The Financial Conduct Authority’s recent report into the asset management industry didn’t go far enough for one frustrated fund manager. Requesting anonymity (but known to us at Monevator) they share their thoughts below…
The report by the Financial Conduct Authority (FCA) into the asset management industry is, in the view of this writer, a lost opportunity.
Nowhere in its 144 pages does it mention the words beta or alpha. Yet the heart of the problem with fund managers is not costs, as the report focusses on, but miss-selling.
Active managers claim to deliver better returns than the average – i.e. to offer alpha – but the reality is that in aggregate active management fails to even deliver beta – i.e. the market return – because of the higher risks and costs associated with trying to achieve alpha.
As regular Monevator readers will know, the evidence is overwhelming. Over meaningful time periods, most active fund managers underperform.
Should not the fact that most private investors fail to understand or take this into account when buying funds be a key concern?
Cut out the middlemen
In its defence the FCA says it didn’t want to use the terms alpha and beta because they are too technical for investors to understand.
This is the second mistake the report makes. It consistently refers to ‘the investor’ yet the reality is that most funds are bought by intermediaries – that is, IFAs and wealth managers.
They are not the principals in the transaction but the agents. That gives then a very different incentive from the owners. As agents they are far less worried about the costs of ownership and returns, and more worried about the risk to their reputations and businesses.
As a consequence they would rather recommend a fund that appears safer than one that is cheaper. It is the old “no one ever got fired for buying IBM” argument.
There is a secondary element to this issue of who makes the purchasing decisions relative to who is the ultimate beneficiary, too. The agent has a vested interest in making his role look more complex and demanding to his customer than it really is.
If the end investor realised that it was not actually that difficult to buy beta then he would do it himself and cut out the middleman – and about 1% in charges.
After all, that is essentially what budget airlines have done by cutting out the travel agent and marketing direct to the consumer. It is the same with many products and services now sold over the Internet.
Massive cost savings are available by bypassing the distribution chain and going direct to the consumer. The consequences can be seen in high streets and shopping centres up and down the land as shops are closed and boarded up.
Truly disrupting the financial services industry
This brings us to the real failure of the report. It is still difficult for asset managers to present hard data, such as turnover rates, information ratio, beta or even compound interest directly to the public for fear of giving advice. Instead the FCA seems to prefer them to use intermediaries, who have a different agenda. This is what is preventing real competition from shaking up the industry, reducing costs and bringing in new ideas.
The FCA says fund management is too complex for the average investor to comprehend. In this writer’s opinion, that argument is fallacious. Mobile phones, computers, cars and TVs are far more complex than the average fund but that does not stop the population buying them and, by and large, making decisions in their best interests.
Why should that logic not apply to asset management?
The reason is of course that there are lot of well paid, and highly intelligent, people who have a vested interest in preventing the public from buying beta, the market return, very cheaply.
Instead, they want to sell alpha, the goal of outperforming everyone else, for a much higher price.
The illogicality of that argument is not lost on them but they respond by saying that while it might be true that, like the children of Lake Wobegon they all claim to be above average, they can always find some element of complexity – often related to tax wrappers – to persuade the investor he should be guided by an expert.
Expecting the public to effectively separate signal from very noisy data, and then factor in risk and costs is deemed far too onerous. Intermediaries get around that problem simply by using past performance, despite all its flaws.
A beta solution
As Upton Sinclair famously said: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
There will always be a need for intermediaries for more complex financial situations. However, the reality is that the average investor can satisfy much of his basic investment requirements by purchasing beta cheaply and simply through a passive fund without using an intermediary at all. The FCA report makes this no more likely now than before it was written.
If we really want transparency in this industry we need to use simple clear language to explain directly to investors what they are being sold. The FCA’s reluctance to use technical but clear labels like beta and alpha does not help the process.
Transparency is also aided when goods and services are sold directly by the provider to the consumer. Making it difficult to do this – and encouraging the use of intermediaries – makes transparency more difficult because the agenda of the agent is different from the principal.
Further reading
- The issue of intermediaries is set to be explored in the FCA’s follow-up platform market study, which launched on July 17th.
- You can also download and read its Asset Management Market Study [PDF].
Great article. Increasing transparency and simplicity in products is in the finance industry’s best interests and should be considered no more difficult than getting a mortgage, which is certainly within the realm of everyday people.
@fremantle – interesting that you mention mortgages. Having applied for a mortgage recently the process is significantly harder. I remember entering How much I earned, how much the house was worth and how much I wanted to borrow and that was it. Now there are heaps of questions and it certainly is a lot more work to do. The main difference is everyone gets excited to buy a house so are happy to put up with filling out the forms. So will perservre. Saving for retirement is not something people get excited about and so people can’t be bothered to look into. It you are lucky they may get someone else to do it or do it through work.
Also do they get a good deal? Loads of types of mortgages, one with fees or one without etc. How many still got I am advisor to help get through the relative non-complexity.
How do you get people excited about investing?
For me the trouble with labels like alpha and beta are not that they are too technical, it’s more that they are vague and non-descriptive. They potentially mean very different things to different people.
As someone involved in software development the terms alpha and beta basically mean something in-testing / pre-release – something i wouldn’t like associated with my investments.
Excellent piece!
@Richard
Well the application process is complicated, but the basic premise of the product is not with regards to costs and obligations, but I’ll concede your point.
Follow the money, rip-off Britain never went away, the media just tired of the phrase. Most commodities and services here are inexcusably overpriced, in direct correlation to the industry-in-question’s ability to lobby the govt. over the issue. In slavishly copying the US in all things, we now have legislation hugely influenced (in some cases outright written) by the powerful vested interests with the most to gain in that particular area.
This corporate cartelism with co-opted govt. input can only be counteracted by the education of the populace so they are no longer played for fools, in the same way that corruption cannot flourish where there is transparency, you have to shine more light.
This is only practically possible where people have a serious interest in taking responsibility for their future, but sadly they prefer to entrust that to third parties if at all.
@fremantle – Your point stands from a perception point of view. People understand mortgages. But they would understand index trackers as well. And how to open a pension or ISA. None of this is really very hard (in fact buying an index tracker is arguably far easier than getting a mortgage, application wise). But a mortgage is exciting, people will make the effort to get one. Investing sounds complex and it sounds risky and it sounds boring and there is no instant gratification like there is with a mortgage. So no one can be bothered. Rather spend the cash.
As the article says, it is also in advisors interest to make it sound scary and complex and boring. The more likely you are to take advice. The less likely you are to DIY. Though equally the more likely you will sit on your hands and do nothing.
Genuine question here: how does the notion that trackers will always win out in the end over managed funds compare to the likes of Fundsmith Equity (as but one example) that according to Trustnet has beaten its equivalent index over recent years?
Is the thinking that over (say) 20 or 30 years the index will win out because whatever short run edge or luck a fund manager has will have to fade? Thanks
@SurreyBoy – a tracker will not always perform better than an active fund.
But over the long term, a tracker will very likely to out perform an active fund, after costs/charges.
The difficult part is picking the few active funds that does better than a tracker.
http://monevator.com/passive-investing-uk-evidence/
UK Equities have returned a real CAGR of 5.0% over the last 116 years (source: Barclays Equity Gilt Study 2016)
Someone entrusting £100k for 10 years to a UK financial advisor or investment manager would on average pay 2.56% annually for planning and product expenses (source: Grant Thornton Study, FT, Aug 2016)
Step right up and lose 50% of your annual investment return to the ‘professionals’.
So glad I went DIY and now lose only 0.22% per annum for both the products and the wrappers I house them in.
Excellent piece – well done @TI for posting it. Very clear with very consumer-friendly language and an absolutely solid point.
Any idea of other (overseas) regimes that do it better? Do the Dutch, the Swedes or the Australians manage this better than us, for instance?
@SurreyBoy — Trackers as a class invariably win out over active funds as a class because it’s a zero sum game. Nobody (sensible) is saying no active managers will ever beat trackers. A few do for decades. (E.g. Buffett, but there are others). Simple maths shows a percentage will for many years through sheer chance.
Here’s a good recent blog on the subject: http://www.evidenceinvestor.co.uk/will-always-winners/
Active fund management as an industry relies on people seeing something like Fundsmith Equity doing well and thinking it’s even vaguely typical. You write “as but one example”. Trustnet’s fund league table lists 3,320 funds! 🙂
You could have 100 examples and you’d still be talking less than 4% of 3,320… Feeling lucky? 🙂
Remember huge numbers of funds are closed/merged when they underperform over time, so survivorship bias is huge.
Also, I appreciate Terry Smith’s smarts and strategy and I think he has as good a chance as any but five or six years is only just edging out of diddly-squat territory in terms of telling whether he’s got genuine edge, especially as he has a style that he sticks to. It’s very possible the kind of companies he invests in have just been in vogue in the kind of market we’ve been in. He’d surely say not but time will tell.
Reminder: I invest actively (stock picking) and am not a passive fundamentalist. 🙂
Another excellent article, thanks @TI for hosting and writing such informative pieces over the years. This website, together with RDR, prompted me to realise i had outgrown my IFA, and set me on the path of independent, “slow and steady” investing.
And @anonymous frustrated fund manager- anyone who slips lake wobegon quotations into a critique of UK financial regulation gets my instant respect.
I recently completed an OU “Open Learn” course entitled “Tackling Income Inequality”.
I was astounded by the number of comments made by fellow participants referring to ‘gambling on the stock exchange”
These people were, I suggest, not poorly educated, so it infers that the level of financial education in our society is truly dire.
@ The Investor – wrt Terry’s return history, a large part of his pitch when he originally started Fundsmith was that it was essentially a continuation of the pension strategy he’d run at Tullett since 2003, which delivered fairly acceptable returns:
https://www.youtube.com/watch?v=Jo5e2TlGuoQ&t=186s
I entirely agree that people don’t typically see that kind of performance, but then people are very bad at realising just how much difference there is between a compounded 12% return and a compounded 8% return, so they may not be too unhappy about it.
Most funds, and IFAs and wealth managers, are not in fact trying to achieve either alpha or beta, but actually trying to manage risk, i.e. produce a reasonably predictable, above inflation return through (for instance) asset allocation, that matches a client’s ‘risk profile’, their comfort level with market swings. It’s fine to advocate a stock market tracker, or a combination of trackers, but you then get market volatility, which history (and psychological study such Kahneman’s) has shown most people just cannot cope with, e.g. because we feel losses two or three times more than we appreciate gains . You can combine trackers covering different asset classes, but you would likely want to research that allocation, trying to forecast appropriate splits based on market valuations, currency movements, the economic cycle and so on, and re-balance the splits regularly – but aren’t you then straight back to the value of your time and how confident you are in doing that. So many people will consider paying a manager / IFA / whatever 1% to 2% per year to do that as being fair enough.
The data on funds’ information ratio, turnover, beta, etc is pretty widely available if you choose to look, e.g. at free resources such as Trustnet. So the current market seems pretty good to me – if you want to do it all yourself you can, at very low cost, and good luck to you; if not there is a wide diversity of funds, advisers and educational resources offering different service levels and costs. And the simple truth is retirement and investment ‘products’ are in any case largely sold, not bought, so there is a great deal of sunk cost in advertising and sales work – and the FT still had a headline the other day that the UK savings rate is the lowest in 50 years! To my mind there is no comparison between the failings of this market and the failings of the regulator and government / tax / educational system – for instance people with no interest in stockmarkets are obliged to use them to save because government and regulatory failings have led to the suppression of interest rates 80% to 90% below the historic norm (and incidentally the level at which any normal market would be lending money), so people cannot just stick money in the bank, the historic mediators of people’s savings and the money needs of enterprise, and get reasonable interest.
“Every profession is a conspiracy against the common man”
What advice would you give a small company who is setting up their pension scheme from scratch?
I’m an avid follower of Monevator, but I think you’ve really missed the point with this article.
Regulation is there for a very good reason. Yes mobile phones, TV’s, etc. are complex and not understood by the consumer – but have you ever tuned into a TV channel so disastrously bad that you lost half of your life savings in a year? Or accidently pressed the button on your phone that means you have to delay retirement another 5 years?
The consequences in finance far outweigh the risks in those comparisons you make.
Yes – advisers aren’t perfect, some are good, some are bad. But on the whole they do put their clients into reasonably conservative portfolios that may be a little more expensive that the passive choices. At the end of the day a 1% fee is annoying, but not life changing. Opening the market to actively encourage people to seek their own beta would see us greeted by an onslaught of newspaper articles about grannys who put their life savings in an 3x levered equity ETF and are now being kicked out the care home. The taxpayer would end up picking up the tab.
I’d rather have a market where cheap beta is available if people have the effort in to self-educate but generally push the mass market into being hand held. I think you’ve failed to consider the consequences of what you are truly rallying for….
@The Austrian @TomB – you both make similar points, you pay your 1 or 2% for someone to manage the risk, someone you can later sue if they didn’t manage the risk level appropriately. This is a very good point.
I would play devils advocate by saying that this assumes investing is difficult and most people wouldn’t have a shot at doing this themselves. Isn’t the risk argument based on the propaganda of advisors?
Time (i.e. can’t be bothered to learn that, get someone else to do it) seems another reasonable argument. And to contradict my devil’s advocate, fear of getting it wrong (i.e. risk again), but perhaps an unfounded fear.
Investing is simple. Just put your money in the lowest cost tracker you can find, keep adding to it when you can and by the time you retire you will have beaten 95% of the IFAs.
All the education ordinary people need is to keep broadcasting to them that, unlike managed funds, market indices have no manager risk and never failed to recover from any fall.
Joe: As Mike Tyson said, “Everyone has a plan until they get punched in the mouth”. What are you tracking? It’s easy to keep investing when markets grind upwards.
The Japanese TOPIX index is still below the 1989 highs. If it can happen to Japan it can happen to any other country, or even MSCI world. Yes, generally markets should move upwards, but that it not inevitable – even for fairly long time horizons.
I think @The Austrian @TomB have nailed it, it’s not just as simple as my namesake Joe above, and the author say ” just buy some index funds and stick with them ”
But which index funds ? It’s not at all common for example, to see the newbie investor with all their savings in a FTSE100 or FTSEA fund. These days few would buy a managed variant of these they would buy a low cost tracker – but either of these indexes would be a lousy choice for a long term investment for obvious reasons I won’t mention here.
Ok so you say, buy a global index. Which one .. Vanguard that has an over allocation of U.K or say an HSBC which either has U.K. at global allocation of 6% or an ex UK variant?
Which Vanguard ? The one with 20% bonds? No bonds? 80% bonds?
So even if you accepted the position that only indexes will do, there’s still the question of which ones, which mix, and how that relates to the requirements of the investor – taking into account the time scale, how much return they need absolutely, what their attitude to risk is – maybe the knowledgeable here are sanguine when their investments drop 25% in a year but what about the person who’se used to their savinsg rising ata steady 1 or 2% ? Will they think you’ve sold them a crock and sell out when a dip occurs ? Let alone a crash.
In essence I think the article misses the point, it’s not just about returns but about fit for purpose and fit to investor.
FWIW I am a DIY investor and I do think many people can learn to understand the above issues about risk and need, but I have seen many work colleagues just hand it over to a professional because they either cannot or do not want to spend the time. That’s their loss, and they could do better, but if they don’t want to, OK maybe they will lose 1% to an IFA than if they did it all perfectly, but they’ll still be better off than just picking FTSE100 and putting their whole pension in that.
+1 on mortgages being far more complicated nowadays. In terms of the application process at least, and don’t get me started on the actual process of finding and buying the house in the first place!
I found it an order of magnitude easier to open up a broker account, dump some money into an ISA then buy some index funds with it.
I think the problem is the overwhelming amount of funds to actually buy where most people get analysis paralysis, plus worrying about tax affairs, that is why the intermediaries are still a thriving breed.
But once you get your head around the rather simple advice as contained here and many other places that you just need to buy the market, and actually internalise and believe it, then it makes things much easier.
Also, I had no idea what beta and alpha meant till I read this post (embarrassing but true) but the meanings couldn’t be more simple and understandable. Why this can’t be put in such a report along with a quick explanation of what they mean is quite baffling.
Great article as usual guys! Cheers!
@AnotherJoe @TomB – you make good points about risk and the general public attitude to them, and also about the likelihood of panic if their chosen tracker falls a lot in a year. But your implication is that paying 1% to an IFA would mean this would not happen. That is clearly nonsense. If a tracker falls, then unless you have picked a lucky, or more realistically a very defensive fund that goes up when markets go down, then you are going to suffer the same order of fall. Perhaps a few percent more, perhaps a few less.
Just as the majority of funds don’t beat the index as it goes up over years, they fall as much or more during downturns too.