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.
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.
It would be, except for the fact that the vast majority of these funds are worse than useless. Fashionable at the time they were launched, their excitement has faded, management has become semi-detached, and their size is slowly diminishing. Such funds do nothing for the investor and are only kept alive because, by manipulation of buying and selling prices, the sponsors of these funds can profit from the cash left to them by lazy, ignorant or stupid investors.
While true that past performance is no guide to the future, there are certain managers, and some fund management houses, that have a slightly better than average reputation. However, these are expensive, like the majority of actively managed unit trusts, and such managers often have more than one fund that they are managing – so again, which one to choose?
For most investors – and the cleverer IFAs – the better choice is those funds that are both cheap to own and have well publicised and proven investment objectives, of which a prime one, as last month’s column stated, should be not to lose investors’ capital.
The other is to keep investment costs low; the prudent investor should not expect a return to the past. Pension fund planners, and large investment management groups, may well plan for nominal returns of 7 to 8 per cent; individuals more concerned with their future wellbeing should think of 3 to 4 per cent a year.
Crashes and rallies since 1999
Table 1 highlights that some of the oldest and least fashionable of investment truths are the need for patience, and to be in the market, and to have a diversified portfolio. The FTSE is now approaching its high of 7,000, but the 13 years since the start of this secular bear market has been a series of dramatic ups and downs. These may well be repeated. Only the market’s belief that central bank governors are Plato’s philosopher kings, who will keep us safe whatever happens, justifies its ignoring of gathering political and economic storms.
Despite this, an investor in the average investment trust would have averaged a return of 5.25 per cent a year, and a rather better 7.3 per cent from UK Growth investment trusts. This is not only higher than anything available from a bank deposit - as is only right because of the acceptance of the equity risk – but also much better than the 4.5 per cent or so available on the equally risky peer-to-peer lending programmes available on the internet, and now appealing to some investors fed up with a dysfunctional banking system.
The regular saver of £50 a month would have doubled the invested capital over these years, and so more than kept pace with inflation.
Controlling the future
These returns are after assumed expenses of 3.5 per cent a year on the 400 or so funds on the Association of Investment Companies (AIC) database. But the shrewd investor would have done better than this by concentrating on the couple of dozen investment trust survivors from the 19th and early 20th century. Mostly these have total expense ratios of between 0.5 and 1 per cent and their dealing and other charges are unlikely to double them, or indeed rise to the 3.5 per cent p.a. used in the table.
This much smaller investment trust universe gives any investor more than enough variety for adequate diversification – global and UK growth, growth and income, smaller companies, property etc as shown in the MM tables. Only after a basic income producing portfolio of some four or five generalist investment trusts has been bought does any investor need to explore the larger, more expensive specialist world of venture capital trusts, environmental, infrastructure, hedge funds, and energy and commodity investment trusts.
A practical IFA will discipline the investor into saving, and this is worth paying for in today’s financially frightening world; a well chosen investment trust will keep investment costs low, a necessity in a low return world; then patience and compounded dividend income and the markets themselves will produce the returns necessary, as the table shows.
This is Russell Taylor’s view on 1 August 2013. He will be happy to answer readers’ letters arising out of Investment Spotlight.
