When going about my nefarious business of active investing, I try to look out for divergences between real-world markets and their stock market proxies.

For instance, gold mining shares were doing poorly long before the gold price really fell from grace.

Similarly, UK housebuilding shares turned down before the house price wobble a few years ago. They came back much sooner, too, as I predicted they would.

The list goes on (and is burnished by hindsight bias, of course!)

One of the most intriguing potential disconnects at the moment is between the stock markets increasingly dim view of the housing sector and – until recently at least – the rabid enthusiasm and commentary about the strengthening economy, low unemployment, and the prospects for house prices, especially in London.

True, house prices have finally come off boiling point, but the stock market was growing increasingly grumpy about their prospects many months ago.

Now investors seem to believe that the entire UK-wide housing recovery is going back into the emergency ward.

Before considering why and whether it’s right, let’s have a look at a few sectors to see what I mean.

UK housebuilders

The government’s various supportive schemes – together with low interest rates and an economy and financial sector that at least stopped getting worse – did wonders for UK housebuilding shares in recent years.

I wrote in November 2011:

The government clearly wants more houses to be built – if only for the economic activity it generates – and most of us seem happy to keep paying an awful lot for those houses. Planning changes should also play into the house builders’ hands.

No guarantees, but I think housebuilders share prices will likely be much more upwardly mobile than general house price inflation over the next few years.

Since the date of that article the major housebuilders rallied between 100-300%. (If only stock picking always worked out that well! It doesn’t…)

However 2014 saw housebuilders’ shares stall or even decline before recovering a bit in the past few weeks, as the following graph from early 2011 to now illustrates:

I’ll discuss below what I think is going on here. The important point though is that positive press stories about UK house prices only really began appearing in 2013 – even in London it was almost a stealth price rally until 2012.

Share prices moved ahead of the market, in other words.

UK estate agents

The recent performance of this sector has been even more dramatic, with Foxtons (LSE:FOXT), LSL Property Services (LSE:LSL) and the much-smaller Winkworth (LSE: WINK) all getting the kibosh in recent months:

This graph goes back to Foxton’s high-profile – and immaculately timed – flotation in September 2013.

Foxtons floated at what seemed a heady 230p but the shares still shot up another 20% on the day. In March they touched 400p, but you can now buy them for just 165p.

LSL and Winkworth, which are less directly exposed to the prime London market, have also seen their share prices fall.

UK residential home ownership proxies

Perhaps surprisingly, there aren’t many ways to invest in residential property via the stock market (probably because it’s hard to turf out sitting tenants in a liquidation crisis, though that wouldn’t be an issue for closed-end funds like investment trusts).

Some useful – imperfect – proxies are Mountview Estates (LSE: MTVW) and Grainger (LSE: GRI), which both own substantial portfolios of UK property, albeit discounted for various reasons.

Here’s a graph since 2011:

Grainger is a pretty diversified beast, but over the long-term Mountview is a fairly direct play on the fortunes of London property prices.

The thing to notice here is that Mountview isn’t fair off its highs seen in mid-2014 – and over the year the share price is still well up.

What does it all mean for the UK housing market?

So all you budding Bud Foxes (and foxettes), what do you reckon it means?

Is it time to yell “Buy, buy, buy!” into your PC monitor while soberly executing a few online share trades? Or would you be a seller? Should we even reconsider where real-world UK property is going based on these gyrations?

Probably not the latter, in my view, but the share movements do present an intriguing prospect. I’ll tell you what I think is going on, but I’m sure we can have a spirited conversation about it in the comments.

Reasonably people can disagree on, but I have come to believe that the UK does indeed have a shortage of the right homes in the right places. The recent recovery in housebuilding has barely dented this situation, especially when you take inward migration into account.

I therefore think the prospects for housebuilders still remain pretty solid over the next few years, assuming interest rates don’t truly soar or the economy flounder.

So why did their share prices wobble?

I am not convinced it’s a valuation issue. While they’re no longer cheap on a price-to-assets basis, most of the housebuilders still look a steal on earnings metrics. The market presumably doubts the good times can continue for years to come, perhaps because building costs will rise as well as the cost of home buying. This looks a potentially short-sighted view, especially in light of the big dividend policies declared by the likes of Berkeley that might help ward off a boom-to-bust cycle in the sector, as well as underpinning an investor’s returns.

That said, there are shorter-term factors at work, also.

Time to vote

Earlier this year, consensus was moving towards the ‘fact’ that interest rates were about to rise. Well, we all now know what happened there – bond yields have actually fallen!

I think there’s little doubt that this talk of rising rates did hit sentiment about the homebuilders. But tougher lending requirements stipulated by the Bank of England back in Spring has likely had a more concrete impact on the ground.

While the housebuilders have been stressing that their results are only coming off the ‘mega-gang-busters’ setting because it’s hard to improve markedly on last years super-gang-busters results, most do allude to financing being a bit harder for homebuyers to come by.

I noticed too that Bank of England governor Mark Carney said this week as an aside that the housing market had cooled more than he’d expected – or presumably planned for when they moved to cool it. So it is a factor.

Most interesting however – because it’s nailed-on as a short-term factor – is the upcoming UK General Election.

The estate agents in particular have pointed to this as a reason for the market slowing. They blame political uncertainty about, for example, the mooted mansion taxes, as well as wider qualms about whether we’ll remain in Europe. The latter could have a particular impact on the appetite of the foreign buyers who’ve bought heavily in the London new build market in recent years.

The housebuilders have also mentioned the general election as a factor – Redrow (LSE: RDW) and Henry Boot (LSE: BHY) just said in their latest updates that they think local planning decisions will be disrupted for political reasons until after May.

So the housing market does look set to slow – yet at the same time Mountview’s share price might be telling us that investors don’t see house prices falling much as a consequence, even in London.

Potentially then, this is an opportunity to buy the estate agents and especially the housebuilders. A six-month hiatus won’t matter at all to the latter in five years time – and the housing market is one of those where pent-up demand is typically unleashed once the clouds lift.

The picture for estate agents is a bit less clear to me, but their dividend yields look tempting if this is just a hiccup.

Set against all this, house prices in London and the South East still feel toppy. So that curbs my enthusiasm somewhat.

What do you think?

Disclosure: I currently have stakes in Henry Boot and Redrow of the shares mentioned. I’m considering taking stakes in other housebuilders as well as the estate agents.

Good reads from around the Web.

There’s a certain kind of private investor who is drawn to ‘story stocks’ such as:

• Hyper-growth loss-making companies.
• Tiny mining outfits.
• Revolutionary app developers.
• Aggressively accounted roll-ups.
• Radical hemorrhoid cream suppository manufacturers.

That kind of thing.

Very occasionally one of these makes its early investors a mint. Much more often, they become the latest cautionary tale against jam tomorrow gambling.

Except they don’t, exactly. The general idea that it’s a risky game is reinforced, but the specific firm that failed is soon forgotten.

Who remembers the microcap companies that went bust in 2003? Not me.

I think this is one reason why it’s so hard to make story stock fans understand the risks they’re taking. Like budding authors who see bookstores full of best-sellers, they see only the ARM Holdings and the Vodafones of the world – the once tiny companies who made it huge.

The myriad failures are lost in the memory even of those who watched them fall.

Tragic reading

The Internet can help to change that. Reading old bulletin boards that chart the demise of doomed companies is a sobering experience that I highly recommend for preventative medicine purposes.

For example, White Coat Investor featured a sad summary this week of posts from investors in GT Advanced. The firm made a material called sapphire crystal, which is used in high-end devices like the iPhone. It went bankrupt in apparently controversial circumstances.

GT Advanced is as much a tale of danger of getting so wrapped up in a story that you invest far too much in it; the company’s value peaked at over $1 billion, so this is not a classic small cap bear trap.

Here’s one post that White Coat Investor highlights as the sort of terrible thing that can happen when you bet all on red and lose:

I am totally numb. Just got home after working.

I saved this money for over 25 years and it is gone in a day.

I haven’t sold my shares because I just don’t know if the shares will be worthless soon or any chance that they may come back.

I bought at $18 and $18.25 and have about 4,700 shares. This is everything. My retirement and my savings for my son and me. This is so hard for me to take in because my son has special needs and this was for him and his future, especially when I’m not here any longer. He is getting of the bus soon so I need to dry my tears and put on a smile.

He is the best son a mother could ever wish for. I just feel and know that I have failed him and trying to figure out what to do.

Should I sell now and at least have a couple thousand for us to at least have a few weeks to figure out what to do. I feel for everyone on here who lost.

I was advised by someone who I trusted dearly not to sell. My instincts told me otherwise but I put my trust in this individual because I just felt so inept at trading and believed he knew much more than me. I will more than likely have to sell our home and struggle with this only because change is so difficult for my son.

I apologize for venting but I am too ashamed to share this with my family or friends. I shared this with the person who advised me to hold and my messages go unanswered.

This sort of thing makes for heartbreaking reading. No ifs or buts.

Position size is everything

I have seen countless story stocks dwindle to nothing or go bust over the years. Many were the subject of frenzied interest from private investors. Very often any warnings about the wisdom of investing or criticism of a company’s performance or practices were shouted down.

Indeed, a bulletin board full of evangelical supporters is pretty much a contrarian ‘avoid’ signal for me these days.

Now, you know what I’m going to say next – the best way for most people to avoid this sort of thing is to invest in passive funds, which will never have more than a tiny smidgeon devoted to companies like these.

And that’s true. But I’m an active investor for my sins, and I do steer my little ship through some of these choppy waters.

Totally avoiding dubious story stocks would be a good rule of thumb, but my idea of a dubious story stock is someone else’s idea of a great growth opportunity.

So my best blanket advice for investors drawn to microcap, loss-making, or one-shot wonder type shares is to limit your exposure, no matter how much you like the company or the price.

I’m talking initial 0.5-2% positions here, not the 10-30% you’ll see touted as ‘safe’ in some dark corners of the Internet.

Also, I think you should rarely add to risky loss-making story stock winners, at least not until they’re years out of the incubator stage.

Just let the winners run. Just in case your wrong.

• If a story stock defies the odds and eventually lives up to its hype, you won’t need much to make a big return.

• If – as is far, far more likely – it goes tits up, you’ll be glad you didn’t own much in the first place.

[continue reading…]

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:

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.