Q&A: 15 January 2015

Money matters

I have been reading IC avidly for several years now, mainly out of interest and the pursuit of knowledge, rather than investing. IC has a very nice balance of everyday practical with the theoretical.

Over time, I cannot recall reading anything about the fundamental creation of money and its control to ensure it maintains value. I understand how it is consumed, but fail to understand the methods used to control its creation. It may be my ignorance, as it could be that it’s being explained all the time but my inability to understand the terminology has allowed the explanation to pass me by.

My daughter has just qualified as an actuary and when I posed her the question, how is money created and controlled, we turned to the web where we found the Bank of England had some good short articles but not quite in layman’s language.

I realise it may not be fundamental to the IC’s principal focus, but what would be nice is a simple ABC article along the lines that Chris Dillow does so well. Also are the control methods different for different currencies?

MP Clarkson

Chris Dillow replies:

Personally, I’m very wary of writing about money because I think people overrate its importance. In fact, the subject attracts a lot of cranks. The

significant facts about the economy are due not so much to how money is created, but to non-monetary factors. For example, the 2008 crisis was due to bad decisions by banks, unemployment is due to a lack of demand for workers at reasonable wages, and so on.

That said, to see how money is created, first see what it is. There are many possible measures and definitions, but in the UK the most closely watched one is the so-called M4 measure, which consists of the sterling bank deposits of UK non-bank private sector residents. Given this definition, the money stock will change because of:

1. Bank lending. If a bank lends me £1m to buy a house, it in effect creates a deposit – my £1m – from nothing. Usually, this is the biggest source of money creation.

2. Bank share issues. If a bank just issues loans, it is taking on risk. One way to reduce this risk is to have a larger capital base. It does this mostly by issuing shares. When it does so, M4 shrinks: when I buy a bank share, I exchange a bank deposit (which is money) for a share, which isn’t.

3. Government borrowing. If the government pays someone’s wages, it increases their bank deposits and M4. If it taxes them, it reduces those bank deposits. If government spending exceeds taxes, M4 thus increases.

4. Gilt issuance. If the government sells gilts, M4 falls: when I buy a gilt, my bank deposits fall and I get in exchange a government bond, which is not money. For most of the period from 1979 to 2008, the government sold gilts to roughly equal its borrowing: this was so-called ‘full funding’ policy, which ensured that government activity, net, had no effect upon M4.

5. Bank of England money printing. The Bank of England can buy gilts by creating money itself. When it does so, the bank deposits of those who sold gilts increase. (Note that if the Bank buys a gilt from a bank, the M4 measure of the money stock doesn’t change: M4 comprises the deposits of only non-banks, remember.)

6. External transactions. If I buy a good or asset from a fellow Englishman, M4 doesn’t change: my bank deposit falls but his increases. If, however, I buy something from a foreigner, M4 does fall, because the corresponding increase in deposits takes the form of a rise in foreign currency deposits, which are not part of M4.

More market beating

Almost exactly a year ago I wrote to you on the subject of ‘overdiversification’ and the performance of my portfolio containing around 80 shares. The shares had been largely selected from information and tips in IC. I was particularly critical of tracker funds, which by their very nature must slightly underperform the relevant index. You were kind enough to use my letter as the basis for an editorial (‘Follow your own rules’, 9 January 2015).

It will not surprise you, therefore, if I say that I agree wholeheartedly with the points made in your recent editorial (‘A not-so-dismal year’, 31 December 2015). Let’s face it – 2015 was a disastrous year for tracker funds. The performance of my portfolio is very much in line with the results of your analysis into the performance of all the IC share tips. Clearly one will have some losers but this is usually more than compensated for by a significant number of excellent tips.

Regarding the overall performance of my portfolio in 2015, I registered an outperformance of the All-Share index of +11.3 per cent, probably much in line with that of many other active investors who have a higher weighting to mid-cap and small-cap shares. However, it does mark the sixth year in a row of outperformance of the index.

May I say how much I enjoy reading IC and the balance you give to different topics and ideas.

Keep up the good work.

Alistair Woodroffe

John Hughman replies:

While I agree that passive investors will not have enjoyed 2015 very much, there is a place for these vehicles for those without the time to manage large share portfolios like your own – the asset allocation decision is said to account for more than 90 per cent of returns over time, with good years compensating for bad ones like 2015. However, your own six years of outperformance is no fluke, and suggests that a disciplined stockpicking approach can certainly deliver alpha.

A New Year rant

Firstly, thank you for Investors Chronicle magazine – it may not provide me with untold wealth and riches, but it is always an interesting and stimulating read.

In particular, I liked your recent (31 December) editorial complaining about the lack of granular market-specific ETFs available in the UK. Compare this with the US where I have in the past benefited from ETFs such as iShares US Medical Devices ETF (US:IHI), ROBO Global Robotics and Automation Index ETF (US:ROBO) or First Trust ISE Cloud Computing ETF (US:SKYY). Of course, none of these is treated by HMRC as distributor funds, so they’re not advantageous for the average UK investor.

If you feel like a good 2016 rant (I like a rant at least twice a day) then may I suggest the following: 1) the nonsense about the tax treatment of distributor and non-distributor funds, and 2) the iniquitous surcharge placed by brokers on dollar dealings – as much as 1.5 per cent on the exchange rate

Arthur Oppenheimer

John Hughman replies:

As I said, I would love to see more index level passive products, particularly those that allow investors to capture returns from smaller company indices. However, I am slightly wary of the thematic-style ETFs you mention, a trend that is coming to the UK; we extensively covered one recent launch, ETF Securities’ ISECyber Securities GO UCITS ETF (ISPY) (‘Cyber security and the risks of following fashion’, 18 November 2015). It’s an interesting product that taps into the growing issue of corporate IT security, but we’re wary of such tight investment concentration and the risks that, in a fashionable sector, valuations can become overblown. As for your rants, we quite agree – again, we’ve challenged brokers on their FX charges before and will continue to keep up the pressure, but with low-cost international brokers such as Degiro and iDealing challenging the status quo we think competition will do the job for us.

Broken brokers

Investors’ Chronicle seems to have discontinued its letters-to-the-editor page, so please excuse my impertinence in inviting myself directly into your inbox.

I was one of those on the support staff made redundant from Pritchard Stockbrokers, and so your two-page IC article (‘When brokers go bust’, 11 December) was of particular interest to me. I note, however, that the obvious solution to nominee nightmares such as Pritchard’s is conspicuous by its absence.

What comfort can the average investor take in a Financial Services Compensation Scheme which limits itself to only £50,000? Is this not a ludicrously low figure for Mr Average? As an immediate temporary remedy, surely the price of the average home would be a more appropriate starting point? As it is, with its unrealistically low limit for loss by stockbrokers’ fraud, I consider the FSCS unfit for purpose and in need of urgent reform. There is an opportunity here for IC to lead the way in campaigning to right such wrongs.

All the more so given that stockbrokers are herding their clients into nominee accounts. Ask any of Pritchard’s ex-client little old ladies what they think of nominee accounts and the FSCS. Find me one who does not now wish that they had never heard of nominee accounts. Indeed, if they had insisted on keeping their shareholdings in own-name (certificated) form, they would have lost none of their capital in Pritchard’s administration – and would have saved themselves so much time, energy, stress and distress. Nearly

four years after the event, I believe that there are still ex-clients who have not recovered their money.

Nominee shareholding has a lot to answer for. One would think that the 17th century second Viscount Falkland had the Pritchard case and time-tested certificated shareholding in mind when he stated: ‘When it is not necessary to change, it is necessary not to change’. Does not the Pritchard case prove the point?

Jonathan Crozier

John Hughman replies:

I’d agree that the UK’s FSCS investment compensation limit of £50,000 is inadequate, especially in the context of recent pension liberalisation that encourages us all to take more control of our retirement savings. The current compensation level is way short of the level of investments you’d need to accumulate for a comfortable retirement. We’d like a compensation scheme closer to the $500,000 offered by the US equivalent, the Securities Investor Protection Corporation.

As for the UK’s nominee structure, it’s an issue that we’ve taken a clear stance against: it has obviously helped lower trading costs, but at the expense of shareholder rights. We’d like to see the UK’s nominee and paper-based certificated systems consolidated into a single electronic register in which all shareholders are recognised as nominal rather than just beneficial owners.

PS: the letters page isn’t dead, just irregular.