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.

When an investing concept is designed to appeal to your emotion, tread carefully. We all want security and nourishment and that’s precisely the draw of the low volatility – market-beating returns with less risk than yer average clutch of ticking time-bomb equities.

There are known problems with low volatility, but if you still want a slice of this action then what do you need to know?

The two faces of low volatility

Below you’ll find a handy list of the low volatility Exchange Traded Funds (ETFs) available to UK investors.

But before we get into it, you should know that – like the other return premiums – there’s more than one way to skin the low volatility cat.

In most cases, a low vol ETF will track an index that falls into one of two broad categories:

• Low volatility index: Ranks the equities of its parent index according to their return volatility over the last 12 months or 24 months or whatever timeframe the rules dictate. Lower volatility equities are over-weighted in the index and higher volatility members are under-weighted.

• Minimum variance index: Also weights equities according to their historical volatility, but then analyses the correlations between the equities in order to reduce volatility at the portfolio level.

Which is best? Well, according to the paper A Study of Low Volatility Portfolio Construction Methods from Research Affiliates:

We find no evidence that one low volatility portfolio construction methodology stands out from a returns perspective.

Okay, that makes things  easier – but it doesn’t mean you should just pick any ETF out of a hat.

So how do they differ?

All low volatility ETFs are known to skew towards defensive sectors of the economy, such as healthcare and utilities.

However minimum variance strategies typically impose greater constraints on the concentrations of individual equities, sectors and countries within the index. For example, MSCI rules that sector weights must remain within 5% of the weights in the parent index.

By contrast ‘naive’ low volatility strategies generally do not cap constituents. This means they can become highly concentrated in the healthcare and utility sectors at times. Similarly Japan will often loom large in World ETFs that follow low volatility strategies.

The Research Affiliates paper found the minimum variance approach is likely to be:

• More diversified.

• More costly, due to higher turnover.

• More effective at reducing volatility where the index tracks dissimilar markets, such as emerging markets.

While there wasn’t much in it, the authors tentatively concluded:

While [minimum variance] portfolios generally have the lower volatility, heuristic approaches [naive low volatility] tend to have the higher long-term returns. (We caution against comparing low volatility strategies on the basis of short-term performance.) The resulting Sharpe ratios are statistically similar.

The historical record of low volatility shows that it’s generally beaten the market during declines and taken a beating during upswings.

This means your blackest periods of doubt are likely to come during extended bull runs when the low volatility slice of your portfolio is lagging the herd like a lame elephant.

You’ll have to resist the temptation to abandon it at its lowest ebb if it’s ever to come good for you.

What should I look for?

While the research concludes that there is little to choose between the various strategies, you should know what matters to you as an investor.

• If you don’t like concentrated bets then err towards minimum variance.

• If return is all that counts then naive low volatility may be the way to go.

Of course, there aren’t any guarantees – fate does not give us advance notice of its plans. But at least you’ll know you’ve put out the welcome mat.

And such good value, too

It’s thought that low volatility outperforms partly because it overlaps with the value premium. So you could compare the value signal strength of your target low vol ETFs using Morningstar’s Fund Compare tool.

Jump to the equity valuation section and look for the lowest numbers in the following categories:

• Price/Prospective Earnings
• Price/Cash Flow
• Price/Book

You can compare sector and country concentrations using Fund Compare, too, although past returns will be of little use because low volatility ETFs are still very young.

Check out the ETF’s factsheet for important info such as how many holdings it has (the more the better) and make sure you read up about the index on the index provider’s site, so you broadly understand how it works.

A low volatility ETF hitlist for UK passive investors

Here’s the low volatility range currently available, organised by asset class:

Global Low Volatility ETFs1	Index strategy	OCF2
iShares MSCI World Minimum Volatility	Minimum variance	0.3%
Ossiam World Minimum Variance	Minimum variance	0.65%
Lyxor MSCI World Risk Weighted	Minimum variance	0.45%
db X-trackers Equity Low Beta Factor	Low volatility	0.25%

Source: Author’s research.

UK Low Volatility ETF	Index strategy	OCF
Ossiam FTSE 100 Minimum Variance	Minimum variance	0.45%

Source: Author’s research.

US Low Volatility ETFs	Index strategy	OCF
iShares S&P 500 Minimum Volatility	Minimum variance	0.2%
Ossiam US Minimum Variance	Minimum variance	0.65%
SPDR S&P 500 Low Volatility	Low volatility	0.35%

Source: Author’s research.

European Low Volatility ETFs	Index strategy	OCF
iShares MSCI Europe Minimum Volatility	Minimum variance	0.25%
Ossiam iSTOXX Europe Minimum Variance	Minimum variance	0.65%
SPDR Euro STOXX Low Volatility	Low volatility	0.3%

Source: Author’s research.

Emerging Markets Low Volatility ETFs	Index strategy	OCF
iShares MSCI Emerging Markets Minimum Volatility	Minimum variance	0.4%
Ossiam Emerging Markets Minimum Variance	Minimum variance	0.75%

Source: Author’s research.

Low volatility in your portfolio

Regardless of the comfy name, low volatility ETFs are equity products and they will still take a hit during a market tumble. If you decide to use them in your portfolio, the money should come out of the equity portion of your asset allocation.

If you think you’re likely to regret a long period of market lagging performance – and few of us wouldn’t – then I’d suggest you limit your low volatility bet to a 5-15% slice of your equity allocation.

Take it steady,

The Accumulator

1. Note: Global usually means developed world. [↩]
2. Or TER. Learn more about the difference [↩]

Good reads from around the Web.

Lots of amateur investors daydream about being the next great stock picker – a contrary-minded Buffett for the 21st Century.

But very few people are wired right (or perhaps that should be wired wrong…)

For most, being a contrarian investor gets no further than reading a magazine article about being a contrarian investor, and then investing in whatever shares or funds it suggests.

And that just isn’t going to cut it over the four or five decades of a lifetime of buccaneering investing.

As Patrick O’Shaughnessy of Millennial Invest wrote this week in a piece on the virtues of cheap yet scary-looking companies:

To buy into a terrifying portfolio, you need to have a contrary mindset.

This mindset is almost sociopathic, because it requires not just ignoring the crowd, but actively trading against it.

Most people can’t do that. They run with a herd even when they think they’re standing apart from it.

That’s surely for the best, given that more than seven billion of us are trying to get along on this little planet.

Gold given the finger

The wannabees come and go.

Remember when any mention of gold brought out dozens of precious metal bugs to call you an idiot, no matter what you wrote?

For all the noise they mostly seemed to think the same thing – that the dollar was about to collapse, and that a Neo-Aztec Kingdom of Gold was set to emerge from spare bedrooms and basement PC dens across the land. Conspiracy theorists who’d buried Krugerrands under their lawns would inherit the earth.

We’re still waiting.

Who knows, things are precarious enough that even I wouldn’t write off the gold bugs’ predictions entirely. But one thing I’m sure of is that the love-in for gold a few years back was as contrary as feeling a bit sad when Robin Williams died.

Look at this graph of the assets amassed at the height of gold mania by the US gold tracking ETF – ticker GLD – as posted by Ben Carlson on A Wealth of Common Sense:

At that peak in summer 2011, GLD became the largest single ETF in terms of assets – bigger than even the mightiest S&P 500 tracker.

But since then, Ben says:

…the fair-weather gold investors have been shaken out, and then some, in the latest drawdown.

Although the GLD fund’s performance is down by a quarter, the total assets invested in GLD are down by 60%.

In other words, GLD’s assets have shrunken far, far faster than the gold price.

Meanwhile the SPY stock market index tracker has returned 60% in gains, and it’s doubled in terms of assets.

Golden brown

This isn’t a post to say that stocks will always beat precious metals, or that you should race out and buy the S&P 500.

(If anything it makes me want to trickle money into a gold ETF!)

It’s more a reminder that like teenage goths who feel they’re uniquely dark snowflakes but all seem to shop at the same branch of Emos ‘R’ Us when you see them outside a Marilyn Manson concert, so any investor who has gone off the beaten-track mob-handed is likely not blazing a trail but heading for a cliff.

This stuff is hard, for all of us.

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