True and fair investment costs

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” So said the economist John Maynard Keynes, and he would not be surprised to find that the investment management industry is still in thrall to a hypothesis developed more than 60 years ago.

The Efficient Market Hypothesis

Back in the 1950s, CEOs of large international companies were being pressured to establish pension plans for their workers. These plans promised to pay a percentage of leaving wages or salaries to their retired employees (defined benefits schemes), and so the weekly contributions of workers and the company had to be invested in more than bank deposits.

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But senior businessmen had no desire to hand over large and growing sums of their company’s cash to stock markets, perceived as both risky and far from honest casinos.

Happily, academics and the newly invented computer were there to help. Much number crunching was able to show that share investing was a scientific business that CEOs could trust to finance their pension plans.

This was known as the efficient market hypothesis (EMH). ‘Hypothesis’ in scientific circles means a suggested explanation of events or data that needs to be tested, both by reality and also additional academic work. Academics find no difficulty in proving themselves wrong; practical men hate it. So although the EMH has been proven wrong theoretically by stronger and faster computers – as well as practically by the markets themselves – this is the mindset preferred by investment managers and their regulators.

EMH and the cost of ‘specialists’

The industry has good reason for not rethinking its belief in the EMH. It is very profitable, for the debt-fuelled markets of the 1980s and 90s encouraged a proliferation of ‘specialists’ to refine the investment process, and ensure that funds met their investment targets (such as asset allocation, portfolio rebalancing and risk consultants). When these funds failed to do that, there were so many to blame, that no one was accountable.

John Kay, the economist commissioned by the government to look into the country’s equity markets, reckons that the investment industry has now lost the trust of investors, particularly through the increase in its costs from the proliferation of fee-charging ‘middle men’ including registrars, custodians, nominees, fund managers, trustees, investment consultants, platforms and independent financial advisers.

There was supporting news of this from Platforum, an analyst of the growth of platforms. Its survey showed that the number of people in the UK with a risk-based investment of some sort is 13.7 million. Of those, only 15 per cent use an adviser exclusively, while more than half prefer to get occasional advice. The rest make their own investment decisions. As the survey discovered, this DIY community increased from 3.4m to 4.3m in the six months following the introduction of RDR, with investors increasingly buying investments directly from providers.

The DIY investor

The widespread publicity given in recent years to the hidden costs and investment failures of the pension fund industry is reason enough for investors to be worried about their future in retirement. Yet with tens of thousands of funds from which the DIY investor must choose, this might seem an impossible task for any individual.