Chapter Four: Efficient Investing in Inefficient Markets
Why investors get less than corporations earn
The wealth management industry doesn’t create any wealth. All the wealth creation happens in the operating companies both private and public and the “wealth management” contributes nothing but is a parasite on the returns available to the owners of those companies whose securities are listed and posted for trading on a stock exchange. “Wealth managers” charge clients fees for choosing investments for them and those fees come out of the returns the clients would otherwise enjoy.
Secondary trading doesn’t create wealth, just redistributes it. Gains by one trader are offset by losses of another and the transactions are subject to a “rake” in the form of the tax consequence of the trade and the transaction fees and commissions the traders must pay to play. Fund managers charge clients fees and incur costs which are lumped together and disclosed as the “management expense ratio” or MER of the funds they “manage”. Whatever returns are earned by the investments, they are reduced by the MER. The fund managers and brokerages are the “house” in the market casino and the “rake” is the amount they earn at the expense of those they claim to serve.
But that doesn’t explain why returns on the broad market are less than returns earned by the companies making up the market since neither is adjusted for the costs making up the MER. The leakage from corporate profits to investor returns is more nuanced and is found in the propensity of the “wealth management” industry to pretend it can pick and choose securities that will rise in trading price faster than the market averages. Often they do but what is missing is an understanding of why that does not benefit investors as a class. The clue is the percentage charged for AUM.
Higher stock prices do not benefit investors unless they sell some or all of their holding. If they do sell, some will enjoy a gain and a new investor will assume their position - the buyer of the shares they sold. For any given security, the only wealth being created for any of the series of investors who hold such securities is the profit of the underlying company, either reinvested in the company’s operations and reflected in future profits and dividends, or in dividends or interest paid on the securities. Higher prices for the securities compel lower returns for the investor, but not for the “wealth manager”. Instead, the higher prices result in a higher amount paid to the wealth manager as a percentage of AUM.
Stock prices rise and fall with economic events and government actions. Higher interest rates manifest themselves in lower stock prices. Higher inflation manifests itself in higher interest rates (to curb the inflation) and lower stock prices. Lower rates and lower inflation or even deflation make companies earnings stream more valuable. The price to earnings multiple often used as a simple valuation measure for shares of a company will vary between 10 times and 20 times for the same company with the same profitability if interest rates are very high or very low. Since 1927, the price to earnings multiple of the S&P 500 has ranged from a low of 6.4 times in to a high of 122 times in the Global Financial Crisis of 2009. This chart of the S&P 500 price to earnings multiple also shows periods of economic recession shaded grey.
When price to earnings multiples expand as a result of, for example, artificially low interest rates driven by so-called “quantitative easing” or QE, stock prices rise and the fees charged as a percentage of AUM rise in tandem. The higher stock prices do little or nothing to improve corporate profits, but do a lot to increase the profits of “wealth managers”. Clients of those firms rarely complain since they have an apparent increase in their own “wealth” as a result of the higher share prices and tend to believe the wealth manager (who has had no role in driving interest rates lower) “earned” the higher fees for turning in “better performance”.
The entire wealth management industry promotes the illusion that higher stock prices benefit investors, an obvious fallacy as described earlier. Talking heads on Bloomberg, BNN Bloomberg and CNBC have program segments with names like “Fast Money” “Hot Picks” and “Top Picks” with guests from the wealth management industry touting their choices for investments that will “outperform”. The record of fund managers compared to market averages is dismal despite the hype. Over 90% of fund managers over a 15 year period produce returns lower than market averages, but still charge fees for their “management”.
Individual investors do no better. Most are ill-equipped to make investment decisions and deluded by the barrage of promotional material from sell-side institutions and money managers that urge them to believe what they need is to pick stocks that will rise in value. Yanked from pillar to post, the average investor trades too often, buying when prices have risen and running for cover when they fall. The same people will defer discretionary household expenses when prices are high and rush to stores to load up when items are on sale. It seems they understand that it is better to buy cars and groceries at lower prices but can’t grasp that it is better to buy shares of public corporations when prices are low and avoid such purchases when prices are high.
As Nobel laureate Richard Thaler found, investors over react to negative inputs and under appreciate long term growth in profits and dividends. The often frantic trading motivated by fear of missing out (FOMO) sees retail investors chasing prices upwards as they rise, a sure way to earn lower returns, and dumping their holdings in economic downturns when they should be adding to holdings or at least keeping money in cash until there is evidence the downturn is abating.
In the next chapter, I will make a rough attempt to reconcile the amount of money that comprises the gap between what corporations earn and investors receive and how it compares to the revenues of money managers. The comparison compels a conclusion that “wealth managers” consume their client’s wealth. When investors begin to understand that the “wealth management” industry profits at their expense and produces lower, not higher, returns on their investment dollars, they will begin to understand how to improve their investment returns. When it sinks in that higher stock prices produce lower returns for them but higher returns for the “wealth managers” they pay to help them choose investments, the light will begin to flicker or may even go on.
In Chapter Five I will put some hard data against these concepts to demostrate the size and scale of the damage done to investors by “wealth managers”. In later chapters I will expand on the theory and ultimately demonstrate how retail investors can improve the outcomes on their investments without paying unearned fees to “wealth managers”
Oh oh but don’t I need wealth manager High Priests to tell me which stocks have the best ESG so I can virtue signal and go to heaven ?