1: Their performance just isn't good enough
The vast majority of fund managers will fail to outperform their benchmarks in the long-term, after their fees have been deducted. This is the wealth management industry's inconvenient truth. You will generally be much better off buying a 'tracker' ETF or fund that tracks the relevant benchmark.
Consider this. A good ETF should have annual charges of about 0.25%. If your fund manager charges 1.25%, then they need to outperform their benchmark by 1% every year just to match the ETF. Over the very long-term, you can expect stockmarkets to go up by about 6-7% a year, so a 1% outperformance every year, just to get to zero, is quite a big ask.
Take it from Warren Buffett, one of the world's greatest investors, who said in his 1996 letter to investors (and if anything it holds more true now): 'Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.'
2: YOU are part of the Problem
Harsh, but true. Clients are partly to blame for the Fund Management industry culture. The client's defence, if it counts as one, is their lack of education. Most clients have a limited understanding of how the stock markets work. What they do understand, and care about, is if their investments are going up. Therefore convention has led to clients receiving an update every 3 months from their fund manager.
There is a big problem here. Companies are large and complex beasts. They do not generate profits like clockwork in a linear fashion every three months. Their earnings are 'lumpy'. There are all sorts of cycles to contend with, and unpredictable macroeconomic events that can affect their earnings.
Conventional wealth managers therefore iron out these 'lumps' to present easy-to-understand results for their clients – at a cost. In contrast all the great fund managers take a much longer-term view. They, and their loyal clients, will accept that there will be times when the performance of the past 3-months is abysmal, because the companies are going through a temporary rough patch, but in three to five years time, these companies will have recovered and gone gangbusters.
In interviews with some of the world's most successful wealth managers, they often cite the intelligence and long-term mindset of their clients as one of the reasons for their success. It is only when they have such clients that they have the freedom to invest unconventionally.
Therefore as a client it is your responsibility to ensure that you are educated enough to understand when your money manager is doing something unconventional but correct.
3: The problem of index benchmarking: “I'm delighted to announce that we only lost a Quarter of your Money last year”
The fund management industry has cleverly implanted the idea of a financial index 'benchmark', such as the FTSE 100 or S&P500 as the measurement of their performance. They then state that their performance is 'satisfactory' as long as it does not deviate much from that benchmark.
This creates the rather ridiculous results whereby in a market crash, if the benchmark index has gone down by 30%, and your wealth manager has gone down by 25%, it is seen as a 'good result', as they have 'outpeformed by 5%'. This may be true, but it belies the fact that they've lost a quarter of your money.
If you combine the fact that wealth managers are content with a good enough performance for their clients, and their wish to not deviate too far from the benchmark, it makes sense that they want to mostly imitate the benchmark. This leads to the issue of 'benchmark-hugging' (see below).
4: Hug your Benchmark tight
The 3-month reporting requirement means that wealth managers take less risk than they might otherwise. If their performance is measured against the benchmark every 3 months, it stands to reason that the safest way of achieving this is to invest in a portfolio that is broadly similar to the benchmark – this way you will never do terribly. However neither will you ever do terribly well.
This modern trend is known as 'benchmark-hugging' and it is quite extraordinary how many funds are guilty of this. If you find the Fund you are invested in is a benchmark-hugger, you should sell it immediately and buy an ETF which tracks the benchmark instead (for more on this, see below). You will get an identical gross performance, but your net performance will improve as you will be paying a much lower fee.
One of the great illustrations of the problems of benchmark hugging is in the late nineties tech-stock bubble. The success of the tech-companies meant that the benchmarks were suddenly full of them. The only way a fund manager could therefore match their benchmark in that period was to buy these extremely over-priced companies.
Of course, many people were convinced that it was right to buy these companies. The problem came with the smart fund managers who didn't buy tech-companies, realising the great bubble that was taking place. For two or three years, they significantly underperformed their index, to the displeasure of both their boss and their clients. Some were even fired – why – for doing what in retrospect was the right thing. Consider the irony that in contrast those fund managers who lost their clients money by buying tech stocks kept their jobs.
This absurdity of the fund management industry is summed up by John Maynard Keynes' saying, 'It is better for reputation to fail conventionally than to succeed unconventionally'.
(In fairness, bubbles are extremely hard to handle. Psychologically, humans find it very difficult to perform differently when everybody else is doing something the same thing, and this is a key factor which sustains bubbles.)
5: What is the opposite of a banker's bonus?
One of the issues at the heart of trust in investment (and anything else) is the alignment of incentives between agent and principal i.e. you and your money manager.
Everyone knows about bankers' bonuses. They are rewarded in the good times. But logically does this not mean they should be penalised in the bad times?
Consider the owner of a small business. They participate equally in both the upside and the downside of that business, meaning they take a very careful and long-term view of how to care for it. They assess risk very carefully and have no interest in taking short-term risks if it increases the chances of long-term failure as they will bear the brunt of it.
In contrast a banker or money manager (or of course an employee of pretty much any company with a bonus structure) participates in the upside but not the downside. The existence of an effective insurance 'floor' means that money managers at big companies have an incentive to take on extra risk to achieve higher returns and to hell with the consequences.
If their horse wins, they get all the winnings. If it doesn't, they get their stake back (and you cover the cost). It's Heads I Win, Tails You Lose. A fee structure where a wealth manager was penalised for long-term sub-par performance (e.g. by rebating some of their fee to the client) would counter this, but ideas like this are heretical in the wealth management industry.
This is another example of why it is so important that you invest with money managers whose interests are aligned with yours. It is only where either a) a money manager has a substantial amount of their own money invested in the same things as you or b) the money manager owns a substantial stake in their firm, so have a longer-term view in the success of the firm and its clients, that you can be confident that your money manager is really working for you, and not taking unneccessary risks.
6: Fiduciary Duty and Confidence Men
Traditionally, wealth managers consisted of 'old-school' City firms. They were often small partnerships, which meant that the partners had a strong sense of personal responsibility and fiduciary duty to their clients. A firm's reputation was dependent on this, as the serious business of looking after a person's hard-won savings ought to be.
Over the past fifty years, a combination of globalisation, industry consolidation and institutional involvement in investing has changed all this. The corporate nature of most modern money management companies means that their own interests take priority, and the fiduciary duty to clients has been largely lost.
However there is still a historic perception that wealth managers can be 'trusted' to look after their clients' money. Clients still have 'confidence' in wealth managers and their ability to make money, despite substantial, statistical evidence to the contrary.
And in this respect the smart suits, smooth patter and glossy office meeting rooms in the City suddenly take on a more sinister edge as classic weapons used by a 'con-man' (which you will remember is the abbreviation of confidence man) to propagate a belief that turns out to be untrue.
7: How to impress your Boss (but not your Client)
'The stock market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch. The problem when you are a money manager is that your fans keep yelling, “Swing, you bum!”' Warren Buffett
Imagine you started a new job, and discovered that it was incredibly boring. Once you'd set up your system, you didn't have that much to do, except read reports. What would you reaction be? The typical human response would be to worry that your boss would think you're not pulling your weight and, to combat this, create unneccessary things to do so that you look busy.
This is one of the problems the wealth manager faces – pressure to do stuff. It is an alternative version of the Pascal quote, 'All men's miseries derive from not being able to sit in a quiet room alone'. Money managers feel that it's inappropriate to update their clients saying, 'Hi there, we bought and sold absolutely nothing in the last year' as though this means the client is not getting value for money. The perversity is that since the client is charged for every transaction, by doing nothing they are saving the client money.
Of course there are times when it is appropriate to buy and sell things, but ideally you want to hold your investments for as long as possible (think of growing an oak tree – if you uproot it early on, it will be like any other tree, but the longer it grows, the more power it will gain proportionately).
In contrast, the personal investor, as long as they have the discipline to be boring, does not face the same pressure to do things. Behavioural quirks like this are reasons why in investment, the amateur can have the advantage over the professional.