, like investment trusts, ETFs are not covered by the FSCS.
A much trumpeted feature of ETFs over OEICs is that they can be traded at any time of the day when markets are open. In contrast OEICs can only be traded once a day, but does that matter if the investment time scale is going to be several decades?
This is not to imply that ETFs are bad, but they are not as simple as a plain vanilla OEIC and merit some research as to exactly how each one is constructed. In any event the tax system should not discriminate between collectives and give preference to one type over another. Especially, if like ETFs, they are more complex than the taxed alternative.
Of course, the simple solution to this discrimination would be for the Chancellor of the Exchequer to exempt stocks and share from stamp duty. This would not only level the playing field it would encourage people to save and reduce the long term liabilities of his, and future, Governments. How good would that be?
August 2010
How rebalancing helps reduce risk and improve performance
“Run your winners, cut your losers” “Buy when others are fearful, sell when others are greedy”. Two of the best known stock market aphorisms directly contradict each other. How can the rational investor manage a portfolio that accommodates both positions? They can’t of course which is why they, and most stock market clichés are worse than useless.
There is though a very real issue behind both phrases and that is stock selection is actually less important than stock weight for determining portfolio returns. After all, not holding a stock is simply a zero weight. Owning a stock that doubles in a year doesn’t do much for a fund if it only has half a percent invested in it. On the other hand putting 5% into a micro cap stock is a big risk and it also may create liquidity problems. Even more important than the initial exposure though are changes in weighting as stocks rise and fall relative to the index and other holdings. Investors need to know how fund managers deal with this problem to understand exactly how a fund is run.
This issue was thrown into the forefront of investors minds in the second quarter of 2010 after the Deepwater Horizon rig drilling the MC 252 well exploded and caught fire on 21st April and then subsequently sank. The scale and cost of this disaster precipitated a massive fall in the share price of BP, the operator and 65% owner of the well. At the time the disaster struck BP shares were trading at 642p. By the end of June they had dipped below 300p. Over that period BP’s weight in the FTSE 350 index fell from about 7.1% to 4.6% and created a huge change in the shape of portfolios for investors.
The way managers responded to that event gives a good indication of whether their actions added or subtracted value. Some money managers used the opportunity to buy more shares but soon found the experience increasingly painful as the stock continued to fall. Exactly who sold remains unknown but it is hard to imagine that US investors were proud of seeing that holding on their statements for the end of June going out to clients. Is it just coincidence that the nadir of the share price was reached three business days before the end of the month?
Conventional capitalisation weighted index funds simply followed the stock down and then back up. New investors in such index funds, depending on when they dealt, could have been investing anywhere from 4.6% to 7.1% of their portfolio into BP.
Active managers, on the other hand, would have determined earlier whether to be underweight or overweight in BP. That would have a major impact on their relative performance, at least initially. Overweight investors would have been hurt relatively more badly than those underweight the index. However, as the stock fell, and assuming active funds did not top up and buy more, the portfolio impact would have diminished as BP’s weight in the index and portfolios shrank. So called active funds that did nothing would, in contrast, experience progressively less pain as the holding shrank. A 1% fall on a 5% holding is much less painful than a 1% fall on a 9% stake.
Then, in July, sentiment turned and BP rose dramatically from 300p to 400p.
All funds now benefited from a double whammy. Not only was BP going up but its size in the portfolio was increasing. A 1% move on a holding of 3% is very nice, but not as good as 1% move on a 4% stake and nothing like as good as when it gets to 6, 7 or 8%.
This feature of an expanding balloon growing rapidly is at the heart of stock market volatility and is easily compounded by additional buying into a rising market. In a small way this experience describes exactly how stock market bubbles are formed. A process, incidentally, that is exacerbated by conventional index trackers. Everyone loves this stage. It is the next stage, when the bubble bursts and investors frantically dump positions that have become far too large, that the risks of this approach become apparent.
The only way the volatility caused by index trackers and what might be called lazy active managers can be beneficially exploited is to use a process that determines the size of a holding by some measure other than price. Using a different reference point it is then possible to continually rebalance the holding back towards the desired weight whatever the market does. In other words the fund trades to maintain the holding of the stock at a certain predetermined level. And this is exactly what a fundamental tracker does.
The way it works in practice is best illustrated by the actions taken during the BP crisis.
Having been a buyer of BP all the way down to 306p to maintain a 9.5% weight The Munro Fund increased the number of shares it held in BP by over 50%. Once the market turned though it rapidly found itself overweight in the stock and it was a steady seller into a rising share price. Stock bought for 306p was sold for 322p, that bought for 334p on the way down was sold 343p on the way up. In this way a passive fund exploited volatility in the market to add value. Over the period from early May to mid July the fund increased its net holding in BP shares by 32% in addition to the additional value added by trading shares on the way down and back up again. That additional holding was secured at a weighted average cost of about 399p.
It might seem odd that a tracker fund should trade so actively. But the concept is to take advantage of market volatility and use that to benefit a fund that knows exactly what it wants to hold. The alternative is to let the market determine your weighting. How much value does that add? The appellation of “active tracker” might seem oxymoronic. But once you get away from the dogma that the “price is always right” there is plenty of scope to add value.
July 2010
Who cares what others think, especially about BP?
Apart from football there can be few industries that generate more speculative comment than the world of finance. It is easy to see why so many people want others to hear their views. What is less obvious is why there is such a huge demand for it.
Members of the financial chatterati and commentariat will obviously claim that they are informing clients and readers about the latest products and impacts of tax and regulatory changes. That is certainly true and they provide a great service for investors short of time. However, you don’t have to go far into the financial press or message boards before you find someone pontificating on the virtues of a certain stock, sector, currency or asset class. Less often there will be some analysis of why such financial assets are overvalued.
This fare keeps many magazines, websites, trade publications and the financial pages of the newspapers well supplied with copy on a daily, weekly and monthly basis. Some of it is there of course to fill in what would otherwise be blank spaces between the adverts. Nevertheless, it is clear that there is a real demand for a lot of punditry, advice, speculation and musing about finance. While some of this commentary is provided by journalists with no axe to grind much of it is also provided by money managers who definitely have an agenda. One that says: “Trust me, I sound as if I know what I am talking about.” Since only one third of those fund managers will beat the market in any one year the odds on getting good advice from such articles are against you.
In truth these comments do provide a service to investors and advisers alike, but perhaps not in quite the way intended. In a complex and confusing world they provide reassurance that someone out there does actually know what is going on. So many investors and advisers are now so totally unsure of what is happening, and lacking in confidence, that they seize on any words of wisdom from those in elevated positions. The variety of advice is such that almost any view can be found to have support if you look hard enough.
Those that are not reassured by the written word can get a much higher degree of confidence by hearing it direct from a guru at a conference. Just reading that someone is bullish on, say, China carries nothing like the weight of actually listening to those words being spoken with total conviction. What is more, being in a large group all with a similar frame of mind is a fantastic mechanism for reinforcing mainstream views. Emboldened with the knowledge that everyone agrees with him a delegate can return home with even stronger faith that he is right.
To an extent what matters more these days is the degree of conviction a money manager has rather than the veracity of his opinion. The future never turns out quite as predicted so it is hard to pin managers down and ask why such and such didn’t happen. So many events erupt that change outcomes that there is never a shortage of excuses. That doesn’t matter. The disciples still clamour to ask the guru what will happen next, even if the guru got it wrong last time. Getting it wrong passionately seems to carry more weight than being cautiously correct.
In such an environment it is no surprise that the man who professes to have no idea what the future holds is held in low regard. Surely a fund manager is paid to second guess the future? Unfortunately history shows that the track record of fund managers guessing the future is about the same as Mystic Meg. In fact they are worse. At least Mystic Meg’s forecasts have a 50% chance of being proven correct while we know that two thirds of active funds fail to beat the index each year, and even more over longer periods.
Nonetheless, soothsayers, shamans, witch doctors and fund managers fill the same basic need to provide guidance for the future. Their prognostications on marriage prospects, the recovery of the Retail Sector or the year end level of the FTSE provide hope and guidance for consumers and intermediaries alike, however accurate or inaccurate.
The recent crisis at BP is a classic example. No one saw it coming and nobody knows how it will end. But that hasn’t stopped pages and pages of newspaper print and endless megabytes in the blogosphere being devoted to it.
For the rest of us accepting that no one actually knows what is around the corner can be a deeply destabilising moment. Finally accepting that the future is unknown is unsettling, but once done is truly liberating. Now you can select investments purely on their cost and valuation. No longer do you have to weigh up the veracity of one set of forecasts against the other. You don’t have to read the trade press or go to conferences to hear what others think. Suddenly, you have an enormous amount of time to spend on growing your business or enjoying life. Having the confidence to concentrate on what is known is far more rewarding than trying to guess the unguessable.
June 2010
*Regulators make investing riskier*
The crash of 2008 was unique. It was not triggered by a war, a shortage of raw materials, a famine or indeed any external factors. It was caused by a massive expansion of credit that was condoned by regulators and the authorities. When cheap and readily available credit disappeared at the Minsky Moment (when consumers started to reduce debt rather than increase it) in the summer of 2007 it left everyone gasping for money. And no one could quite explain why it wasn’t there anymore. One day it was there and the next day it wasn’t. Why?
Bizarrely, it might have been the abundance and pervasiveness of the regulatory authorities that increased consumer appetite for debt that created the bubble in the first place. Could it be that the confidence from knowing that “some official has reviewed this product and therefore it is safe” actually put in place the conditions for a boom that had to be followed by a crash? Governments too fell into the trap that regulation was devolved and they need not concern themselves with the nuts and bolts, or even the larger impacts, of financial services. Unfortunately, it is governments, and taxpayers, who now have to cope with the consequences.
Although some fraud was committed the majority of the problems arose from activities that were legal and fully permitted by the regulators. Selling mortgages to people who clearly had no ability, or even intention, of repaying them was allowed. Banks that were already trading on low levels of capital adequacy were permitted to buy other banks. Investment banks in the US borrowed up to $29 for every $30 they invested, and financed that on loans that could be called at one day’s notice. While IFAs were forced to ask longstanding clients for evidence that they were who they said they were banks were under no obligation to secure evidence that borrowers earned what they claimed.
Foreign banks offered abnormally high rates of interest to UK depositors in order to fund balance sheets that dwarfed their domestic economy. No regulator seems to have questioned or prevented these or many other activities that at the time seemed odd to many. Even Warren Buffet claims he didn’t spot the bubble. Though it is hard to believe he was the only man on the planet not getting junk mail offering cheap finance in 2007?
Despite the abject failure of regulation the cost of maintaining the regulatory bodies has been paid by all consumers. The FSA took in £350m in 2009 and total UK compliance costs must surely exceed £1 billion. Paying for this service gave the public a false sense of security about the soundness of the institutions they were dealing with. Would consumers of financial services have been so eager to make transactions if they knew the provider was unregulated? Probably not, but the absence of a regulator did not hinder economic development in the past. There were of course spectacular bubbles and crashes before like the South Sea, Tulips and the railways. It was only in the twentieth century that the concept of regulating finance took solid form. It would be hard to argue for the total removal of all financial regulation. However, the current system has patently failed and the instinct of politicians to a crisis is simply to introduce more regulation. But the evidence from history suggests that more regulation will not solve the problem.
So what’s to be done?
Any advocate of capitalism would look for a market solution in preference to one imposed by the state. And there is one. At the peak, or depending on your point of view the nadir, of the crisis the authorities blamed the short sellers and acted to halt short selling. Yet it was people like Mike Burry and Steve Eisman who had actually spotted the incipient problem years before and had already acted on their views by going short. In fact the shorts were probably the only buyers of distressed financial companies during the crisis. Not only had they acted, out of self interest, to bet against the prevailing wisdom some of them went out of their way to tell the bulls they were wrong.
Two things are needed to help regulate the market and thus make it safer for simple investors. One is transparency and the second is the right incentive. Although Northern Rock did not fully disclose all its data on failing mortgages towards the end of its life most investors knew it was lending more as a percentage of house values than its competitors and that it was reliant on the wholesale market for funding. None of that was illegal. But there was little motivation for an averagely paid FSA official to sniff around and investigate whether the situation could get a lot worse. After all, lots of highly paid executives had strong incentives, like share options, to pretend everything was hunky-dory. In the US a modestly paid ratings agency apparatchik is likely to be outmanoeuvred by a Wall Street executive hoping for a multi-million dollar bonus if a deal works.
The problem is that regulators will always be paid less than the best in the industry so the game is never equal.
What society needs to do is harness the intellectual firepower of firms who take short positions and use that with the balance sheet of the state. That way it can help prevent valuations that reinforce risky behaviour. It was the ability to raise cheap finance to fund high risk trading that helped create the finance. After the crisis broke companies like Lehman Brothers, Northern Rock and RBS were unable to raise capital when they needed it. If their business models had been challenged earlier valuations might have been lower. In that case the capital would not have been there to fund such high risk activities. As a consequence they might have been obliged to change their balance sheets to use more conservative funding for a less aggressive business. That said, in a bull market the most highly levered company will always do best. Being short in that environment can be painful and expensive, so you need a big balance sheet. Eventually though the rewards will come through and once the crash happens the shorts will make money, and at just the right time to support those that need it.
So all we need do is change the name of the regulatory body to “The Financial Shorting Authority” and reduce its staff to a handful of retired practitioners. They will be mandated to allocate capital to hedge funds to trade as they wish, but for the ultimate benefit of the state, after performance fees of course. To ensure a level playing field each trade that a fund places on behalf of the FSA must be published the following day so everyone can see what is being done on its behalf. The process would naturally be self-funding and the FSA would be able to remit profits back to the Treasury.
One former Chancellor of the Exchequer claimed to have abolished “boom and bust”. In reality the business cycle is a part of the modern economy in just the same way as taxes and fashions. Regulation will not eliminate the economic ups and downs, nor will it ever eliminate all fraud and corruption. The best we can hope for is that if someone, or some business, claims to have discovered a new way to make gold from lead that it is subject to the full scrutiny of interested parties. There is more chance of anomalies and malpractice being discovered if the investigators have the right incentives. And there is no better motivation in finance than money.
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.
April 2010
What is the best way to measure dividends?
Dividends, it is generally agreed, are a good thing. Indeed, the majority view is that the more the better. Long term research by Barclays, Credit Suisse, Société Générale and Professor Jeremy Siegel all provide convincing evidence that the bulk of equity returns over the long term, five years and more, actually comes from dividends, growth in dividends and from reinvesting dividends.
On the basis of these data then it should be a straightforward process to construct a market beating portfolio. Simply buy a collection of the highest dividend paying shares and away you go. Indeed, for many investors over the last decade that has been a winning strategy. A number of professional money managers made great careers running high yield funds; until 2008 and 2009 that is. The last two years have been very painful for income funds with catastrophic falls in 2008 for many and lacklustre returns in 2009 when market recovered very sharply.
To the detached observer these events simply proved the validity of stock market aphorisms like “There’s no such thing as a free lunch” “You can’t beat the market” or “Higher returns only come with higher risk”.
To understand better why income and yield funds have been so disappointing over the last two years it might help to do a little analysis on what exactly a high yield share is. Yield is the product of two figures divided together. The top line is the dividend a company pays, usually expressed in pence per share. That number is then divided by a second figure, the share price, to calculate the yield. Although they are related there is no direct correlation between the two except through the yield calculation. It might therefore make sense to look at each figure separately to see how they originate and what they are telling us.
A dividend is the amount of money a company feels it can afford to pay out to its shareholders after it has paid all its creditors and invested enough to sustain and grow the business. Although it represents a cash payment of several tens or hundreds of millions of pounds it is invariably referred to in pence per share. The figure is set by the board in relation to the reported earnings per share and by what the company has paid in the past. Determination of the dividend may also be impacted by the board’s view of the future. A particularly worrisome outlook may persuade the directors to leave the dividend unchanged, cut it or reduce it.
Alternatively, the board may be so confident in the future of the company it might want to send a signal to the market that things are great, and are going to get better. An earnings per share figure is, more or less, simply a record of what the company has done and does not send a message about future prospects. Even though two of the options open to the board are reducing or not paying a dividend in practice boards are reluctant to do this and will often pay the same dividend as the previous year even when its financial circumstances might indicate otherwise.
Much is made of the dividend cover. This is the difference between the earnings per share figure and the dividends per share. Typically boards and investors like a figure of around two or more as this provides some scope for maintaining the dividend even if the company has a bad year. In practice these days the many distortions to profits from exceptional and or non-recurring items often makes the earnings figure a poor guide to what the company can pay out to its shareholders. A better understanding can be gained from analysis of the cash flow statement, although that too can be fraught with issues around lumpy capital expenditure and corporate activity.
The dividend that a company actually pays is thus a complex blend of what the company can afford and what the directors think is appropriate given the current business conditions.
In contrast the directors have no control over the share price. That said directors now are all acutely aware of the requirement to inform the market if they believe current consensus forecasts are more than five percent adrift from what they think will happen. In essence share prices are set by “Mr Market” as sagacious investor Warren Buffet calls it. All the available data is collected and assessed by existing and potential holders of the stock to discover the most accurate price for the shares. Except in periods of extreme market dislocation exactly half the market will think the shares too expensive while the other half will view them as too cheap. Share prices can therefore best be viewed as an opinion while a dividend is very definitely a fact. The question is what happens when we divide a fact by an opinion. Surely, it must just be another opinion.
And that is where income and yield funds run into problems. High yielding stocks are trying to balance the conflict between the fact of the last dividend payment and the opinion of the market over the size of the next dividend. In many cases, especially over the last few years, the market opinion that a dividend will be cut, or reduced, has been correct. Even when that downside has been priced in a dividend cut usually triggers a further fall. And that is painful for funds that hold the shares. In practice the effect is compounded because income and high yield funds will migrate to stocks that, on paper, offer a high yield and ignore stocks where the income is safer, but smaller. In effect what is happening is that dividends are being valued by price and these funds over-invest in shares whose income has a low value; in many cases for good reasons.
Investors buying conventional tracker funds ignore share prices when they invest. So what happens if we ignore the price of dividends? Why don’t we use some other measure to assess them? The simplest way to do that is to rank companies by the gross cash dividend they pay out. In other words you measure dividends by volume rather than price.
When we compare a portfolio constructed in this way we see a lot of similarities with a conventional portfolio ranked by market capitalisation. After all a company paying out several billion pounds in dividends is hardly likely to be lurking in the Small Cap sector. It is therefore no surprise to see that companies like Vodafone and BP that constitute the largest companies in the market are also the largest dividend payers. Moreover, assessing dividends in this way gives an excellent mechanism for determining how much of each stock a portfolio should hold. Using each company’s contribution to the total income of the market provides a logical basis for calculating portfolio weights.
Using dividend data in this way provides a neat riposte to Oscar Wilde’s accusation that some men know the price of everything and the value of nothing. It is more important to know the value of dividends than their price.
March 2010
*For Sale: A one year old rally, no careful owners*
March 3rd 2009 marked the bottom of the UK bear market. One year later the FTSE 100 is up 51%. While that is pleasing it is outclassed by the FTSE 250 Index that is up 63% while the FTSE Small Cap is a staggering 69% higher. Have these gains arisen because profits in the constituent companies have risen by that much? Alas no.
In the case of the large companies profits have actually been pretty pedestrian over the last twelve months. Indeed, mining companies probably reported profits in 2009 that were about half the levels of 2008. Oil companies too all had much lower profits as oil prices fell. The saving grace for these global megacap stocks was their international exposure that enabled them to benefit from strong growth in emerging markets. Nevertheless, overall profits certainly did not rise by over a third.
In the case of the Mid Caps the performance was, if anything, even worse. This group of companies has a much stronger focus on the UK and includes sectors like house building, car retailers and many consumer facing industries. Most importantly over a quarter of the sector is financial stocks. Overall, they had a torrid time in 2009, and profits are, in many cases, sharply down on 2008. Finally, last but not least, the Small Caps are a mixed bag of companies that are much more sensitive to the economic winds because of their small size and can be best be described as the canaries of the financial world. They too had a tough time in 2009 and certainly did not increase profits, let alone anything like 69%.
So why then did the smaller companies do so much better in this rally than the big caps? The answer lies in the events leading up to the market trough. In 2008 the financial crisis led to a dramatic reappraisal of risk and it suddenly become important to price it correctly after years when it had been ignored.
Risk is associated with many things but an important factor is liquidity, the ability to get out of an asset when you want. Small cap stocks have famously been described as lobster pot stocks; easy to get into, impossible to get out of. As the true scale of the financial crisis became apparent at the end of 2008 the small cap and mid cap sectors cratered as investors exited the riskiest assets. A lack of liquidity meant brokers could not find buyers and prices were marked down sharply. The process continued in the first few months of 2009 and valuations of all equity markets, but especially small and mid caps, reached distress levels in the first week of March. It was then the Bank of England started its programme of quantitative easing. Although it had been flagged in advance the start of the programme gave investors the confidence to reprice stocks on a going concern basis rather than as basket cases only an accountant away from liquidation.
Over the next six months investors started to look at the whole market, but especially the small and mid cap stocks, on the assumption that eventually business conditions would normalise and that the recession would end eventually, even if no one knew when. So the market did what it loves to do, but is actually very bad at, which was to “vote” on all the beaten up shares and revalue them on expectations that they would return to profitability. All the evidence from long term studies on stock market returns, such as those from Barclays and Credit Suisse, show conclusively that the bulk of returns comes from reinvesting dividends and allowing the magic of compound interest to do its work. It does not come from chasing capital growth.
In the rally of 2009 all that was forgotten as investors clambered about car dealers and house builders in the expectation that profits would return to previous levels. However, by anticipating the recovery, the market has risen on valuation rather than earnings. It is the expectation of profits rather than actual delivery of earnings that has boosted share prices. Nowhere is that hope higher than in the mid and small caps.
This rally has been a painful experience for value investors who prefer the tangible evidence of dividends rather than the faith of recovery investors who expect balance sheets to deliver the same profits as before. The bounce has put the market on a much higher valuation than a year ago and has left more conservative investors behind. This is best measured by comparing the dividend yields of the three size categories. The FTSE 100 yields 3.4%, the FTSE 250 2.6% while the FTSE Small Cap yields 2.7%. It will take time for compound interest to work in favour of dividend paying stocks again. But there is no doubt it will happen and, as it does, funds with a value bias will start to close the performance gap on growth and momentum funds.
February 2010
Agents versus principals
In all the outpourings of angst over the global financial crisis there is one group that has suffered more than any other, yet its voice has been drowned out by politicians, the media and taxpayers. It is shareholders in banks that have been the hardest hit by this financial Armageddon. Some commentators would argue that speculators holding bank shares simply got their just desserts for holding such risky investments. That is unfair though because for most of the last half century bank shares were regarded as rather boring and less risky than other sectors such as technology and commodities. Moreover, many individual shareholders became accidental capitalists as a consequence of the demutualisation of a number of building societies. Few could accuse those venerable institutions of playing fast and loose in the world of finance in their original form.
The reality was that banks shares formed the bedrock of a great many portfolios ranging from individuals, income funds and pension funds. For those investors to have avoided a sector that was generating about £20 billion of dividend income, about one third of the total cash flow from the market, would have been nonsensical. Two years ago, before the great implosion, this sector was valued by the market at about £200 billion. That was a staggering large amount of capital.
So who was responsible for vaporising it? The simple answer is that it was largely in the hands of a small group of people who were, for a while, on the front pages of newspapers up and down the land. Sir Fred Goodwin, Andy Hornby, Sir Victor Blank and so on. In fact these men were not custodians of that capital but the agents responsible for deploying it. They, in the truest sense of the phrase, were merely managers. They did not represent the owners of that capital but were deploying it for the greater good of the shareholders.
The agents deployed the capital on behalf of the principals. But the rewards for the risks incurred went to the agents who organised the trade, not to those who took the risk. No wonder the system blew up. If the principals, the shareholders, had been properly rewarded for the risk, and kept the proceeds, the banks would all have had stronger balance sheets.
Of course history records that then, and even now, the executives made themselves very rich in the process. Not only did they reward themselves very handsomely through wages and bonuses they also decided that they would like to become shareholders as well. So they awarded themselves options enabling them to become part owners of the business. Unlike other shareholders though, they did not have to write out a cheque for their investment. They got the shares for free just for turning up and doing their job as directed by the owners. It’s not a perfect analogy but it is a bit like a window cleaner turning up on a regular basis, cleaning the windows of your house and, in addition to being paid, demanding and being given a small share in your house.
Most householders would not contemplate such an agreement. Why should they give up a part share of an asset to someone who is merely following orders? Yet this transfer of ownership is precisely what happened at the banks, and it is still going on. When Barclays sold its iShares business in 2009 Bob Diamond received millions of pounds for the shares he owned in that division. Did he buy them? I don’t think so.
It is this insidious dilution of the original owners of the business that is at the core of the financial crisis. Managers, the agents, acquired part ownership from the shareholders, the principals, by stealth and then treated all the capital in the same way. As if it was free.
In theory the rights of the shareholders are protected by the watchful eye of the non-executive directors. But take a look at the board of Barclays as an example. CEO John Varley, with 622,000 shares and Bob Diamond with 8.3m shares are executives, as is Finance Director Chris Lucas with 101,700 shares. They have to explain their actions to the shareholders and take instructions from the non-executives. But who are they?
The Chairman is Marcus Agius, a Swiss banker, so he doesn’t represent British shareholders but has 113,500 shares. John Sunderland, with 80,000 shares used to run Cadbury. David Booth owns 73,000 and used to work for Morgan Stanley. Simon Fraser with 46,000 shares was a fund manager at Fidelity before he retired. Fulvio Conti has 39,000 shares and currently runs Enel, the Italian energy company. Leigh Clifford with 35,000 shares used to run Rio Tinto and is now Chairman of Qantas. Richard Broadbent with 34,500 shares is Chairman of Arriva. Andrew Likierman with 23,000 shares is Chairman of the National Audit Office. Michael Rake with 15,000 shares used to work for KPMG and is now Chairman of BT. Finally there is Reuben Jeffery who spent 18 years at Goldman Sachs.
The non-executive directors are clearly there to cement business relationships. It is patently clear that none of them represent large, long term shareholders. There is no one on the board of Barclays Bank who is actively involved in managing money. There is no representative from Schroders, Prudential, Standard Life or Aviva, the biggest money managers in the UK. Neither is there any representation from hedge funds or sovereign wealth funds, many of whom will have capital invested in the bank. Traditional fund managers will of course declaim that they cannot be directors because it would generate a conflict of interest and would inhibit their ability to trade if they became privy to inside information. That is less relevant now because so much money these days is run on a passive basis. Portfolios are constructed totally independently of any “information” that fund managers might be able to acquire from a board meeting or anywhere else.
Passive mangers now have the worst of all worlds. They are custodians for pensions and ISAs yet can only stand and watch, passively, as large banks deploy that capital in a way that could destroy it.
Alan Greenspan, former chairman of the US Federal Reserve, was surprised by the financial crisis. He thought the self interest of all the participants would inhibit them from undertaking activities that were likely to result in such a catastrophe. The problem was that the agents of the crisis were not risking their own capital. The principals, whose capital was being risked, never got a chance to express their opinion.
There will be other financial crises, it is human nature. But it is possible to ensure that this one is not repeated. The first step would be to ban the use of share options as a means of incentivising bank executives. The second is for shareholders to ensure that they are adequately represented on the boards of banks. Once there they need to understand the risks that are incurred and ensure the return is sufficient compensation. Most importantly, they need to make sure the risk takers are rewarded, not the agents.
January 2010
As a conversation stopper telling someone you are a tracker fund manager is about as good as saying you are a traffic warden. It makes a good excuse to edge closer to the canapés and drinks. But not all tracker funds are the same and the portfolio of a fundamental tracker fund, such as The Munro Fund, has significant differences from a conventional market capitalisation weighted fund. It is this difference that creates the potential for a better return than conventional trackers.
Examples make explanations easier. Anglo American has a market weight of 2.37% yet only 0.36% of the Munro Fund is invested in it. Why the discrepancy? In 2009 Anglo American surprised investors by suspending dividend payments and said they would be reinstated when market conditions allowed. It did not pay an interim dividend and few analysts are expecting a final dividend to be declared when it reports results for 2009 in February 2010. Dividends are a key part of the covenant between investors and managers. Investors supply capital to the managers in order for them to generate cash, not just profit. That cash can be then be used to grow the business but there is usually a clear understanding, especially in mature businesses, that some of that cash will be returned to investors as a reward for the use of that capital and as a gesture of good faith. Banks have dramatically proved in the last few years that the inherent tension between principals and agents can be stretched too far.
Managers have day to day control of the cash and it is often easier to find new and exciting projects to spend the cash than return it to the providers of capital. In the case of Anglo American its immediate downfall was the multi-billion dollar iron ore project in Brazil. But that was just one of many problems. The sharp contraction in the world economy at the end of 2008 sent commodity, and especially diamond prices plunging. Anglo American has a 45% stake in De Beers which needed emergency financing after closing all its diamond mines due to the financial crash. Even though diamond prices have recovered a little volumes are still low and how De Beers will refinance itself is unclear. Will it need a rights issue?
Then there is the 80% stake in Anglo Platinum. It is has $3b in debt and is struggling to find cash flow for capital expenditure. Will it too need a rights issue? All these, and other, pressures on Anglo American convince analysts that a meaningful dividend is unlikely for some time. Instead it has to decide how to ration the pot it has and consider whether to ask for more. The stock market has placed this company in the select group of corporations that are expected to pay out over a £1billion pounds in dividends next year. Our data indicates that even a quarter of that would be overly generous which is why the fund has a modest exposure. The question is why do other trackers hold so much?
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