Market myths

It will soon be two years since Professor John Kay, a renowned but practical economist and Financial Times columnist, published his 40,000-word, government-commissioned report on stock markets. Nothing has been done since then, despite clear recommendations and evidence that neither banking nor financial services remain effective in channelling the nation’s savings into productive industry.

Something rotten in the state of Denmark

A significant conclusion was that there was too much trading in markets, because there are too many people involved in investment decisions. The investment link between the saver and fund manager - who chooses what assets to buy - is ludicrously complex with, at its most simple, an investment chain consisting of the saver, a financial adviser, a wealth manager, an investment platform, a fund manager to selection of fund managers and finally a fund manager who actually buys - or sells - something.

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This chain is more complex and larger still with institutional funds, and it is because these have been producing such niggardly returns for the investor that the government was forced to commission Professor Kay. Of course, all these intermediaries receive fees, so it is in their interest to encourage trading both to justify their role and to boost their fees. But it is not necessarily in the saver’s interest.

It is, however, good for the fund management industry, which is why it has always been more profitable for the saver to buy fund management companies rather than their products. The justification for this trading behaviour, swallowed hook, line and sinker by the regulators, is the Efficient Market Hypothesis [EMH]. The words “hypothesis” and “theory” may be used synonymously, but they are not the same. A scientific hypothesis is a proposed explanation of a phenomenon, which needs to be rigorously tested; a scientific theory has undergone extensive and peer-reviewed testing, and is accepted as an accurate explanation of the phenomena.

Investment as it used to be

Back in the unenlightened 1960s and 70s, investment managers thought their job was to buy a growing income for their clients and protect their capital at the same time. Today this is known as value investing. Managers did this by identifying the shares of cash-generative businesses with a franchise well protected from competition either by patent, reputation or distribution strength. A typical portfolio would consist of about one third bonds or preference shares for income, with the remainder in shares for a growing dividend income.

Hopefully the shares purchased were considered, if not underpriced then at least fairly priced, and would be held for several years. Some 15 to 20 different companies within different sectors of the economy were assumed to give sufficient diversification to avoid disaster to the portfolio and its income, when either the economy turned, or the market collapsed; both were expected to happen.

This is still much the same philosophy used today by the older investment trusts, and value investors such as Warren Buffett, and Jeremy Grantham of GMO. Of a similar vintage, Jack Bogle of Vanguard transformed the mutual fund business by understanding in the words of Grantham: “When we offered indexing in 1971 we did so because we knew it was a zero-sum game. That for us was a complete and sufficient reason for indexing: active managers summed to market returns less large fees and commissions while indexers summed to market returns less small fees.”