Money managers and brokers destroy your pension savings
But they make out just fine
Stocks are the only commodity I know of where the buyers want higher prices. Investors benefit from lower stock prices, not higher prices. Need proof?
If you have an interest in a business that earns $2.00 a share and pays a dividend of $0.80 per share (a typical manufacturing company) and if that company is growing with the economy at 3% per year, standard valuation theory (the Gordon model) values that share at $0.80 / (7% cost of capital less 3% growth rate) = $20 or ten times earnings. You get a 4% dividend in the first year, and that dividend will grow with earnings at a 3% rate so that 24 years later your dividend will be $1.60 and the value of your stock will have grown to $40.00 a share. This was the world Benjamin Graham was born into and most of us old coots grew up in. Faster growing companies were worth more, slower growing companies worth less, and a diversified portfolio tended towards the mean. Money managers were not “stock pickers” but followed the Efficient Market Hypothesis and used the Harry Markowitz portfolio theory to create a portfolio that yielded the highest return for a given level of risk, with some portfolio managers offering to take advantage of the Sharpe capital asset pricing model (CAPM) to use modest leverage to produce a higher return with modestly higher risk. In a nutshell, you would double your money in 24 years and by the 30 year point your $20 would grow to $47. The 30-year point is a reference datum for points that come later herein.
For many decades, price to earnings multiples on the Standard & Poor stocks averaged 5 to 15 times, largely unchanged from 1880 to 1980.
STANDARD AND POOR’S PRICE TO EARNINGS RATIO
Then money managers got into the act and brokers became their allies. Money managers claimed they could pick stocks with higher “performance” and brokers sold those with the support of “sell side” analysts whose “research reports” touted bullish theories to prompt trades and generate commissions. Over the decades, it became pretty clear that money managers underperformed stock market indices almost universally, no surprise since their fees and brokerage commissions came out of investors’ hides. Enter central banks with the idea that lowering interest rates would benefit investors since stock prices would rise, the so-called “wealth effect” lauded by sell-side analysts and portfolio managers who could claim higher “performance” as stock prices rose. Promoting stocks and tinkering with interest rates saw price to earnings multiples rise to average 16 to 22 times for the past 40 years with a few “bubbles” well above trend (see chart above). By charging fees based on a percentage of “Assets Under Management” the money managers benefited from the higher stock prices and higher earnings multiples, and corporate CEO’s and officers benefited from a “lower cost of capital” which simply means a higher earnings multiple. This utopia saw many fund managers like Ned Johnson who started mega-manager Fidelity become billionaires while claiming they were helping ordinary investors build retirement income.
The term “active management” was promoted as if there was some unique talent that a particular fund manager had in “picking stocks” that would produce higher returns for investors in that fund. But in reality, active managers underperformed market indices by a wide margin with few exceptions.
What was and is wrong with the industry rhetoric is plain and simple. If you pay a higher price for the same stream of earnings and dividends, you get a lower return on investment while the fund manager gets a larger fee (based on a percentage of AUM) and the corporate CEO gets a larger bonus (based on compensation tied to “stock performance”) while the investor whose money is being “managed” necessarily gets a lower return and ultimately a smaller pension fund. Smaller than what? Smaller than what that fund would have been if the fund purchased a diversified portfolio of stocks and simply left them alone for decades.
No fun in that if you are a broker or fund manager who wants a new Range Rover, Porsche or a larger home in the Hamptons. Nope. You need to have an excuse to talk to “clients” (you know, the people who actually own the investments) about the latest investment fad (e.g. crypto, ESG, ETF, and a plethora of other acronyms). You can only charge more if you appear to be doing something despite the reality that if you went away, your clients would be better off.
A recent study by Fidelity (founder Ned Johnson died in March and his daughter Abigail runs the show today) made what I consider the most unsurprising fact - the best performing accounts were those of people who were dead or inactive. You don’t really deserve a home in the Hamptons or a new Mercedes if you can’t do better than the deceased.
The latest fads are among the worst. Driven by left-wing ideology the money management industry has become infatuated with Environment, Social and Governance (ESG), an idea that corporate issuers should be compelled to adopt “social goals” over and above operating legally and trying to make a buck, and with the idea that “green” companies will produce better results for investors. Poppycock, but an excuse to talk to clients, create new “ETF’s” and “clean technology funds” and so on.
The Securities and Exchange Commission (“SEC”) and the Canadian Securities Administration (CSA) are signing on to this foolishness, considering or already mandating ESG and “climate risk” disclosure. “Climate risk” is the most egregious since CO2 is harmless and the whole “climate change” charade politically motivated and devoid of scientific reality. There is no doubt that these “mandated disclosures” come at a cost and reduce the income of the companies compelled to report ESG and climate change details. Lower income means lower returns. The “benefit” claimed is a lower “cost of capital” which is finance speak for higher share prices. As discussed above, higher share prices benefit money managers by boosting the AUM figure and CEO’s by increasing the value of their stock options, but they don’t benefit the ordinary investors (as a class) since the people they are paying to “manage” their money are taking higher fees and commissions and the earnings stream that flows to them is correspondingly reduced.
For about 50 years, the Standard & Poor index has returned a pre-inflation return of 11.7%. The average management expense ratio of “managed money” is about 3% (although ETF’s are lower) leaving about 8.7% for investors which, after inflation, is closer to 5%. If you invested $100 at 11.7% for 30 years (as part of a retirement plan) your investment would grow to $2,764. If you invested the same $100 through a money manager with a 3% MER who was able to match the indices (less than 2% do) that same $100 would grow to only $1,221. If your investment fund was average and earned only 7% for that 30 year period, your $100 would have grown to on $761. None of those end of period “retirement” funds are adjusted for inflation.
Ask yourself why anyone who had the expertise to “outperform” the stock market would work for a salary, bonus and commissions as a broker or portfolio manager. Answer - most can’t, and they can make a lot of money pretending they can. The sucker on the other end of that trade is YOU.
"Ask yourself why anyone who had the expertise to “outperform” the stock market would work for a salary, bonus and commissions as a broker or portfolio manager. "
This is the killer question. I consider the same question with people who teach or write books.
Sometimes they demonstrably have the skills they say and sometimes are doing it for status, not money. Often those are older guys who want to pass on some learning to the youngs, for the feels.
But in many cases those who can't - teach. Or talk.