I meet a lot of fund managers. I tend to like them. Fund managers are mostly charming company; they are, on the whole, clever, interesting and full of sensible-sounding ideas; and if you see them at a conference, they often have something nice you can take home for your kids.
I've written before about how all these nice men purport to be into value investing (buying cheap stuff) or at least quality value investing (buying good stuff at fair prices) at the moment. They tend to tell me they are running their fund just as Warren Buffett used to run his before it got way too big. They have strict valuation criteria they aren't going to deviate from. They defy consensus, shut their ears to short-term noise and focus on the long term.
It all sounds great. And it would be, if they stuck to it. But they don't they go off and mostly do nothing of the sort. Instead, as far as I can figure, they assemble a portfolio of conventional stocks and overtrade it just like everyone else. They also produce returns that, give or take a few percentage points, track whatever their benchmark index is.
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At first glance this is something of a mystery. After all, there are well-established ways of outperforming over the long term. If you look at the tables of the cyclically adjusted price/earnings ratio (Cape) for various countries, for example, you can see very clearly that if you invest when the Cape is low, you make excellent returns over the following ten-year period.
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If you do so when it is high, you make low returns over the following ten-year period. Long-term investing should therefore be very easy. Avoid buying markets with a high Cape (that would be the S&P 500 at the moment). Choose a market with a low Cape (that would be Russia, Italy or Spain), buy it and wait.
This approach works with bonds as well. GMO's James Montier has some analysis that shows that if you buy government bonds when yields are high, you will make high returns over the nextten years and not just in nominal terms, in inflation-adjusted terms as well. The opposite is also true, which is why there is "no point" in holding US government bonds at the moment. You won't make any money, but you might lose a great deal.
So if it is so easy, why do most of my delightful acquaintances either track or underperform their markets? Simple. It's because the institutional structure in which they operate forces them to. The key point is obvious but crucial.
Large fund management companies make their profits more from gathering money than they do from making money. If you take 1% of the assets you have under management in fees, your management focus tends to be more on selling additional units in any given fund than working on making money for those already invested in the fund.
Most clients of fund managers hate uncertainty as much as they hate short and medium-term losses. Lose them money relative to the market and odds are they won't wait for your value play to come good. They'll sell up and move on. There is little career risk in tracking the index and massive career risk in underperforming it.
This conflict of interest between manager and client is not the only contradiction at the heart of the business model. I listened to fund manager Jeremy Hosking, formerlyof Marathon Asset Management, speak at a conference last week. He pointed out that "size is the enemy of performance". The bigger a fund gets, the happier its top execs might be, but the less likely it is to be able to take the opportunities that will let it do well.
There is also the fact that to gather enough assets to make you and your partners fortunes out of fee collecting, you need to at least pretend to have different products to sell. But then you get conflicts of interest between your own funds: if there is a good idea, which fund gets it?
This is just the beginning of a long list problems, but in an admittedly cruel nutshell, the average fund manager is overly short term; has a tendency to massively overtrade; suffers from endless exposure to too much information, most of which is completely useless; has an ad valorem fee structure that prioritises "product proliferation and fee collection"; and, in an effort to be liquid enough to support daily pricing, almost always holds too many shares in very large companies.
This all sounds like bad news. But it isn't. That's partly because there are some managers who get all this and run concentrated portfolios that don't turn over much. But mostly because you and I, with our own investments, don't have any of these constraints.
We don't have to buy into bubbles, so we don't underperform in the short term and we don't have to dump investments that don't work within a random timeframe set by our marketing consultants. We were able to buy Japan five years ago and wait (although to be fair, Japan has never had a low Cape). And should we feel like it, we can do the same today with Russia and Italy.
Better still, we can do so happy in the knowledge that while we are buying cheap assets and avoiding expensive ones, traditional fund managers are doing the opposite. Think of it, says Hosking, as a poker game. If there is one player around the table who is both predictable and irrational, it makes the game much easier for everyone else. In the financial markets, the traditional fund manager is that player.
This article was first published in the Financial Times.
