When Gary Porter and Jack Trifts, two American professors of business administration, checked the performance of 2,846 American mutual funds managed by 1,825 investment managers from 2006 to 2008, they made some intriguing discoveries. Just a quarter of the managers survived more than five years in the market, and only 195 of them survived more than a decade.
The bad managers, who lost their jobs early in their careers, had done worse than more experienced managers. Here’s the interesting part: The veteran managers who survived more than a decade did not demonstrate improvement over time. The only thing that enabled their survival is that they didn’t present particularly poor performance. Porter’s and Trifts’ conclusion was simple: The way to survive in money management is not to deliver outperformance over time, but not to make particularly egregious mistakes.
They also concluded that if your career started well and made you a good name, money will stream to you irrespective of performance. Just make sure not to have particularly bad years.
Last week, reporting on the work by Porter and Trifts, the British magazine “The Economist” presented another study published by the mutual funds management company Vanguard, which manages mainly index-tracking funds – meaning funds that don’t pick stocks to try to beat the market, but stick to investing by given market indices. The Vanguard study looked at the performance of the top 20% of mutual fund managers and discovered that five years after they excelled, their performance deteriorated to the bottommost 20%.
These two studies join dozens more in recent decades, proving that hardly any investment managers beat the market over time, and that “the key to a long career in the mutual-fund industry seems to be related more to avoiding underperformance than to achieving superior performance,” though if he significantly lags behind the market – so will the money flow to him.
Why can’t managers beat the market? Simple: 40 years ago professional managers handled only 10% of the volume of trade in the market. Today they manage 95%. The information to which they have access is the same, and for reasons of liquidity, most prefer to stick to big large-cap stocks, the ones about which everybody has the most information.
The astonishing thing is that this has been true for decades, yet investors don’t get it. They continue to pay high management fees of 1% to 3% a year to “active” managers who try to beat the market. Even though the volume of portfolios tracking market indices had increased dramatically, they still handle just 11% of the total volume of financial assets.
If you believe ...
Finance experts have tried to elucidate why investors remain willing to fork over hefty fees to managers, fees that eat at much of the investment or pension savings. One explanation is overconfidence among the investors, who think they can pick the next successful manager (which is almost impossible). Another is that investors are attracted to brand names, which gives them psychological security for which they’re willing to pay excessive fees.
It’s no coincidence that the biggest asset management company in the world is called BlackRock, and most of its ads don’t present fund performance over time, just atmosphere photographs like stable boulders or the company’s luxurious offices. It simply works on people.
There’s another explanation: The giant pension funds have to keep “believing” that they present high returns over time in order to meet their customers’ expectations of a decent pension, which usually assumes annual returns of 7% to 8%. Since risk-free interest rates are very low in the markets today, less than 3%, their ability to whip up returns like that in the stock market constantly decreases. The pension funds have to convince their customers that they can beat the market, and to do so, you can’t rely on index-tracking vehicles: You have to actively manage the money and “believe” your picks will beat the market, though there’s no evidence that this is true.
The practically inescapable fact is this: Most investment managers around the world, including in Israel, don’t justify the high fees they charge. They deliver mediocre returns and charge high fees that eat at your money over decades and make a very small group of finance industry people and a larger group of people who market these investment vehicles very rich.
This isn’t news but at this time, around the world and especially in Israel, one should think about it, because there’s not only risk – there’s opportunity.
How the cellular reform empowered the public
The danger is clear: The low interest rates greatly increase the risk that in the decades to come, the pension and other long-term funds won’t manage to deliver the kind of returns that their customers expect – they’re still thinking in terms of 7% to 8% as has been the case in the last 20 years. Which means the fees these managers are charging are especially deadly and cruel, because they’re eating up much of the yields – meaning, your retirement money.
The opportunity lies in the fact that in Israel, unlike most countries, since the social-justice protests began in 2011, the public has woken up to the fees they’re being charged by the independent tax militias, monopolies and bodies such as the insurance companies, which are protected by the regulator.
One reason for the Israeli public’s sudden empowerment is the cellular reform. The entry of new players into the oligopolistic cellular market caused prices to collapse, saving the public about 6 billion shekels over three years. The main beneficiaries are the general public and unorganized customers, whose monthly bills dropped by half to as much as 90%.
The finance system is five times bigger than the cellular market and charges the public nearly 100 billion shekels a year. A third of that money goes to the two biggest banks, Hapoalim and Leumi, a concentrated duopoly with tremendous surplus costs that it rolls over onto its customers. In recent years a big part has also been going to the pension fund and mutual fund management market.
Fees at the new pension funds are relatively low and competition between provident funds enables money to be mobile, so fees have been dropping there fast. The biggest problem now is the veteran executive funds, in which some 200 billion shekels lie, where fees are double and triple the rates at provident funds and pension funds.
The first challenge is therefore to rescue the trapped policy-holders of the veteran executive funds, who pay fees of up to 2% a year. This will require a collaborative effort by a strong insurance commissioner and determined politicians.
An even bigger challenge before the government is to initiate the entry of new players into the banking and pensions market, like Golan Telecom took the cellular industry by storm. It should set a national goal lowering the cost of the finance industry in Israel by a quarter or a third, at least, over the next decade. The public would gain six times more than it did from the cellular reform.
Increasing competition in the finance system will have another huge benefit, beyond cost: The tremendous concentration in the system doesn’t only enable companies to charge through the nose on fees and interest rates, but creates inefficient allocation of resources. The powerful and their cronies get to grab a huge portion of the public’s money. The more concentrated the finance system, the harder it is for new players to come in.
Mammoths and monsters
The challenge is big. The technological entry barriers to the finance system have been dramatically reduced in the past decade, but it remains difficult to compete with the two banking mammoths and the five insurance monsters. In its capacity as regulator, the Bank of Israel is a prisoner of the banks, being mandated to care mainly about their stability – which bears the cost of economic concentration and constrained competition.
What’s needed are creative regulators or politicians who can persuade the government to encourage, protect and possibly support new ventures like Golan Telecom, who want to take on the finance system. Yozma is a good precedent: It was a fund established 25 years ago by the Ministry of Industry and Trade which granted cheap financing to venture capital funds. Ten new VC funds arose, whose success helped create an independent, privately held ecological system which cultivated the Israeli venture-capital industry.
To break the finance duopoly and cartels and reduce concentration in financing, the state should consider more creative, aggressive ideas. For instance, existing public bodies could provide the infrastructure for low-cost competition to arise in banking services and money management.
Smart savers or people with means who want special service, or think they really can choose good managers, may continue to ply the existing insurance companies and pension funds. But millions of Israelis who earn low pay and don’t swim like fish in the financial markets can be offered simple investment vehicles with low fees that are chosen based on the saver’s risk preferences and age.
The ultimate goal is simple: for Israel to have, within a few years, Golan Telecoms of financing that substantially lower the fees and interest, shatter the concentration and give the public back control of its money.
Astonishingly, the public forgets that these 3 trillion shekels that it’s deposited with training programs and insurance companies are its own, though most of it is beyond its control. Just five years ago, Israelis accepted that their cellphone numbers “belonged” to the companies, not them, and had to switch number if they switched operators. Now they can “take” their numbers with them. Similarly, people need to get back control of their money and be entitled to a competitive market.
Would this solve the problems in Israel’s pension market? No. Let us be clear: The pension problem in Israel, like in many countries, is much bigger than fees or investment avenues. It starts with the structure of the economy, low productivity and the structure of the labor market, which lead to low pay, continue onto high housing prices and a sky-high cost of living, which in turn lead to diminished savings and continue onto poor government services to the public (which has to complement them with expensive privately-purchased services) – and it ends with the consumption culture, waste and borrowing in certain circles of society.
All these things need handling. But the best place to start is the simplest points, using tools that have already proven themselves: aggressive government encouragement of competition and diversification of the finance system, which is the life blood of the economy, and a reduction in its costs.
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