The cost of being too clever
Richard Butcher says its time to learn that complexity is generally costly
My school teachers were okay, but in a lifetime of learning since then I’ve come across so many other people who would have been better. Imagine Jonny Ball teaching you maths, Bill Bryson history, geography or science or Brian Cox physics.
I’m rereading one of the books of one such individual at the moment – Tim Harford’s The Undercover Economist. He makes it all so easy, so clear. So clear, in fact, its worth relating – particularly since it also resonates with a recent Financial Conduct Authority (FCA) paper.
In a chapter entitled “Rotten investments and rotten eggs” he sets out a quick and highly simplified summary of why the banking sector crashed in 2008 – in essence, a misunderstanding of the maths behind packing and repacking high-risk debt. While making his case, he also explains the efficient markets hypothesis. It’s this that I want to relate.
The semi-strong form of this hypothesis says that anything which can be predicted by a rational, well informed investor will already be priced into the market. In other words, if you knew that prices would increase tomorrow, you would buy today.
On the assumption that everyone is rational, the behaviour of asset prices should be completely random
As a consequence, on the assumption that everyone is equally well informed and rational, the behaviour of asset prices should be completely random – because if all predictable factors are priced in, all that is left to drive prices are factors that are unpredictable (or Harold Macmillan’s alleged observation: “events, my dear boy, events”).
In practice, however, gains relative to other investors can be made by speed of trade (which Harford seems to overlook) and through informational imbalances (the law prevents, or at least outlaws, many informational imbalances, although they still exist between investors who can be bothered to do their research of publically available information and those who can’t). Harford concludes: “The hypothesis says there are no obvious bargains, no easy forecasts, no get-rich-quick schemes … we should instead merely gently invest in a wide variety of shares, with no expectation of making a killing – we should diversify, keep charges low and avoid trying to be too clever.”
Managers are poor, so are consultants, so are many trustees, so are the schemes they govern
Last month, the FCA published their Asset Management Market Study Interim Report. Over the course of its 206 pages (plus nine addendums) the asset management market is taken to pieces. Managers are poor, so are consultants, so are many trustees, so are the schemes they govern. We are all, apparently, guilty.
With the benefit of the re-read of Harford’s book, I can see that many of their observations chime with the basic economics he puts across. Active asset managers, observed the FCA, on the whole, are failing to produce better returns than passive managers. (Although institutional active managers do marginally outperform, before charges.) How could they do so without an information imbalance?
They could reduce charges if there were more pressure on them to do so
All asset managers charge too much, implies the FCA. Their costs of production have dropped, but their pricing hasn’t. In addition, their profit margins are at the top end of the range for similarly skilled businesses. In other words, they could reduce charges if there were more pressure on them to do so.
Investment consultants have an inherent conflict if interest – they want to show they are clever and sophisticated, and so worth their fees – that causes them to favour complexity in the solutions they recommend. This, the FCA concluded, added little if anything and probably contributed to worsened outcomes.
In other words, the FCA found, we are not living up to the Harford mantra of “diversify, keep charges low and avoid trying to be too clever”.
The new year is a good time to read a book and learn something new. Perhaps it’s time all trustees went back to school.
P.S. I inadvertently bought two copies of Harford’s book. If you’d like the spare one, just ask. I’ll give it to the tenth person who does.
Richard Butcher is managing director of PTL