Modern finance is “a greedy giant out of control”, says Jonathan Ford in Prospect. It’s hard to disagree with him. The financial-services sector employed one in five Britons last year, while its contribution to total corporate profits is estimated to have grown “from around 10% in most developed economies” in the 1960s, to around 35% in both the US and UK by 2005. And because finance has become “too big to fail”, governments are now pouring vast sums of taxpayers’ cash – £37bn in Britain – into propping up failing banks, and even $150bn into a US insurer, AIG.
Meanwhile, central banks have stepped up their roles in money and short-term credit markets to avert a full-scale financial meltdown. None of this surprises financier George Soros, who believes we are witnessing the spectacular bursting of a “super bubble of the last 25 years”.
But aren’t our financial markets supposed to be rational? Aren’t they the most efficient way to funnel capital to where it will be best used? Unfortunately not, argues Paul Woolley, ex fund manager and IMF economist. In fact, what our financial markets are really efficient at is funnelling great chunks of an ordinary investor’s capital into the pockets of an army of ‘agents’ or middlemen (brokers, fund managers, traders and the like). Here’s how the system really works – and how to avoid being ripped off.
The rise and rise of financial services
The rise of modern finance is anchored on the grand-sounding ‘efficient market hypothesis’ (EMH) devised in the 1960s. The EMH says that financial markets are great because they make it possible for instantaneous trades to occur among rational, fully informed buyers and sellers. So the prices of everything from shares to currencies to commodities are quickly driven to their correct, ‘fair’ values, which reflect all relevant, available information. As soon as new information hits the market, investors absorb it en masse, trade accordingly, and the price changes. As such, capital can be channelled cheaply to the most profitable assets for the maximum return. No other mechanism delivers these benefits as effectively – or so the argument goes.
Once you’ve accepted that, it’s a “small step”, says Woolley, to argue that larger and larger financial firms are needed to engineer this ultra-efficient reallocation of capital from investors to borrowers. And as the financial sector expanded further, proponents argued that financial markets were a good thing in themselves. They seemed to employ lots of people and generated “dizzying amounts” of tax revenue, says Ford. For example, by 2000 about one third of UK corporation tax came from the financial sector.
The ‘efficient market’ myth
But there’s a big problem with the theory – it doesn’t work. In a rational market, if prices drift too far from the ‘fundamentals’ or an intrinsic ‘fair value’, buyers and sellers should react, buying undervalued assets and selling expensive ones. But clearly this isn’t the case, or we would never have seen the crash of 1987, the dotcom crash, or the carnage we’ve seen this year, to name but a few. Investors don’t have perfect knowledge, so decisions to buy or sell are based on flawed analysis. This causes unexpected price movements that then feed into future analysis. The result is a chaotic world of booms and busts, argues Soros. But there’s another fundamental problem, says Woolley. Financial insiders know more than investors. Woolley calls this ‘information asymmetry’ – and this “has far graver consequences for the functioning of finance”.
Head you lose, tails you don’t win
Financial markets are nowhere near as transparent as the EMH might suggest. The more the industry surrounding the markets expands, the easier it becomes for agents to profit from their better understanding of what goes on behind the scenes. This has an increasingly harmful impact on returns.
As Warren Buffett’s partner, Charlie Munger, once put it, “the croupiers’ take” – the chunk of returns taken by stockmarket intermediaries – has been steadily rising. Take, for example, the long-term annual real return of 5%-6% earned on shares, says Ford. Share options granted as compensation to directors amounted to 20% of corporate profits in 2002, so you can knock 1% off that real return right away. Another 0.5% typically goes in merger and acquisition fees, themselves increasingly skewed to reward success but not punish failure (whoever heard of a corporate financier returning a bonus?).
Your broker will pocket, on average, another 1% in bid-to-offer spreads. So you are down to a return of just 2.5%-3%, even assuming the stockmarket has a relatively good year. And it doesn’t end there.
Buy shares through an actively managed fund and you could wave goodbye to 5% in up-front charges, 1% or more in annual management fees and perhaps the same when you cash out. To cap it all, the more times a fund manager spins the wheel and trades shares, the more often you suffer that bid-to-offer-spread and the lower your returns. Needless to say, that wheel has been spinning faster and faster. Woolley estimates that, over time, a typical pension fund manager will trade equities back and forth with other fund managers with the sole effect being to slash the end value for a typical client by 25%, thanks to trading costs.
Timing matters
Of course, fund managers can only get those fees if investors are in the market. That’s why it’s important, particularly during bear markets, to persuade the man in the street to stick with stocks. So the view that it’s ‘time in the market’ rather than ‘timing the market’ that matters is encouraged by the industry. “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves,” says Christopher C Davis of Davis Advisors. “Stocks have rewarded patient, long-term investors.” His data show that anyone who was invested in the S&P 500 between 1993 and 2007 would have made an average annual return of 10.5%. Miss the best 30 trading days, and this drops to 2.2%. Miss the best 60, and the return actually turns negative. Hence, “timing the market is a loser’s game”. But is this really the case?
The problem is that to catch the best days by staying invested you also risk being pummelled by all of the worst ones. And catch too many of the stockmarket’s whopping downers, such as the dotcom crash or last August’s slump, and you could be waiting years to make a return. Indeed, Peter Coy in BusinessWeek believes that, far from being irrelevant, “timing is everything”. He quotes London Business School economist Elroy Dimson, who points out that, while long-term investing has its merits, “the long run can be very, very long”. While 1993 to 2007 was a great period for US stocks, others have been catastrophic. Between 1905 and 1920, for example, the return on US stocks was negative in real terms. The same is true for the 22 years between 1900 and 1921 in Britain, and the entire 73 years between 1906 and 1978 in Italy. Japan’s Nikkei 225 is today back roughly where it was in 1981.
Value investing doesn’t always work
Inefficiency needn’t be a bad thing, though, surely? Legendary stockpicker Ben Graham liked the idea that markets are inefficient. Pricing errors make value investing – selective ‘bottom up’ stock picking – much easier. Irrational waves of optimism and pessimism throw up great opportunities all the time, say fans. Many of the investors who followed in Graham’s footsteps (Warren Buffett and Peter Lynch among them) have made fortunes as a result. Using screening tools such as low price-to-book (PTB) and price-to-earnings (p/e) ratios, or high dividend yields, they snap up unpopular stocks and then wait for other buyers to cotton on and send their prices skywards. Surely, that’s the perfect solution to imperfect markets?
Not all the time, says Edward Chancellor on Breakingviews. “Many value investors have recently lost heavily”, becoming the “collateral damage of the credit crunch”. For example, anyone who piled into ‘cheap’ property firms or banks on the basis of record dividend yields since the credit crunch began last August has suffered as dividends are slashed. That’s because value investing isn’t suited to a “100-year storm” of the type we are seeing now, says Chancellor. And it’s the smaller, more cyclical firms favoured by value investors that are being hit hardest, as the market is ravaged by a “truly devastating economic downturn” which is changing expectations about what a share is worth at “mind-numbing speed”.
So although value investors could, until the credit crunch, earn decent returns by buying unpopular, smaller, riskier stocks in a rising market, that won’t work while it’s still impossible to tell what good value actually means. Those with a long memory will note that cheap stocks, as measured by, say, PTB ratios, fared “much worse than the market” between 1929 and 1932. The Great Depression battered even Graham himself – by 1933 his investment partnership Graham-Newton, which bought stocks “cheap enough to withstand any imaginable blow”, had lost 70% of its starting capital.
Momentum – enemy of the people
If value investing doesn’t work, what does? The answer is something that shouldn’t exist in an efficient market: momentum trading. In short, you catch an upward or downward trend and follow it, even as fair values go out of the window. Its popularity is reflected in numerous asset-price booms and busts. As such, it is “no friend to the end investor”, says Woolley.
First, it results in “capital misallocation on a grand scale”. Take the estimated $150bn raised during the dotcom boom by internet entrepreneurs from venture capitalists and investors. Most of it was wasted. Or the £1,200bn of mortgages extended to borrowers here, which spawned mortgage-backed securities, swathes of which are still being written off. Second, financiers actively encourage momentum trading, simply because it creates price volatility and therefore greater demand for their most expensive services. Without huge price swings, share prices would be more stable and would better reflect fair value and more people would understand them. Where’s the fun – and the fees – in that? Far better to generate maximum volatility and ‘noise’ and frighten investors into seeking out the best and most expensive fund managers.
That’s how we end up with hedge funds with upfront and performance fees that can easily take out 20% of your annual returns. It also accounts for the explosion in derivatives and structured products, many of which, says Woolley, are more of a “testament to the ingenuity and salesmanship of investment bankers and fund managers” than of actual use to investors.
Spreading risk also spreads losses
The solution cited most often by the financial industry to what Davis Advisers labels “uncontrollable and unknowable variables” (ie, volatility) is “creating a properly diversified portfolio”. Don’t put all your eggs in one basket, says the theory. Spread them over many different and uncorrelated assets. That way, when one takes a dive, the rest will hold up the overall value of your portfolio. Sounds good in theory – but sadly not in practice, says The Economist.
The idea of spreading your cash and thus your risk over property, stocks, bonds, and so on has hit the buffers following the “first truly global bubble”. Over the past five years in particular, all assets were chased higher, often using cheap debt. So now everything is deflating at the same time too. Many supposedly uncorrelated asset classes have turned out to be nothing of the sort – private equity, for example, “gives investors the same kind of exposure as quoted companies, only with added leverage”. Worse, anyone who diversified into relatively obscure (say, emerging-market) assets via specialist hedge funds has come up against the “rowing boat” factor in illiquid markets – “when everyone tries to exit at once, the vessel capsizes”. Geographic diversification hasn’t helped – so called ‘decoupled’ emerging markets, such as the Bric countries, are suffering too. To cap it all, diversification is expensive as it tends to involve moving money into more specialist funds with higher management fees to achieve a wide exposure to either different geographic regions or products. Diversification “has been another free lunch for the fund managers”.
How can you avoid falling prey to the financial industry? We look below at what to do and what to avoid.
Four tips to help you invest wisely
Keep costs down
Use exchange-traded funds (ETFs) whenever possible rather than actively managed funds with their much higher fees. As the S&P Spiva scorecard reveals, benchmarks outperform managers “in 70% of cases”, according to their head of global research, Srikant Dash, who tells the FT that this is the case “even in relatively inefficient segments of the market such as small caps and emerging market stocks”. Next, don’t follow fads, or the latest advice from investment experts, and then overtrade. For example, consultants Davis Advisers compared the interest-rate forecasts in The Wall Street Journal Survey of Economists for the period 1982 to 2008 with actual interest rates. The ‘experts’ got it wrong 35 times out of 52. That’s a 33% success rate. Share tipsters are often no better. They don’t have to be. A broker earns commission on every trade, good or bad.
Don’t fall for sucker rallies
“It has been a depressing week,” says the FT. Citigroup announced over 50,000 redundancies; a sharp drop of 0.7% in the consumer price inflation rate to 4.5% “raises the spectre of deflation”; and the Confederation of British Industry forecasts the highest drop in GDP since 1980 – 1.7% in 2009. Yet, although the FTSE 100 fell this week too, it is still above October’s 5.5-year low. So perhaps we are at the point where “bad news can’t shock anymore”– the long-awaited bottom.
Don’t believe it. Market bottoms tend to be “much lower than you ever expected in your worst nightmare”, says Jeremy Grantham, founder of investment management firm GMO, in the International Herald Tribune. He believes the odds are 2 to 1 that the US market will sink to new lows in 2009, as there is precious little evidence that “the economy will be rebounding soon”.
And where America leads, we follow. Philip Isherwood of Dresdner Kleinwort agreed in The Times: “forget the 10.5 times earnings that the UK and European equities traded at in October 1990 or the 7.5 times and 8.3 times today – try six and seven times instead”. What’s more, even at those levels, p/e ratios are not a sure sign that stocks will recover – the S&P remained pretty flat during the 1970s, for example, when market p/es were consistently below ten. And the S&P 500 is still above that level at around 12. Above all, says John Mauldin at Investorsinsight.com, investors must grasp that we are now in a decade-long secular bear market. In previous such markets it has taken years for shares to hit bottom because (less than rational) investors “overreact to good news and underreact to bad news on stocks they like and do the opposite to stocks that are out of favour”. That process will be stretched this time following “the biggest sucker rally in history” between 2002 and 2006. So, he says, there is “much more pain coming. I don’t think we’ll hit the low until 2010.”
Keep it simple
As Woolley notes, the modern finance industry has become “incomprehensible” to many investors. That’s deliberate. Complex problems usually require expensive solutions. So we would avoid most structured products of the “80% of the FTSE 100’s returns or your capital back” variety. If you don’t understand it, or the payoff looks complicated, don’t buy it. The same goes for hedge funds, which are notoriously opaque.
Don’t ignore asset allocation
Right now certain assets such as British property and many equities still look expensive and risky, despite recent falls in value. Cash, on the other hand, might be dull, but at least it has offered a positive return over the last 12 months. Cash doesn’t make big fees for fund managers, of course, although they will happily, and expensively, sit on yours to foster the illusion that they are cleverly beating a falling equity market.