the stock market crash of 1987

The Wall Street Journal has an interesting article today on the birth of the ETF–and the index fund, for that matter.

Two factors stand out to me as being missing from the account, however:

–when the S&P 500 peaked in August 1987, it was trading at 20x earnings.  This compared very unfavorably with the then 10% yield on the long Treasury bond.  A 10% Treasury yield would imply a PE multiple on the S&P of 10x–meaning either that bonds were dirt cheap or that the stock market was wildly overvalued vs. the bond market.

–a new product, called at the time portfolio insurance, a form of dynamic hedging, had very recently been created and sold to institutional investors by entrepreneurs steeped in academic efficient markets theory.  Roughly speaking, the “insurance” consisted in the intention to stabilize equity portfolio values by overlaying a program of buying and selling futures against the physical stock.  Buy futures as/if the market rises; sell futures as/if the market falls.

One of the key assumptions of the insurers was that willing/eager counterparties for their futures transactions could be found at all times and at theoretically predictable prices.  On the Friday before Black Monday–itself a down day–the insurers’ model required them to sell a large number of futures contracts.  Few buyers were available, though.  Those who were willing to transact were bidding far below the theoretical contract value.  Whoops.

On Monday morning, the insurers, who appear to have had negligible actual market experience, capitulated and began selling futures contracts at whatever price they could get.  This put downward pressure both on futures and on the physical market.  At the same time, pension funds, noting the large gap between the price of futures and the (much higher) price of the underlying stocks, began to buy futures.  But to counterbalance the added risk to their portfolios, they sold correspondingly large amounts of stocks.  A mess.

Arguably, we would shrug off at least part of this today as just being crazy hedge funds or algorithmic traders.  Back in 1987, however, equity portfolio managers had never before seen derivatives exerting such a powerful influence on the physical market.  It was VERY scary.

conclusions for today

Stocks and bonds are nowhere near as out of whack with one another as they were back in 1987.  The nearest we have today to a comparable issue is what happens as worldwide excess liquidity is drained by central banks from money markets.

The trigger for the Black Monday collapse came from an area that was little understood, even by those involved in it–activity that had severe negative unexpected consequences.  The investors who did the best after the crash, I think, were those who understood the most quickly what had happened.

Collateral damage:  one of the most important results of Black Monday, I think, was the loss of confidence in traditional investment advisers working for the big brokerage houses that it created.  This was, I think, partly because of individuals’ market losses, but partly, too, to the generally horrible executions received when they sold stocks in the aftermath.  This was the start of a significant acceleration of the shift to discount brokers and to mutual fund products.

paying for brokerage research

As part of an EU overhaul of the financial industry, the UK has recently concluded an inquiry into pricing practices for mutual fund and other products offered to individual investors.  Press commentary is that the good luck for an industry with a bewildering array of prices (much higher than in the US) and little link between cost and value is not having been referred to the law enforcement authorities for criminal prosecution.

One big issue has been “soft dollars,” that is, paying brokers higher than usual commissions in return for their research, or for trading machines, or even newspapers–items that customers generally believe (and rightly suppose, in my view) they are paying for through management fees.   …but no!

Asset managers have been proclaiming that this is a weighty and complex issue, that the don’t know how to proceed.  They’ve generally been gnashing their teeth.

To me, this is all somewhat comical.  For decades, firms that do business in the US have been following an SEC mandate to keep meticulous records of the amount of their soft dollar expenses and what is being paid for.   The general rule was that if you stayed in line with industry practice, meaning doing whatever Fidelity did, you’d be ok legally.  They know exactly what they’ve been doing.  Also, the EU inquiry (see the link above) has been going on for three years.

There are two real issues:

–there’s a lot of money at stake, and

–handling the potential outcry from customers when they realize they’ve been paying twice (management fee + soft dollars) for research expenses.

An example:

A mutual fund has $50 billion in assets.  It turns those assets over at the industry average of 50% per year.  That means $50 billion in buys and $50 billion in sells.

Let’s say: the average stock trades for $40; the soft-dollar markup is $.02 per share; and the markup is taken on 20% of all shares traded (maybe slightly high, but the math is easier).

So, the fund “service” includes giving up $10 million a year of customer money on brokerage commissions in order to get the management company free goods and services.  That’s even though they’re collecting something like $250 million in management fees from the same customers.

disclosure vs. restructuring

Internally, I think disclosure is the lesser of the two issues.  The more difficult one is that industry revenues are stagnant or falling and by far the largest expense of any investment manager is salaries.  So, whose pocket does the lost soft dollar revenue come out of?

Vanguard, this decade’s Fidelity

Just prior to the 2007 financial crisis, Fidelity decided to turn up the competitive heat on fund management rivals by declaring it was unilaterally going to stop using soft dollars.  This time around, it’s silent so far.

Last week, Vanguard made a similar announcement.

 

UK investigation of the investment management industry

The UK Financial Conduct Authority is wrapping up a two year investigation of the money management industry in this important global financial center.

Despite heavy industry lobbying which has squelched similar inquiries in the US, the FCA’s just-released preliminary report is an indictment of many traditional industry practices.  Excessive fees, lack of disclosure and conflicts of interest among asset managers and pension consultants are recurring themes.  The Financial Times, which seems to me to be in the best position to know, thinks that the “good” news for the industry is that the FCA has not recommended a government investigation of its practices for potential breach of UK law.

Although the investigation began before Brexit became a reality, it occurs to me that the FCA’s conclusions are being shaped by the idea that UK investment services no longer need simply meet the (very) low bar of being better than what’s available in the rest of the EU.  Without a built-in clientele, services must also be good in an absolute sense.  A regulatory regime that gives investors a fair shake is a sine qua non–as well as miles better than what is generally the case elsewhere, including in the US, the current market leader.

The FCA investigation has two implications I can see for US-based money management:

–increased disclosure of fees/performance in the UK will increase pressure for similar disclosure in the US.  One particular bone of contention is the use of “soft dollars” or “research commissions,” meaning a management company pays a broker, say, 2x the going rate for a portion of its trading.   In return it receives goods/services that the manager would otherwise have to pay for from management fees.  The kinds of stuff a manager can receive is already regulated in the US, but disclosure of the amount of money in extra commissions ultimately being paid by clients is not.  The FCA will require such disclosure in the UK.  My sense is that the amounts will be surprisingly large.

–during the years prior to the financial meltdown, US banks opened London branches to process transactions–often involving US buyers and US sellers of US products–that were allowed in the UK but illegal domestically (think:  sub-prime mortgage derivatives).  This was a result of the UK’s decision to build up its financial services industry using a “regulation lite” approach to governance.

In the absence of any changes to US laws, why wouldn’t large US institutional investors demand that their investment managers similarly conduct business out of London.  In this case, however, it would be to obtain lower fees, greater transparency and better legal recourse in the case of disputes.

Yes, this sounds a little crazy, but the legacy investment management industry–both managers and consultants–are so powerful that I think favorable change for investors is unlikely to happen otherwise.

 

 

professional investment advice (ii)

Yesterday, I wrote about the problems a Wall Street Journal reporter had in discovering how much she paid in fees to the professionals she hired to invest her money.  The task, which we’d think should be a piece of cake, turned out to be very difficult.  Although the reporter didn’t identify the firm in question, the corporate philosophy seems to be the usual one for active managers of emphasizing service rather than fees.  This decision, which is hard to fault in itself, has been transmuted into two courses of action–bury fee information as deeply as possible, and keep the fees (1.4% of assets per year, in this case) very high, in the hope no one notices.

Oddly enough, this strategy has been relatively effective for decades.

It seems to me, though, that being aware of what one is paying for professional investment advice is only part of the assessment process.  A second important criterion is what the gains in investment performance are that come from having an investment adviser.  The relevant metric is how effective the adviser’s asset allocation and portfolio management efforts are in keeping the client at least even with the appropriate benchmark after subtracting fees.  

Andrea Fuller’s case would work out like this:

Let’s say her “moderate” asset allocation ends up being 60% stocks, 40% bonds.  If we take the returns of the S&P 500 and of some broad bond index as proxies, a rough benchmark return for her over a given period is easy to calculate.

In my view, a reasonable expectation would be that one’s portfolio should (at least) keep pace with the index after fees.  I say “reasonable” although knowing less than a quarter of active managers are able to consistently exceed my standard and over half consistently fall short.

In an ideal world, an active manager who is consistently unable to perform in line with the appropriate benchmark after fees has an easy fix–at least a partial one.  Lower fees to the point where the portfolio is at least close to the index.  Her firm’s high fee level and the teeth pulling needed to figure out what they are suggest this is the last thing on its mind.

Given that this is the case, the operative question for Andrea, and for anyone else, is how much the service the firm may be providing–like determining asset allocation or the availability of a knowledgeable account executive to answer questions or handholding during crises–is worth in terms of losses to an index fund strategy that one could easily implement on one’s own.

It also seems to me that if annual returns consistently fall more than 1% below a benchmark after fees it’s worth the time to shop around for a different investment management firm.

 

how much does professional investment advice cost?

the article

Yesterday’s Wall Street Journal has a curious article in its monthly “Investing in Funds & EFTs” section.  It’s by Stanford graduate Andrea Fuller, a reporter whose specialty is data analysis.  It’s about her trying to find out how much she pays for professional investment advice/management.

the outcome

As she describes it, her situation is a simple one.  She uses an investment firm that’s “one of the largest in the country,” no name though.  The bottom line for her is that she pays a yearly fee, deducted daily, of 1.40% of the assets under management, which consist entirely of ETFs and mutual funds.

The fees break out in the customary way into two parts–an overall fee, sometimes called a “wrap” fee for the service of determining an appropriate asset allocation and selecting funds/ETFs,  plus providing an interface to discuss investment issues.  In Ms. Fuller’s case, that amounts to 0.85% of the assets.  In addition, she pays an average of 0.55% per year for the portfolio construction and management of the mutual funds and ETFs she owns.

pulling teeth

What’s interesting about the story is that Ms. Fuller (1) didn’t know this information before she decided to write the story, and (2) assumed, as I would have, that the figure would be easily available with a phone call or email.  In Ms. Fuller’s case, that’s wrong.

(a longish, maybe pedantic…sorry) Note:  the article implies that all the products are “in-house,” that is, provided by a single investment firm which is also the client interface.  If so, finding out costs is straightforward–what Ms. Fuller pays in total and what she pays to the firm are the same.  If, however, the investment firm uses a third-party portfolio manager for any portfolio products, it typically demands a portion of the third party’s management fee in return for providing access to “its” client.  This means that the total fees paid consist of two parts:  the fees paid to the client-facing investment firm and amounts paid to third parties.  In my experience, investment firms are very reluctant to disclose what their fee-sharing arrangements are.  A Customer Service hotline or a plain-vanilla investment adviser would never have that information.  In that case, the answer to the fee question Ms. Fuller posed is not so simple.)

Tenaciously, Ms. Fuller made a series of phone call (and email?) attempts to get this basic information from her investment adviser.  On at least two occasions, she answer she got was wrong–and, surprise, surprise, understated fees.  Although she finally verbally received the figures I cited above, she was unable to get anything in writing.  Apparently, this basic data isn’t disclosed on the firm’s website, either.  At one point during her journey, she was told to consult Morningstar and figure the fees out herself.

My thoughts:

–Wow!

–By and large, investment firms are run by professional marketers, not professional investors.  Their emphasis is typically on cultivating a relationship that focuses on client service and peace of mind and which deemphasizes the nuts and bolts of fees and performance vs. an index or competitors’ offerings.

Still, I’ve never encountered a situation where fees haven’t been readily available and disclosed somewhere in the small print.  To me, Ms. Fuller’s firm seems to me to be either stunningly inept or to be deliberately choosing to make fee information virtually impossible to obtain.

 

More tomorrow.

 

sovereign wealth funds and ETFs

Monday’s Financial Times notes that the Qatar Investment Authority (QIA), the sovereign wealth fund of the Middle Eastern State of Qatar, is changing its investment strategy.  Qatar is a country of 2.2 million people and 15 billion barrels of oil (that we know about), making it one of the wealthiest places on earth.

Since its inception in 2005, the $335 billion QIA has focused on expensive “trophy” assets, like the Canary Wharf property development and Harrods in the UK and film company Miramax plus 13% of Tiffany in the US.  It owns high-end hotels and office buildings all over the place.

According to the FT, however, the QIA has now decided to shift its focus to index funds and ETFs, indicating to the newspaper that the world supply of new trophies waiting to be bought is running low.

Maybe this is true, although there is a much more obvious issue with the QIA’s holdings that neither it nor the FT allude to.

Such trophies are virtually impossible to sell, except maybe to other Middle Eastern sovereign wealth funds.

Hotel companies in the US, and latterly elsewhere, have spent the past two or three decades shedding their properties–while retaining management contracts–because the returns on ownership are so low.  Iconic office buildings are a much better return bet.  But, again, there are only a limited number of possible buyers of, say, a $5 billion project.  A sharp price discount would likely be in order to compensate for taking on an expensive, highly illiquid asset like this on short notice–doubly so if the buyer sensed the seller was having cash flow problems.

It seems to me that the QIA bought into the narrative of “peak oil,” meaning a looming shortage of crude, that has been the consensus among oilmen for the past couple of decades–up until the emergence of mammoth amounts of shale oil production from the US three years or so ago. that is.  So liquidity was never a consideration.

I think the QIA change of strategy is the prudent thing to do.  It’s odd, though, that the QIA is calling public attention to the shift.  This would seem to imply at least that it has no need to divest any of the trophies it now has on its shelves.

Of course, something deeper may be going on as well, since the unasked question is who else may be in worse shape and may want to offload illiquid assets before its cash squeeze becomes evident.

Surprise!  That train has just left the station.

 

 

more trouble for active managers

When I started in the investment business in the late 1970s, fees of all types were, by today’s standards, almost incomprehensibly high.  Upfront sales charges for mutual funds, for example, were as high as 8.5% of the money placed in them.  And commissions paid even by institutional investors for trades could exceed 1% of the principal.

Competition from discount brokers like Fidelity offering no-load funds addressed the first issue.  The tripling of stocks in the 1980s fixed the second.  Managers reasoned that the brokers they were dealing with were neither providing better information nor handling trades with more finesse in 1989 than in 1980, yet the absolute amount of money paid to them for trading had tripled.  So buy-side institutions stopped paying a percentage and instead put caps on the absolute amount they would pay for a trade or for access to brokerage research.

All the while, however, management fees as a percentage of assets remained untouched.

 

That appears about to change, however.  The impetus comes from Europe, where fees are unusually high and where active management results have been, as I read them, unusually poor.

The argument is the same one active managers used in the 1980s in the US.  Stock markets have tripled from their 2009 lows and are up by 50% from their 2007 highs.  All this while investors have been getting the same weak relative performance, only now they’re paying 1.5x- 3x what they used to–simply because the markets have risen.

So let’s pay managers a fixed amount for the dubious services they provide rather than rewarding them for the fact that over time GDP has a tendency to rise, taking corporate profits–and thereby markets–with it.

The European proposal to decouple manager pay from asset size comes on the heels of one to force managers to make public the amount of customer money they use to purchase third-party research by allowing higher-than-normal trading commissions.  Most likely, customer outrage will put an end to this widespread practice.

Both changes will doubtless quickly migrate to the US, once they’re adopted elsewhere.