InvestmentsMar 24 2014

Market myths

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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.

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.”

Testing the EMH

Such a simple but personally accountable approach was not considered sufficiently scientific by hard-headed CEOs, under pressure to set up defined-benefit pension schemes by the welfare zeitgeist post-1945. Fortunately that same desire for a fairer world had also encouraged a significant expansion of universities, as well as introducing the computer.

Add computers, academics looking to make a name for themselves, and the perennial appeal of stock market profits and, as Mr Grantham recently wrote:

“At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know - even economists - that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).”

“We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the past 25 years at least four of the great investment bubbles in all of investment history. First, there was the bubble in Japanese stocks, which peaked in 1989 at 65 x earnings (on their accounting) having never peaked at more than 25 x previously, to be followed by a loss of almost 90 per cent in the MSCI Japan index.

“Second, we had the Japanese land bubble peaking a little later in 1991. This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor’s Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California.

“Seems efficient to me ... California is so big and unwieldy. Next, we had by far the largest US equity bubble in 2000, which peaked at 35 x earnings compared to a peak of 21 x in 1929, yet had had previous growth rates less than half of those in 1928 and 1929. Finally, we had what I described in 2007 as the first truly global bubble. It covered all global stocks, fine arts and collectibles, and almost all of the real estate markets.

“The last of these was led by the US housing market, which, having benefited from its great diversity, had historically been remarkably stable until Greenspan got his hands on it. Compared to previous ultra-stable data, this measured as a 3.5 sigma event, which, according to the EMH assumption of perfect randomness, should have occurred only once every 10,000 years.”

Reality versus belief

By the 1970s, conventional thinking had decided that investment management was the next new thing. The three decades from 1945 onwards had justified the cult of the equity. Economic growth grew rapidly and those years produced good investment returns at the same time as welfare politics embedded inflation into the economy, so destroying the value of money employed in savings or bonds. The next three decades saw economic growth slow, as the post-War recovery was completed, but an enormous expansion of pension fund money, together with private wealth and institutionalised savings through mutual funds.

These flows, together with increased bank gearing and dealing, force-fed equity revaluations; the last two decades of the 20th century produced annual returns in double figures. This enabled all sorts of ‘experts’ to add their contribution to the investment chain, thus ensuring no one could be held responsible for failure to meet investment targets. As politicians and senior bankers are now discovering, once a ‘specialist function’ has been identified and become fee-charging, it is very difficult indeed to be rid of it.

Back to the future

So, despite the strictures of a Buffett around the dangers of not controlling investment costs, these continue to grow like topsy, and Kay’s recommendations can only gather dust. Worse still, according to the European Commission, and in the absence of comprehensive economic reforms, living standards in the eurozone relative to the US will be lower in 2023 than they were in the mid-1960s.

This prediction is not in tune with the comforting tales of recovery and financial market stability on which Europe’s leaders are congratulating themselves. Fortunately, the emerging markets, with their expanding middle classes, remain a good although tricky long-term bet for investors, as do the changing technologies of business everywhere. IFAs and savers need to rethink the way they trade, and reduce their costs by investing over the long term of five to 10 years.

This is Russell Taylor’s view on March 6 2014. He will be happy to answer readers’ letters arising out of Investment Spotlight.