Fund groups, financial advisers, investment managers and the authorities have reassured investors that recent equity market falls are nothing to worry about and should be treated as a buying opportunity. It is a healthy correction, stocks are now better value. Even the International Monetary Fund says so, they say. Given that markets tend to fall sharply, but spend most of their time rising, the odds are in their favour – but they did this before the technology, media and telecoms (TMT) bubble burst in 2000 and again as the credit crisis started to unfold in 2007. On both occasions the rush to reassure investors was wrong.
So why the rush to do the same again when there is what looks like an enormous speculative bubble in crypto-assets and financial technology (fintech) – asset prices have had a blistering run since the credit crisis, which many seem to expect to continue forever, and equity valuations look rich? Interest rates are on the rise and while we usually get away with that for a while, it’s really difficult to find a time when that has ended happily for equity investors.
Experience suggests that corrections are warnings we should pay a lot of attention to. They often occur before a much more meaningful change in the trend. So why is the message always the same? Surely there must be somebody arguing for caution and proposing investors take money off the table? Is ‘buy the dip’ really the right thing for every client and unit holder?
The key to understanding why the message never changes lies in something called the Agent’s Dilemma.
The Agent’s Dilemma
This is broadly defined as the inherent conflict of interest when a principal appoints another to act in their interests. For example, when we put the family home on the market we appoint an agent to work for us who says the house is worth £1m rather than the £900,000 the other two agents said it would fetch. The additional £100,000 is a meaningful amount of money, so securing it becomes our objective.
However, the agent’s objective is very different because unless they sell the house there is no revenue at all. They simply go out of business. The optimal strategy for them is to pitch a high sale price to win our business, blame a weaker-than-expected market when it fails to sell, recommend we take the lower £900,000 when finally offered, charge a fee of perhaps £13,500 (1.5 per cent) and find another house to sell. Even if they do finally get us £1m the chances are that the agent personally will see almost nothing of the additional £1,500 fee unless they own the business. Our objectives are actually very different.
We can immediately see parallels with the market for financial advice and investment services. As principals and the owners of capital we generally want to maximise our returns, avoid losses and get good value for money from any additional services we pay for. But while they undoubtedly want to do well for us, the corporate imperative for the agents we appoint is to generate revenue, make a profit and ensure they don’t fall foul of the regulator.
The long-only philosophy
As retail customers most of the companies we delegate our investment management to are essentially ‘long-only’. They invest us in ‘real assets’, primarily equities and property that rise in value over time and are the best way to benefit from economic growth and protect against inflation. If you cannot take 100 per cent real asset risk then you diversify into a mix of fixed-interest and alternatives that will generate a more stable but often ‘nominal’ return, slowly losing value after inflation. They have built everything they do around long-term investment theory. Timing the market is impossible and diverging markedly from fully invested is a risk.
But retail investors are more loss-averse than institutions and small enough to get in and out of both markets and individual securities. We might accept a core long-term philosophy for our pension savings, but for the rest of our investments surely some effort to time markets and move from one asset class to another should be a priority? For us, relative performance is almost meaningless when we are down 25 per cent rather than 26 per cent. We are not company pension funds that can go to shareholders if they are short of money. Losses matter.
When we buy a fund or delegate the management of our money to a financial adviser, discretionary fund manager (DFM), private banker or collective fund manager we need to understand that their actions are dictated by this long-only philosophy. It is always a buying opportunity.
Performance is the hook, asset gathering the aim
‘Performance sells’ is as true today as it has ever been and ensures firms remain committed, at least nominally, to seeking better than average investment performance. But returning to our estate agent example, what really matters to the industry is gathering assets or funds under management (FUM) because it is the annual charges on FUM that generate the bulk of the revenue. While a strong or poor investment performance can attract a meaningful rise or fall in FUM and the departure of a key manager can trigger a substantial outflow, both are unusual. The status quo is the norm and this is a business where just standing still takes a huge effort.
For example, excluding market movement a DFM can expect to see an annual outflow of 3 to 5 per cent of FUM due to clients spending their capital, moving to another manager, removing money for inheritance tax planning, death and charges. To generate organic revenue growth of 3 per cent can mean setting a gross new money target of perhaps 7-10 per cent, or generating additional fee income from new services, for example financial planning and family office services. It is made all the harder by the lower rate of wealth creation after the credit crisis and the rise of an index tracker fund industry that is driving down investment management fees everywhere. We see similar pressures across financial advisers, private banks, DFMs and fund groups. Above water all is serene, but below it they are all paddling furiously.
Falling FUM leads to lower revenues and that means lower incomes. With organic revenue growth so hard to come by the alternative is to drive profit growth by mergers, acquisitions and taking out costs. The listed companies and the private-equity-owned firms are particularly active. St James’s Place (STJ) bought DFM business Rowan Dartington and constantly establishes new partnerships with financial advisers. Rathbone (RAT) bought Jupiter’s private client business. Private-equity owned Towry bought Ashcourt Rowan and Tilney Bestinvest and renamed itself Tilney. Consolidation into larger firms inevitably leads to an increasing focus on the agent’s imperatives of revenue generation and profit growth throughout the business and to more central control. Often clients are migrated into model-based systems or new investments, frequently collective funds and into their own products. Corporately driven change is not always a good thing for us and can have hidden costs.
Collective funds are great value for small investors, not large ones
Investment management continues to be charged as a percentage of FUM rather than on a fixed charge basis plus additional time spent, which might seem fairer. While it is possible to keep the cost of self-investment close to 1 per cent, were I to retain a financial adviser who placed me with a DFM that invested me in a portfolio consisting entirely of collective funds I could easily end up paying charges of 2 to 3 per cent every year. That’s far too high.
Investment management is a highly scalable business. It costs little more to manage £3m than it does to manage £500,000. While most money managers use a sliding scale of charges to reflect that and there is often freedom to negotiate further, collective funds are an exception. They charge the same percentage fee however large your investment, making them an expensive option for large investors.
The costs look better when the underlying collectives are low-cost tracker funds rather than actively managed funds, but paying a manager to manage a portfolio of any collective funds is an inherently high-cost way to manage investments and avoidable when our objectives might also be met with managed funds, multi-asset funds, investment trusts and target date funds. These don’t scale their fees down for larger investors, but do charge just one investment management fee and require less monitoring. Another attractive option for larger investors is the traditional DFM that still invests directly in equities and fixed interest and has fees that reduces as you add more money.
We must each assess performance against our own criteria to make sure we get value for money. For many, value will be almost entirely about investment return after costs, so adding together all the charges others pay will likely seem expensive. But for them value may also be about ease of use, additional services such as home visits, the trusted voice on the phone and the ability to delegate everything to do with money and tax to somebody else.
Reducing risk to the agent can reduce our returns
The financial services industry has been subjected to a raft of legislation and regulation aimed at improving consumer protection that has left management highly focused on controlling the risks in their businesses. If you have a financial adviser or discretionary fund manager it is almost certain that you have been subjected to one of the now ubiquitous risk-profiling tools and, after a short discussion with your adviser or investment manager about capacity for loss and objectives, assigned to an investment category.
Companies like using risk profiling tools because a systematic approach should lead to fewer poor outcomes, which in turn should mean fewer claims against them and higher profits. So long as the firm has followed a reasoned process and there is an audit trail then it and its managers are likely in the clear.
It is not quite so clear whether such tools really help us, though. Risk profiling tools lend a scientific feel to the client on-boarding process, but risk profiling is not without its controversies and has actually been a source of constant concern to the regulator. Problems include not insignificant issues such as how to link the output from the tool with a suitable asset allocation and investment policy. The future is hard to predict. Furthermore, different tools provide different results, the same client taking the same test can end up with several results and within companies different advisers can interpret the output in different ways and assign similar clients to different categories and investment strategies.
As one senior private client manager puts it, risk profiling is a blunt tool that only looks at one aspect of character and there is often a large disconnect between how clients have behaved in past and how they say they would behave. Does moderate risk mean always taking moderate risk and riding out corrections and crises alike with hardly a change of asset allocation, or does it mean willing to aggressively exploit opportunities occasionally but otherwise happy to play safe? Surely the risk could average out as moderate? It is hard to capture that sort of difference using a tool, but it will lead to very different management styles and investment returns.
Management’s focus on reducing corporate risk means most companies now have systems in place that manage portfolios within asset allocation bands that are linked back to the risk profiling process. For example, high-risk growth likely means fully invested in global equities while lower risk means invested in a range of alternatives, fixed interest with perhaps only a minimal exposure to equities.
While it might seem obvious to switch from defensive investments into equities when valuations are low, after a market fall those asset allocation bands can greatly limit the extent to which that can happen. One way to get around this would be to move up the risk scale, but that would negate the entire rationale for using the risk-profiling tool in the first place. If it gets it wrong and you then lose money it opens itself up to compensation claims and the regulator may fine it. If it gets it right and you make money the regulator may fine it anyway for encouraging unsuitable risk taking.
From the company’s point of view it’s much safer to leave you where you are and miss out on the higher return for you. It is the same with most funds. If you buy a UK equity fund don’t expect it to do anything other than invest pretty fully in UK equities. Even if there is a better opportunity or the market is falling.
Asset gatherers can’t say sell
The Japanese bubble of the 1980s, the TMT bubble and the excesses that led to the credit crisis spawned a raft of books on bubbles, many of which can trace their roots back to economist Hyman P Minsky’s 1986 book Stabilizing an Unstable Economy. In it Minsky describes a process where ‘displacement’, usually a move to very low interest rates, is followed by boom, euphoria, profit-taking and panic.
Thinking about the Agent’s Dilemma helps us to understand the inherent conflict of interest that prevents fund groups, financial advisers, investment managers and the authorities from changing their message, even when euphoria is rising.
There may well be an enormous speculative bubble in crypto-assets and fintech, asset prices may well have had a blistering run since the credit crisis, equity valuations may well look rich and interest rates may well be on the rise. But while this looks a lot like we are nearing the end of the party to some, the asset gatherers can’t say sell: it is always a buying opportunity.
That means we need to select our agents carefully and be more demanding to ensure we get what we want out of the relationship because, although we have objectives in common, our motives are actually very different. When we select a money manager we need to avoid being boxed in too tightly by the risk management framework. We need to go for companies with only a few risk categories, wide asset allocation bands and substantial freedom to act for us. It will help to select a company where the manager still plays a large part in choosing what you invest in rather than one where a relationship manager simply follows the model. And we need to look for experience: Investment management is a profession where it really does help to have been through it all before.
