Last November, the FCA produced the interim findings of its market study on the fund management industry. Its trenchant criticisms suggested the final report would take action against the failings of this quasi-monopoly – they included a demand to take account of the interests of clients and to offer an all-in charge so buyers can check performance against price.
Other remedies included the appointment of outside directors to encourage price and other competition, and exposing the cost to investors of active churning of portfolios.
How not to act
Fund managers have promised to be good, and the FCA has accepted those assurances. It has allowed them to keep their extraordinary profit margins, now so much better than those of the banks themselves.
The FCA has no need to be afraid to take risks in the face of so much invested money. Since the purpose of investment is the purchase of an income, it has the perfect example of how it should be done in the investment trust sector, allowed by the regulator to “not to be [automatically] complex investment instruments” under the terms of European Mifid II regulations coming into force in 2018.
How to manage money
The effectiveness of this style of client management is proved not only by their survival over the last 175 years of social and economic revolution, but the existence within the Association of Investment Companies [AIC] website of dozens of companies styled as “dividend heroes”. These are those companies that have increased their dividends every 12 months over at least 20 years and, in some cases, for more than 50.
Of course those increases have not necessarily kept pace with inflation, or rising stockmarket values, but an increased payout on an original share price cost is one of the most certain identifiers of a capital gain – the will-o’-the-wisp promise of so many investment salesmen – and the certainty of maintaining some value when everything else is going to the dogs.
The post-war development of the fund management industry took place against a backdrop of high income tax rates and no capital gains tax. It was also the high point of computer-based analysis of stockmarket movements, and the conviction that the volatile movements of these markets were understandable and could be tamed.
Unsurprisingly, silver-tongued salesforces quickly persuaded investors that gains and not income were the rationale of sensible investment.
End of simplicity and certainty
But that simple world has long gone. John Authers, senior financial commentator for the Financial Times, has reviewed an important warning for all investors. Mr Authers says: “In ‘Tectonic Shifts in Financial Markets’, Henry Kaufman offers a scorching account of how Wall Street got into this mess, how it failed to get out and what to do now.
“Coming from a pivotal figure in modern finance, who is now in his 90th year, it will command attention.
“Mr Kaufman was at high school with Alan Greenspan; at the New York Federal Reserve with Paul Volcker; running research at Salomon Brothers as it created the US mortgage market and dominated bond trading; and on the board of Lehman Brothers in the years before disaster hit.
“[Kaufman’s] central point can be made with a scientific analogy. The laws of physics remain unchanged. Credit build-ups will end with disaster, investment bubbles burst and so on. But the geology of the ground, the tectonic plates, has shifted. This is because the nature of financial institutions has changed and, in Kaufman’s words, ‘we cannot go home again’.
“Modern institutions are unfit to withstand potential dangers. So a different kind of regulation, involving greater intervention, more judgment and far less trust for quantitative models, is needed to stop the behemoths from inflicting another financial crisis.
“How did the plates shift? Compared with 1960, US government debt has risen from $320bn (£248bn) to $17trn and the 10 biggest conglomerates control 75 per cent of US assets – in 1990 it was 10 per cent. Financial derivatives, which barely existed in 1960, are now worth $630trn.”
Behemoths and competition
These amount to tectonic shifts. Mr Authers continues: “Some of the effects: when people talk about financial ‘liquidity,’ they now mean that they have access to credit, not cash-in-hand; corporate debt has grown so much compared with equity that in any future crisis creditors stand to lose far more than in past crises; large investors cannot make shifts in their portfolio without disrupting markets; and only the central bank can now be trusted to provide liquidity, as all the biggest private-sector banks are so large and interconnected.
“Mr Kaufman is angry that the Federal Reserve, largely under Alan Greenspan, failed to check the effects of the growth of institutions, and as a result found that its usual monetary remedies no longer worked. He holds that the central bank will ironically have greater power – and become more political – as a result of past missteps.
“Rather than setting interest rates, which will need to be far higher to inhibit financial activity, Mr Kaufman suggests the Fed will need to be far more intrusive in the few big institutions that wield the power, and which cannot be allowed to fail.
“He is disgusted by what he sees as Barack Obama administration’s failure in 2009 to achieve reform.”
Is it just the US?
This analysis is equally true of the UK and the Bank of England, and it helps to explain the weakness of the FCA. In deciding their future, investors must remember that there is no such thing as a riskless asset. Cash in a bank guaranteed deposit and index-linked gilts are riskless compared to normal bonds or shares, but not without risk, as the inflationary 1970s proved in Britain.
When – and it is when and not if – Kaufman’s fears come to pass, investors will need full- time professional management of their fortunes. The two riskless assets mentioned above are no longer in sync – bonds have become expensive while cash has become cheap.
Two related assets would not have gone such separate ways over the last three to four years had the normal balancing act of the markets been working.
The chaos to come in the markets means no private individual can possibly know what is happening, nor what to do about it.
The only way these goals can be achieved is through a portfolio of investment trusts. These are cheap compared to private banks and much more efficient, if less prestigious.
But prestige has no place within financial matters; it is about cost effectiveness in terms of offsetting management fees, administrative and interest costs, and avoidance of tax on portfolio changes. These are all available through investment trusts, but not through unit trusts, private banking or DIY investing.
Choose a manager with care
Not all investment companies are the same. It is vital to read the reports of board and investment manager in the annual report to ensure both are communicating clearly and their policy aims suit your needs.
This is not the case between the fund industry and its clients. And the rise of populism throughout the Western world shows this is no longer so between politicians and the people they are supposed to lead, either. No one can predict what that might lead to over the coming decades.
However, the German hyperinflation of the 1920s proved that, in the end and over several years, investing in real assets was the saviour of some middle-class investors.
The announced aim of President Trump to dismantle the 70-year-old ‘Pax Americana’ is on a par with the desire of English nationalists to destroy the living standards of Britons through a ‘hard Brexit’.
When he was active, Kaufman had the nickname Doctor Doom – he now has even more reason to worry.
