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Is active fund management an industrial sized rip-off?

The long con is the most dangerous kind of confidence trick. It’s not nice to lose a tenner to a street hustler or even £500 to a door-to-door swindler, but the long con – the swindle that runs for weeks, months, or even years – can be a much more deceptive and fatal affair.

The long con – where you’re played as a mug by a whole crew of rip-off merchants – is how you lose thousands of pounds. It’s the stuff of boiler room scams that steal your nest egg, agents who sell you a house they don’t own, maybe even a spouse who only wanted you for your ISAs.

In the hands of truly gifted grifters, you might even reach the end of a long con without realising you’ve been the victim of a scam at all.

Is the active fund management industry a long con?

Perhaps. Sort of.

To be clear, I’m not talking about frauds like Bernie Madoff, or even foul-ups like the split cap trust debacle, the Equitable Life scandal, or sub-prime mortgages, dubiously sliced and diced debts, and dodgy ratings agencies.

I just mean the everyday business of managing our money and charging for it.

The con is on

Most investment bankers, fund managers, or others in the City are definitely not crooks. Far from it – I think they’re overwhelmingly law-abiding citizens and upstanding members of the community.

(A cynic might say they’ve every reason to uphold the Law of the Land, given their place near the top of the tree!)

But much of financial services does look like a giant machine designed to skim billions off a mass-market of oblivious mug punters.

As for the elite, they can give their money to hedge funds and get fleeced in style.

An extreme argument?

Well, we know that the majority of active funds do not beat the market.

All the data shows that. Yet we also know the total weight of money in active funds still greatly outweighs the money in passive funds.

Therefore most private investors are paying for a service that doesn’t deliver what it promises.

They are paying much more than they would if they’d invested passively via the cheapest intermediaries, and simply accepted the market return, minus low tracker fees.

Ring any alarm bells?

Here’s the definition of a confidence trick from Wikipedia:

Confidence tricks exploit typical human characteristics such as greed, dishonesty, vanity, opportunism, lust, compassion, credulity, irresponsibility, desperation, and naivety.

As such, there is no consistent profile of a confidence trick victim; the common factor is simply that the victim relies on the good faith of the con artist.

Victims of investment scams tend to show an incautious level of greed and gullibility, and many con artists target the elderly, but even alert and educated people may be taken in by other forms of confidence trick.

Accomplices, also known as shills, help manipulate the mark into accepting the perpetrator’s plan.

In a traditional confidence trick, the mark is led to believe that he will be able to win money or some other prize by doing some task.

The analogies write themselves.

You’ve got to pick a pocket or two

Now, it’s true you won’t lose your life savings by investing in a portfolio of decent actively managed funds.

Your pension is just likely to be a bit smaller than if you’d gone passive.

Even if you do the maths and discover just how much of your return you potentially give up in paying the costs of active management, your final nest egg probably won’t look too bad, thanks to compound interest.

Indeed the genius of the operation is that rather than financially ruining you by taking you for all you’ve got and then quitting town overnight, active fund management fleeces us for a couple of per cent each year, every year.

But when you add up all the proceeds, you end up with one great tithe on our savings.

Here’s John Bogle, the father of the index fund, on the subject:

“The function of the securities markets is to allow new capital to be directed to its highest and best use.

That’s true, but think about the maths for a minute.

We probably have about $300 billion a year that goes to new and additional offerings.

We trade $56 trillion, and that means something like 99.5% of what we do as investors is trade with one another. And 0.5% is directing capital to new business.

There is a system that has failed society. Period.”

That’s a powerful argument, though I do think Bogle over-eggs the pudding.

For starters, a certain amount of trading is required to have a liquid secondary market in shares. Without that, nobody would put fresh money into newly-listed companies in the first place.

Equally, some measure of trading is required for us to have efficient markets, although nobody knows how much. In the video below, Sensible Investing cites ‘academic consensus’ that a global fund industry of 20% the size of today’s would be sufficient, but I have no idea how reliable that figure is.

But plenty smaller, I’m sure.

Bigger and biggerer

This graph from The Economist from back when people were worried about how vast the financial services industry had become – you know, 2009 – reveals a part of the reason why the rich got so much richer in the past few decades.

Financial services swallowed up an ever-increasing share of GDP:

Financial-services-GDP

Did we ever need so many people shuffling money about for a productive planet?

Or did they perhaps – like the infamous bank robber Jesse James – go where the money is?

Some of the increase in GDP share for financial services may be warranted. It might for instance represent the more sophisticated allocation of capital towards higher return investments, with a decent pay-off for our economies and for society. Greater leverage will play a role, too.

Another chunk of it is the West being the banker for the faster-growing wider world, which is a boon for cities like London.

Still, it’s hard to believe we need Wall Street to make the $26.7 billion in bonuses it clocked up in the year to March.

And it’s hard to believe the many billions spent in the UK on the zero-sum game of active fund management – £18.5 billion of it in hidden charges, according to the True and Fair Campaign – isn’t many billions bigger than it needs to be.

I admit fund management is probably grand fun – I’d imagine I’d love running an active fund – but as I used to rant about bankers before I started feeling sorry for them, wouldn’t it be better if our brightest were curing cancer or solving global warming?

This final video from Sensible Investing TV has plenty more thoughts on the subject:

Ultimately, I think the fund management industry prospers because its practitioners really seem to believe what they’re saying.

Their belief in the face of all that contrary evidence is what makes the whole rigmarole so authentic.

The Fisher king of active management

For example, here’s active fund management company owner Ken Fisher writing in the FT [Search result]:

“One view regularly rendered by supposedly learned finance experts is a tell-tale tip that the deliverers of the following drivel are communists at heart, disbelieve in markets and will surely rot in hell.

It’s simply the leap from the (quite true) observation that active money managers as a group lag passive management returns to the conclusion that active fees must fall from current levels. Finance professors say it, as do journalists and consultants. They’re all wrong.

[…]

The US has nearly 30,000 investment advisory firms, over 4,100 securities firms, 6,700 banks and 16,000 funds. You have fewer but similar choices. English-speaking firms cross borders regularly. Buyers weigh overly abundant choices.

How long should prices take to fall if you believe in capitalism and market mechanisms?

Surely not the 30 years that active management has publicly lagged behind passive? Those who claim that prices must fall obviously have no faith in markets and competition.

Commies at heart, headed for that above-mentioned hell thing.”

That sounds to me like a man jumping through hoops to believe the unbelievable.

Now, I happen to enjoy the writings of Ken Fisher. I own and enjoyed his myth-busting book, Debunkery.

Fisher is typically candid and entertaining, and the piece from the FT quoted above pulls no punches.

He freely admits passive investing beats active investing in aggregate, and I admire how he discloses he’s a “richer than filth” owner of an active fund management firm, too.

However as a defence of active management, his article represents something of a new stretch for the final, flimsy straws of justification.

When not condemning the likes of Monevator to burn in hell for our supposedly communist tendencies, he makes a heroic leap of faith that only a truly believer could ever manage in claiming that active management fees are higher because:

“Most active management includes the cost of high customer service levels.

To date, passive doesn’t.”

Does anybody out there think this statement is correct?

I don’t.

I do agree with Fisher’s further argument that behavioural flaws – our tendency to buy high and sell low – is as much a threat to long-term returns as fees.

So I can see his argument could justify the cost of a skilled independent financial adviser managing a portfolio of passive funds, though you’d need to have a lot of money invested to get to the point where it would be economical for the adviser to call you up and talk you down off the ledge in a bear market.

But what does that have to do with active funds? Or with getting mailed an active fund’s report every six months that spends dozens of pages trying to obfuscate the fact that you would probably do better long-term if you went passive?

Fisher genuinely seems to believe people are paying higher fees because they are rationally gravitating towards this alleged higher service.

I think they’re paying higher fees because they’re ignorant of the maths, and because passive investing feels so wrong. More people now know better – and passive is gaining market share every year – but the race is not yet done.

Also, the irony of an active fund manager arguing ‘the price is right because the price is always right unless you’re a communist’ is, well, priceless.

Is that how you gee up active fund managers in their Monday morning meetings?

Don’t bother looking for opportunities, brave stock pickers! The price is always right!

Perhaps not.

Eyes wide open

I get the appeal of trying to beat the market, I really I do. I’m an active investor myself, though I invest directly in shares rather than using a fund manager.

I would never tell somebody they shouldn’t try to do the same if they fancy the challenge – provided they’re aware of the risks and the high likelihood of failure.

But an industry of thousands of expensive fund managers bankrolled by a nation of savers paying billions upon billions over the odds for a service that mathematically cannot in aggregate justify what it charges them?

If it didn’t already exist, it’d seem pretty audacious to think you could pull it off.

As the physicist Richard Feynman once said:

“The first principle is that you must not fool yourself, and you are the easiest person to fool.”

If you’re in a con game and you don’t know who the mark is… you’re the mark.

Check out the rest of the videos in this series.

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{ 22 comments… add one }
  • 1 magneto November 6, 2014, 11:22 am

    Come on TI this is OTT, not your usual balanced style at all.
    Straw-man perhaps to spark a reaction?

    What happened to the nuanced nod to ITs.

    For the record we are about 60% trackers, 40% low cost ITs, and watch and rebalance as discounts go +ve and -ve.

    Surely Paul will kick in soon with :-

    http://www.irateinvestment.com/2014/04/04/dark-side-of-index-trackers/

    extract :-
    “But the risk is not just about whether the market as a whole is overpriced – it’s equally about whether certain sectors or shares are overpriced. So, anyone buying an allegedly well-diversified worldwide index-tracking fund in 1989 would have picked up a belly full of Japanese shares – and that would have been very painful over the next few years.”
    Unquote

    The investor IMHO, while using trackers, needs to be awake to such outliers, this is when ITs may come into their own.

    All Best

  • 2 The Investor November 6, 2014, 11:56 am

    @magneto — I just reached that final video in the series and thought: What are we doing here? People are paying billions for something that doesn’t deliver, and there’s an alternative that is far cheaper and that does. And we all know it. If it was healthcare or similar there’d be a public outcry.

    The Ken Fisher article just tipped the balance.

    At some point it’s worth looking for useful analogies, though for sure this one is not perfect. So it is a provocative piece to provoke discussion, but I disagree that it’s a straw man.

    I corrected your link but was tempted to delete it. I’ve had to have that argument 3-4 times on this blog (about/with Paul, I don’t even mean notionally!) and I can’t face having it again.

    Bottom line: Active funds have done no better in aggregate that trackers in avoiding crashes, so that really *is* a straw man. If this was an advantage of active over passive funds, then they’d pull ahead as a group over the cycles. They don’t.

  • 3 The Rhino November 6, 2014, 12:00 pm

    The numbers quoted in this article are jaw-dropping!

    Fair play for collating and presenting them – its important stuff to know..

  • 4 Rob November 6, 2014, 12:49 pm

    Bottom line: active funds do worse than passive after costs, in aggregate. So even if active funds did do better in crashes (as TI says, they don’t), logically they must lag during bull markets. If that were the case, we could all pile in to active funds before a crash. Except the evidence shows that investors can’t time the markets either. No free lunch!
    Personally, I agree with TI’s stance in the article.

    On a separate note, I find the prediction that markets could be efficient at 20% of the size reassuring. The implication being we have nothing to worry about as passive funds take a higher % market share over time – at least until 70-80% of assets are passive (not going to happen IMO).

  • 5 Rob November 6, 2014, 1:12 pm

    Fund managers are responding logically to market demand. Whether you believe Fisher or not it is clear that most of his customers think theyare getting good service.
    The real task is to get the investing public to understand the game and then vote accordingly with their wallets.
    But less than 20% do.

  • 6 Neverland November 6, 2014, 2:32 pm

    Fund management is just a service industry

    Most services from the service industry you could do yourself with a bit of time and effort

    Its just a const benefit analysis

    Once you have a fairly large portfolio I can’t think of any service that costs so much year-in-year-out apart from maybe having a live-in-maid

  • 7 Kean November 6, 2014, 2:41 pm

    @magneto, bit harsh! I don’t think TI has deviated from his well know opinions in anyway; and, certainly do not consider any argument OTT or straw-man. As is Monevator MO the article is written in a style to germinate active discussion. Is not that the pull for most/all of us 😉

    Re Fisher belief system …..

    1) if premium service is the reason for higher charges why don’t the fund managers state that in their literature which is ALWAYS around how bright & unique fund managers are or clever market analyst & research process. And must not forget historical fund return stats which incidentally even after holding a fund for years bears no resemblance to my fund investment returns. NEVER have I ever since any words uttered about customer service in any of the documents.

    2) Currently my investments include ~ 60% in active and ~ 20% in passive and the rest in ITs & shares. I am embarrassed to say belatedly I have seen the light & in defence am transitioning :). Point is that in terms of “service” I have not seen even microscopic difference in service or information access.

  • 8 dearieme November 6, 2014, 2:50 pm

    “Commies at heart”: always a hoot when said by an American. I wonder how many Americans have actually met a Commie. Anyone who attended a British university in my day did meet some actual existing Commies. The real thing – probably acting as agents of the USSR whenever they got the chance to be useful to it. Echt commies. And the idea that you’re a commie because you plan to be a capitalist who is sensitive to his costs – totes amazeballs. The bloke clearly has a – how to put this? – blind spot. Deaf, to mix metaphors, to how his words must sound to other people. Aw, be frank; a mutton-head.

  • 9 Jon November 6, 2014, 4:32 pm

    David James the footballer just declared bankruptcy today. Active Managers will always flourish because most people have no interest whatsoever in financial education including my family and feel comfortable just outsourcing to a third party with dire consequences.
    Surprisingly some of these footballers went bankrupt over property investments too …. everyone keeps telling me shares are a waste of time and I should invest in BTLs.

  • 10 Aidan November 6, 2014, 4:39 pm

    Passive investing: the most monstrously conceived and dangerous communist plot we have ever had to face. Since fluoridation.

  • 11 magneto November 6, 2014, 5:16 pm

    @TI
    “I corrected your link but was tempted to delete it. I’ve had to have that argument 3-4 times on this blog (about/with Paul, I don’t even mean notionally!) and I can’t face having it again.”

    Thanks for the correction, and apologies TI for opening old wounds.

    We started out like many here, owning individual shares, then moved to ITs to reduce the workload, then ETF trackers. Have by the way noticed some useful additions to the Vanguard ETF range dating from Sept 2014.

    Trying to keep an open mind on ITs versus trackers, but to date have noted very few serious instances of underperformance in the ITs used, whereas sadly disappointed by iShares ETF ‘SEDY’ under-performance and distribution cut (recently part restored), so switched to IT ‘JEMI’ for EM high yield, as discussed in an earlier post OK so EM high yield may be a bit unusual?

    Global VWRL (formerly IWRD) we regard as an excellent core holding for any investor, the others incl ITs being satellites.

    Where ITs can come into their own IMHO is in retirement attempting to tilt to income, where some human screening of sustainability of dividends seems preferable to a computer carrying out the process. Again when investing in the less efficient markets of the world (example Russia).

    All Best

  • 12 kean November 6, 2014, 5:45 pm

    Going slightly off track ……… to-date there has been a lot of focus on active fund charges & rightly so but I always wonder why no one ever mentions:

    1) Multi-funds which in my experience are an even longer long con. Doubly so if the multi fund mgr is also a platform provider: pay annual mgmt charges to the ground zero fund mgr + multi fund mgr charges + platform fees.

    2) Portfolio Mgmt Service which invest in funds especially when the manager is also the platform provider. Again, pay fund mgr charges + portfolio mgmt fees + platform fees.

    Not so long ago when I was working 10-12hrs/day, I have fallen prey to both. One day came up for air and realised that in portfolio mgmt service I had 48% of my original invested sum in platform provider’s own multi-fund. The rest of the funds held in the portfolio were from their Wealth 150 list. Signed up for this on the understanding that it will give me access to funds not available in the retail market. Brazen or what! Called them to confirm the 3 levels of charges & then immediately bailed out of both.

  • 13 The Investor November 6, 2014, 6:20 pm

    @kean — I have a fund-of-funds post by Lars Kroijer that has been postponed as we’ve worked through this 10-part Sensible Investing TV series. I’ll give this subject a breather, but it’ll be up after that — say 3-4 weeks. 🙂

    @magneto — I think I put in enough caveats and side comments into the article to make it clear I have an open mind about everything — for an individual. We’re all different. I’m an active investor, and only have about 10-15% of my money in pure passives! 🙂 But I try to be very clear in my own mind why that is: It’s because I am taking a risk, I think I know better despite the evidence I probably don’t, I am partly doing it for enjoyment, and I am in the main (bar a few ITs) not paying anyone to run my money by me.

    The issue here is an *industry* that collectively manages most of most people’s money, does not deliver what it says it will, and charges over the odds for it. I think you can believe that and think perhaps it should change, and still invest your own money however you see fit. 🙂

  • 14 The Investor November 6, 2014, 6:26 pm

    @magneto — I think buying long-established UK equity income trusts for income is a solid strategy. They have a great record, and strong reserves of cash to smooth dividend cuts, and they can sometimes be bought at a discount. So they can make the job of (hopefully) getting a smooth equity income easier. That would be an example where an active product is doing something different, and costing more, and likely lagging the market over the long-term (although I don’t actually think equity income ITs have to date, thanks perhaps to our past 14 years of bubbles and crashes) — but all that being a price worth paying because it’s doing something specific.

    Very different from investing because you saw an advert boasting that some fund manager’s team of geniuses scours the globe for the best opportunities and to talk to company managers — and charges 2-3% a year for its quest to beat the market — and then quietly closing the fund down when it doesn’t.

  • 15 magneto November 6, 2014, 7:55 pm

    @TI
    Thanks for those thoughts.

    This thread has set me thinking about country allocations of Global Trackers, and where can we find information about country allocation (or even sector) changes over time!
    Is such information readily available?

    The best I can come up with is based on an old hard copy of iShares factsheets from Dec 2009. So if we compare Global ETF ‘IWRD’ present to (Dec 2009) it looks like the main changes are :-
    USA 56.66% (47.77%)
    Japan 8.23% (9.72%)
    UK 6.99% (10.33%)

    Are the USA and UK changes significant enough to trouble the investor?
    While USA seems expensive and increasingly overweight, the prospect for growth looks more promising than elsewhere.

  • 16 Uncertain November 6, 2014, 9:16 pm

    ”They have a great record, and strong reserves of cash to smooth dividend cuts, and they can sometimes be bought at a discount. So they can make the job of (hopefully) getting a smooth equity income easier. ”

    Maybe my understanding of IT’s is incorrect but few have reserves of cash, many are actually lightly geared ie they are negative for cash. What they have done is reserve some of the dividend income recieved and reinvest it. Although it is described as a revenue reserve when they use it to pay dividends what they are actually doing is selling down capital to maintain the dividend.

    I am not knocking IT’s and for historical reasons have more than I do passives. Though I am putting new money into passives unless I see steep discounts.

  • 17 dawn November 6, 2014, 9:18 pm

    @magneto
    hi there.
    yes ive been thinking on these lines recently myself.
    only started investing this year and having realised USA has had a magnificent run im reluctant to put much money that way. and with global tracker funds they tend to be heavy with US exposure.
    planning on tilting my trackers more towards European Equities and UK ftse 100 . maybe small caps if the aberforth IT is still on discount next year . and also Emerging Markets. im looking for areas that havn,t risen significantly.

  • 18 The Investor November 6, 2014, 9:39 pm

    @Uncertain — Yeah, fair cop, I shouldn’t have said ‘cash’, which is inaccurate and falsely comforting. Your understanding is pretty much correct, and my use of the word ‘cash’ was sloppy. It’s a slip I’ve made before, too, because in practice the long-standing income investment trusts have successfully used their revenue reserving ability to smooth dividend payments for many years and that was the point I was focussing on, rather than the structure of their balance sheets / portfolios (which we can never have perfect insight into, from outside).

    So yes, it’s true, as you say, that this reserve is typically invested — as you’d hope it would be in today’s puny interest rate era, perhaps 🙂 — and perhaps for many trusts it’s pretty notional whether they’re selling down capital (i.e. their main portfolio) or their ‘invested reserves’ to generate any top-ups required. I would contend though there is a difference in spirit and probably in practice in many trusts, and indeed I recall that new rules were brought in a couple of years ago specifically enabling trusts to explicitly sell capital to create income if they wanted to, which was expected by the trusterati to reduce the attractions of reserving.

    There are some weird ones out there (I seem to remember the likes of Hansa and perhaps RIT Capital have massive notional reserves). But in the case of the established income ITs I am comfortable talking about separate reserves as an advantage, versus open-ended funds, say, for delivering the often attractive benefit of smoothing.

    Of course you don’t get something for nothing; the ‘reserve’ is created from income held back from prior years, that would have been paid out to you by a different vehicle or a self-managed portfolio of shares (and indeed you can create such reserves yourself, as I’ve discussed before).

  • 19 rajkanwarbatra November 7, 2014, 9:57 am

    Totally agree with the investor this time!

    It is interesting quirk of human psychology that it is much easier to fool others if you manage to fool yourself first.

  • 20 kean November 7, 2014, 11:35 am

    Hi TI, re fund-of-funds … great, look forward to it! I have very little in fund-of-funds now which I intend to get rid but feel very strongly that the model needs to be put under the spotlight. :))

    Re IT reserves – the whole approach of smoothing/regulating the income tap is a little paternalistic. Ultimately the question is how much is it costing the investors in “managing” the reserve whatever the mechanics of how its held in the meanwhile.

    Re active funds marketing & selling – often wonder why effectively mis-leading positioning of a fund/product and ongoing management of investor expectations does not come under the Sale of Goods & Services Act.

    By the way, I have found these threads using Sensible Investing TV series as anchor really useful in validating my own opinions and generally reconsidering what I have/have not focused on to-date. Thank you.

  • 21 The Investor November 7, 2014, 12:28 pm

    I have found these threads using Sensible Investing TV series as anchor really useful in validating my own opinions and generally reconsidering what I have/have not focused on to-date. Thank you.

    Great to hear, thanks! It has felt a bit of a commitment covering the full 10 parts, but I was hoping it would provide the sort of ground/refresher you describe. 🙂 I’ll probably make a dedicate post covering the entire series with jump-off points, and then stick it in the sidebar to the right for newcomers to the site.

    I agree with you income smoothing is a bit paternalistic, but I don’t see it as necessarily a bad thing. Where I do agree with Fisher is investors want service/guidance. Many people are not going to want to — or perhaps even be capable of — smoothing income as I describe in the link in my comment above. So for them it’s a useful service. Those of us who consider ourselves a bit more sophisticated naturally have more options.

    @All — Thanks for all the comments on this thread. Run off my feet today so can’t reply to everyone.

  • 22 Asset-Grinder November 7, 2014, 8:21 pm

    My motto is not to trust anyone and I always ask myself what are they getting out of it. When people avoid telling you what their true intentions are then I tell them I am not interested.

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