Stock markets celebrated the start of 2013. It was a typical reaction to the signing of a bill by the US Congress in the last few minutes of 2012 that delayed the discussion of the budget deficit by a further two months. Short-term speculation is now the investment game.
Risk-on risk-off trade
It was also apt that in those same closing days of December the 200-year-old New York Stock Exchange (NYSE) was bought by IntercontinentalExchange (Ice), an eight-year-old electronic market based in Atlanta, Georgia, and unknown to most private investors.
Trading in actual securities, whether bonds or shares, has declined and become more competitive, while Ice specialises in contracts tied to commodities, credit, interest rates and derivatives. It is the Euronext futures business Ice wants, not the traditional activity of the NYSE or the European stock markets it owns. These are the services institutional investors desire, as their investment horizons have shrunk from years to days – or even seconds.
However simple in hindsight speculation may look, it is in fact extremely difficult to make such profits, especially when economic, political and financial policies are as intertwined as they now are. It is not only private investors that have suffered psychological trauma over the past 12 years. It has been even worse for professional managers.
Two major market crashes, doubts over the efficacy of the efficient market hypothesis, the realisation first-world government bonds are no longer safe-haven investments (and that the issuers are bankrupt in all but name), have utterly destroyed the consensus that propelled the world from 1950 onwards.
High-frequency trading
The result is that the adviser to JPMorgan’s fund of hedge funds has had to confess to clients that the sector has been disappointing, admitting “the vast majority of all hedge funds worldwide have well underperformed virtually every major stock or bond index for some four years”.
As profits have become harder to find, dealers have handed over trading to computers. Many believe these high-frequency trading activities are predatory, flooding markets with orders to detect interest and then withdrawing them fractions of a second later just as soon as genuine buy or sell interests appear.
Larger, more staid traditional institutional investors are the most disadvantaged by this practice as a recent joint study between regulators and academics shows.
Based on actual trading data from individual firms, it was the most aggressive firms that earned the biggest profits at the expense of everyone else, including less-aggressive high-frequency traders and, of course, the private investor.
Managing money
Bankers deal in credit. They lend long to businesses, borrow short from everybody and rely on their reputations to square their books. Crises of liquidity and solvency were, and are, recurrent. Margins were low but secure and, until 1973, the bigger commercial banks were regarded as a high-quality utility, with shares safe for widows and orphans. Then Walter Wriston, head of Citibank, declared his firm should in future grow its earnings at 15 per cent a year, making its shares ideal for executive stock options.
One of the safer banking businesses was investment management, when it was known as private banking and operated by merchant banks. These were private partnerships that introduced companies to stock markets and undertook more skilled and riskier business lending.
Reforms of Wall Street trading rules in the 1970s, followed by Britain’s ‘Big Bang’ of 1986, encouraged commercial banks to enter what seemed to be both a safe and very profitable business. But what worked in private partnerships worked less well in quoted businesses with managers ‘under the cosh’ to earn profits.
Privatising profits, socialising losses
President Franklin Roosevelt was against guaranteeing bank deposits. Until the 1930s US banks worked well on the basis that if a bank failed, depositors and shareholders deserved to lose their money since it was their money and their bank, and they had failed in their duty of prudence. Although overruled by his advisers, he was right to be concerned.
The crash of 2007-2009 – and its long-lingering aftermath – teaches a moral. Even before this, Roosevelt’s fears had been borne out by governments’ belief in banks that were “too big to fail”, something that certainly benefited Wriston and likeminded competitors. The 1999 repeal of the Glass-Steagall Act, which split commercial banking from its investment arm, allowed bankers to run wild during the first decade of this millennium.
They leveraged their balance sheets to unheard-of levels, pushed products not even understood by those selling them and, in the name of profit and bonuses, indulged in market manipulation and outright fraud that, in any other business, would have had the perpetrators and their bosses in jail.
The purpose of banks is now in question. They have been given favoured legislative treatment for centuries, since they offered a vital and necessary transmission function. By managing the maturities of their deposits and loans, banks were able to shift money from those who might need immediate repayment of their savings to businesses that required certainty for the loans they used for working capital and investment. They no longer seem capable of doing this.
Will banking reform happen?
The UK risks failing to mend its banking industry’s broken ethical standards and structure, says a review of the government’s reform plans by the Parliamentary Commission on Banking Standards (PCBS), an influential cross-party commission. Its conclusion was the Libor rate-rigging scandal was just further proof that banking culture needed to be reined in, claiming “investigations into Libor have exposed a culture of culpable greed far removed from the interests of bank customers, corroding trust in the whole financial sector”.
Overall, the PCBS concluded the Vickers proposals for ring-fencing investment banking from retail banking falls well short of what is required. Andrew Tyrie, the Conservative MP who chairs the PCBS, says “the latest revelations of collusion, corruption and market-rigging beggar belief”.
His conclusion will come as no surprise to IFAs and many unfortunate investors who have suffered from the ‘product push’ culture of the high street banks. They will doubt the likelihood of reform; after all, even the Financial Times questions the propriety of giving a knighthood to Hector Sants, who was responsible for wholesale and institutional market regulation at the FSA from 2004 onwards.
What can investors do?
Investment is a risky business. But holding cash is riskier still because of inflation. There are some good managers who follow old, established principles of investing, so look among investment trusts and directly invested exchange-traded funds. And, above all, keep it simple, keep costs low, and be patient.
This is Russell Taylor’s view on January 1 2013. He will be happy to answer queries arising out of Investment spotlight
Simple strategies for investment success
1. Understand that all the tools currently used to determine policy objectives and implementation are based on the discredited theory of efficient markets;
2. Risk analysis and diversification should be based on the earning power of assets and the usefulness of the corporate product range; not on short-term price changes;
3. Patience is an investment virtue. Adopt a long-term approach to investing based on dividend flows. But remember that companies have life cycles, and do not thrive forever;
4. Cap annual turnover of portfolios at 20 per cent per annum or less to keep costs down. This need not be a rigid rule, but managers must explain their motives for changes;
5. Replace benchmarks based on market capitalisation with those that are more useful, such as RPI inflation or, best of all, records of earnings and dividend growth over at least 10 years, shown as long-term charts as well as arithmetic tables;
6. Be wary of new investment products, ‘alternative investing’ and avoid structured, synthetic products. Some may offer real advantages, but high fees compromise these, and the meaning of their ‘small print’ is often unclear to the inexperienced investor.
