nomonkeybusiness.org

Alternative investments #1: what, why, when and how?

This first in a series looks at how individual investors, whether self-guided or as clients of private banks or financial advisers, should form an overview of the role of ‘alternative investments’ in their wealth management. The big picture needs two perspectives: a no-nonsense view of the industry’s sales pitch and practical awareness of how individuals with different wealth levels can get their exposure. Later items will look at the different kinds of opportunity one by one.

Following this trail will lead to some quite challenging conclusions: there is a lot of nonsense talked about alternatives but for wealthy investors with insights into the nature of the bets and who are also clear about their different goals for different elements of their wealth, they can be useful at times - though their use at all times is greatly (and sometimes maliciously) exaggerated.

Stuart Fowler on 03.22.05 @ 11:48 AM GMT [">more..]

When others damage your credit

Thanks to Vodafone, I now know what it's like finding you have adverse data on your credit report and trying to fix it. All I wanted was a sensible Morgan Stanley Platinum Card so I could get cash back of 0.5% of everything I spend in a year. Mine was a problem specific to people with few credit relationships: a single error in the data provided by firms you have a relationship with, like a date of birth, can put a new lender off. But it's easier to fix wrong data than to put data there when there isn't any. Reliance on credit records means everyone should have their own. So my wife now has her own credit card and can build her own credit record . I recommend paying the £2 to get a credit report from Experian and Equifax. If like mine your service provider was bought by Vodafone, definitely check, because Vodafone have been making up birth dates all over the place. Are they repentant? Will they stop? What do you think: "On transferal from your previous service provider, no date of birth details were given, so in order to complete the transaction and to keep your number on the network, a default date of birth was temporarily placed on your account." 'Temporary', by the way, was over a year and then only when I told them.
Stuart Fowler on 03.10.05 @ 08:07 PM GMT [">link]

Restoring faith in savings industry: ABI has a plan

I'm not at the ABI's London Conference today and the plan Chairman Richard Harvey talks about in the FT today isn't on the published agenda. 'The savings industry has work to do to win back the confidence of customers, consumer groups and politicians', he says in his article. Anything insurers do to improve consumer satisfaction, contribute to consumer education and boost the product of the nation's savings has to be welcomed. But insurance companies are manufacturers of financial products with service obligations that attach to the products and the contracts, not to people. In most cases they have no relationship with people because the economics of distribution have forced them to rely on third parties: brokers and financial advisers. They don't even have the systems to support personal service: they have a hard enough struggle trying to get their legacy systems to support cross selling, (what management consultants call 'customer relationship management').

Their efforts may be welcome but they are not a solution. Insurance company chiefs have only to ask themselves: if consumers were well-informed (or simply streetwise), would they want to trust a manufacturer, would they buy the same products we've been selling them and would they pay the same price or pay the same way? It is the marketplace that will force change, but the unseen hand will be customer-aligned business formats that stand between manufacturers and customers.

The theme of this entry ties in with several topics in the 'public policy' area of the website:
Regulations need to recognise that products as well as processes need controlling and that manufacturer liability (as in other consumer-threatening industries) is much more effective than distributor liability.
Competition policy needs to do more to encourage and reward genuinely independent distribution business models, with or without basic generic advice.
The idea that consumers also have a role to play in forcing change, but not by being more trusting, is a recurring theme in Personal responsibility.
Stuart Fowler on 03.09.05 @ 09:58 AM GMT [">link]

Updated index for: Equity returns

Projecting real equity returns to a personal time horizon with a personal required certainty
This is what the 'Lambda' model does. First developed by Chris Drew and Stuart Fowler in 1999 to drive an online investment service (Fifth Freedom), it has always been unusual in modeling real equity total returns directly, independent of the yield curve and without modeling underlying economic drivers (as most stochastic asset models do). Does it produce better forecasts of equity risk and return? Yes, claim its creators. But to translate those into better forecasts of portfolio risk and return requires the use of a risk-free asset rather than the usual 'optimised' combination of lots of different risky assets.

The behaviour of real equity prices ties in with other areas of the topical index, including 'Asset allocation' and 'Accountants v actuaries'. Comparisons between real equity prices and real house prices are also made in 'Property myths'.
Stuart Fowler on 03.08.05 @ 10:44 AM GMT [Updated index for: Equity returns">link]

Updated index for: Property myths

Buy-to-let: bets with the housekeeping
The buy-to-let fashion has shifted ownership to amateurs, including households whose high-priority financial objectives are put at risk by this business they are ill-equipped to run. This article, based on a real 'money makeover' Stuart did for the FT, examines the inconvenient economics of buy-to-let in terms of i) business cash-flow variance and ii) the long-term likely payoff in real total returns: absolute, relative to required risk premiums and compared with other assets.

House prices: crash postponed or crash avoided?
This updates an earlier article ("Through the Roof", January 2006 - now removed) with house price data through June 2006. The fundamental explanation of the trend and cycle of real house prices (they must be 'real') is explained in terms of 'economic equilibrium': irresistable correcting forces within an economy. Equilibrium can be re-established by a bear market (as in the past) or by a prolonged period of flat real prices until the sustainable trend of about 2% pa 'catches up' - as the 'bulls' seem to hope. The latter is highly unlikely and is potentially even more lethal for borrowers than a bear market.

The first crash to feel like a crash
Stuart Fowler's FT letter, June 2004, together with chart of real house prices relative to post-1957 trend (updated through December 2004). Beliefs about the bubble are likely to have been distorted by 'money illusion'.

What parents tell the children about property
Parents are largely to blame for perpetuating an obsession with 'getting on the property ladder'. This item looks at how wrong we can be about the real costs and benefits of owning our own home.

Money illusion
The failure to distinguish what is really happening to asset prices by adjusting for the effect of general inflation in prices is called 'money illusion'. As the items above suggest, money illusion is a contributor to popular misconceptions about house prices. As this 2003 FT article pointed out, there are other examples of how money illusion has cost individual investors dear.

Stuart Fowler on 03.07.05 @ 05:25 PM GMT [Updated index for: Property myths">link]

Updated index for: Kids' stuff

What parents tell the children about property
Parents are largely to blame for perpetuating an obsession with 'getting on the property ladder'. This item looks at how wrong we can be about the real costs and benefits of owning our own home. Young people expect the benefits to be experienced as gains in freedom. The ladder spells a drastic loss of freedom which, unanticipated, leads to regret.

Various items about popular misconceptions about house prices will appear in the 'Property myths' index.

The lifetime challenge of funding your own retirement
This article answers the question 'What does it take to retire on £35,000 pa net of tax in real terms?' - a realistic target for young people with say twice-average lifetime earnings expectations but not mega-salaries. Though the scale of the task can look daunting and the usual mantra of starting young faintly ludicrous, capital-building targets are sensible even if pensions are not the sole purpose. Indeed, since flexibility is the key empowering feature of capital early in your working life, pension plans are not the obvious place to store the money. Empowerment is what links this item with the one above (on settling down with a nice big mortgage).
Stuart Fowler on 03.07.05 @ 04:22 PM GMT [Updated index for: Kids' stuff">link]

What parents tell the children about property

Parents have instilled in their children the desire to get onto the property ladder, not just as a lifestyle choice but as a way to avoid permanent loss of possible wealth. But the expected economic rewards of home ownership are misunderstood by most parents, biased by the experience of their generation. Tell most people what the long term trend of house prices has been ‘in real terms’, after stripping away the illusion of general inflation, and they will stare at you in disbelief. But unless you believe the real trend of growth will be above the real cost of mortgage debt, there will be a high financial price and loss of flexibility on that ladder. Lifestyle benefits may make it worth a high price but, like work/play or pay/satisfaction choices, that’s for kids to decide.
Stuart Fowler on 03.07.05 @ 04:01 PM GMT [">more..]

Updated index for: Streetwise finance

We don't need to be clever or knowledgeable, we just need to be streetwise
This is a recurring theme of No Monkey Businessand it is explained in the Introduction to the book. Taking personal responsiblity does not require us to be experts ourselves but we need to be streetwise when dealing with experts.
'Streetwise' is a fruitful line to take with young people too: more to come on this in 'Kids' stuff'.

How the industry exploits our poor grasp of probabilities
It is not realistic for most consumers to outsmart clever professionals or spot the flaws in the reasoning of less smart professionals. The streetwise solution is to develop some proxies that will help when selecting advisers and buying products. In this item the proxies are ones that test for the adviser's grasp of probabilities and ability and willingness to use odds to help you make your own choices.
Stuart Fowler on 03.07.05 @ 11:38 AM GMT [Updated index for: Streetwise finance">link]

Updated index for: Competition policy

'The future of financial advice': CSFI press release
The Centre for the Study of Financial Innovation, with support from Accenture, commissioned Stuart Fowler to write a paper on financial advice after polarisation. This November 2002 press release summarises key findings and when and how the author's views differed from many of his working party. CSFI Director Andrew Hilton bills the paper as 'an important step beyond Sandler, Pickering, Myners and CP121'.

'The future of financial advice in a post-polarisation marketplace'
Coming after a number of public policy initiatives, the CSFI working party chose to focus on the business economics of financial advice and the business challenges faced by providers and distributors if we are to cut the need for specific advice, lower the cost of all financial advice, increase ease of access to advice and improve its quality. The dominant revenue model, commission-based, is seen as an obstacle to these objectives, preventing commodity products, keeping more products and providers than efficient product markets require and raising consumer costs. The paper explores the scope for an economically separate and fee-based advice market and what encouragement it will need from public policy initiatives.

What changing polarisation is all about
This explanation of the FSA's original 'depolarisation' proposals in 2002 (from the old No Monkey Business website) is still useful background briefing. The commission proposals changed a lot along the way (see 'Commissions' under Monkey tricks) and the engagement of high street firms as 'multi-tied' distributors of financial products looks like 'more of the same' rather than the strong retailing model, pro-competition, we see in consumer goods.
Stuart Fowler on 03.07.05 @ 11:22 AM GMT [Updated index for: Competition policy">link]

Updated index for: Personal Responsibility

It’s time to tame your money
Stuart Fowler's February 2002 FT article takes a core theme of No Monkey Business: consumers will be better served by less trust in financial institutions and more trust in themselves. The article argues that the nanny state has fostered consumer ignorance about financial products. The answer is more responsibility, not more regulation. The article summarises the key things people need to do as part of taking personal responsibility.

Consumers have responsibilities as well as rights
John Trayner is a financial trainer (yes!) in the retail financial services industry – the front line. He sent us this and we sent it on to the FT who published it as a Personal View in December 2003. John makes the case that if we rely on others to advise us and protect us we have only ourselves to blame. This is at the heart of the unresolved debate in public policy between ‘caveat emptor’ and ‘nanny knows best’.
Stuart Fowler on 03.07.05 @ 10:17 AM GMT [Updated index for: Personal Responsibility">link]

Updated index for: Money illusion

Time to put a ceiling on our money illusions
Stuart Fowler's January 2003 FT article looks at the high cost to investors of thinking and accounting in money terms instead of real terms, adjusted for inflation. Most personal investment goals involve real or 'constant purchasing power' targets and the risk utility functions that matter most are about real outcomes at the end of the journey, not just the path the journey takes.

Amongst the examples of money illusion in that FT article is the unrealistic expectations most people have about housing as an investment. This is also covered in the 'Property myths' index.
Stuart Fowler on 03.06.05 @ 10:58 PM GMT [Updated index for: Money illusion">link]

Updated index for: Asset allocation

Why bonds are not good diversifiers: a primer
This article explains the errors in conventional thinking about the absolute and relative risks of fixed income investments (gilts or corporates) that have no inflation indexation, and how those errors impact asset allocation in financial planning, private client portfolio management and product design and description. The arguments rely on three key No Monkey Business 'distinctions': real versus nominal (or money illusion); path risk versus outcome risk; total return versus income returns or capital returns.

Can holding debt make more sense than holding assets?
When a portfolio has the goal of achieving long-term outcomes expressed in terms of purchasing power, the basic building blocks that are easily and cheaply accessible are equities and index-linked gilts. Other 'real' assets like property and commodities are desirable but not necessary. Non-inflation indexed bonds are useless in these terms. Only very wealthy people can afford to fund their goals with no market risk and no inflation risk, by preferring index linked gilts over equities. This applies to the new low-cost pension accounts as well as to final-salary schemes. No surprises here: everything from pensions to government tax-raising hangs on equity-based risks. We live with them. We might as well try to understand them better.

Asset allocation: what it means for financial planning
Stuart Fowler's article in an e-journal for technology provider 1st Software was intended for IFAs but it is not too technical and it can be useful for customers to see it from a professional's perspective. Asset allocation literally means exposure to different types of asset, hence 'where your money is put to work'. It treats asset types (such as deposits, fixed income investments and equities) as 'building blocks' for assembling in simple or complex ways to achieve a customer's goals. Asset allocation should be at the heart of the advice process, but that is no guarantee it will be.

Asset allocation and 'the 90% rule': the Ibbotson paper
In No Monkey Business the importance of asset allocation in explaining where portfolio returns come from is related to 'the 90% rule'. The book explains how this is often misunderstood and hence misrepresented and refers to a short article by two principals of Ibbotson Associates who set the record right with a paper called Does asset allocation explain 40%, 90% or 100% of performance? The answer is all three - depending on how you define performance. Here's the article - from their website.

The 'mean reversion' debate
Mean reversion in real equity returns is hotly disputed amongst academics. If financial planners assume markets are random at all time horizons, the effects include raising the resources indicated as being required to achieve an objective and increasing the attraction of bonds relative to equities in any mean-variance asset allocation process. In this technical feature from the old website Stuart Fowler seeks to justfiy his own faith in mean reversion.
Stuart Fowler on 03.06.05 @ 08:11 PM GMT [Updated index for: Asset allocation">link]

Updated index for: Low risk products

Product safety claims don't hold water
Stuart Fowler's September 2004 FT article was prompted by Prudential's new smoothed investment bond - 'son of with-profits' - and looks at why most so-called low-risk products disappoint. Reasons include: charges that overwhelm the modest returns earned on low risk products; option-like strategies that offer little benefit after option costs; real risks that are much higher than both sellers and buyers realise.

With-profits for the Sandler Suite: no way
This and several articles in the 'With-profits' index deal with the misrepresentation of the risks of with-profits funds, relative to both cash savings and equity investing. This arises because 'smoothing' cannot do all that it is cracked up to do.

Other related items:
The means by which equity risk is usually dampened to create a less volatile path for a fund is by combining equities with 'fixed income' investments - as in 'managed funds', for instance. The issues this raises, for long term outcomes in real terms and for the short term path when fixed income markets move in tandem with equities, are explored in the 'Accountants v actuaries' index.

Recognising which risk matters most, path volatility or future wealth outcomes after inflation, is vital to selecting the right risk free asset to manage overall portfolio risk. For individuals with real wealth targets (such as to provide a pension), index linked gilts are the true risk free asset, not non-inflation indexed bonds. This common error in investment planning is covered in the 'Money illusion' index.


Stuart Fowler on 03.06.05 @ 06:17 PM GMT [Updated index for: Low risk products">link]

Updated index for: Accountants v actuaries

Can holding debt make more sense than holding assets?
When a portfolio has the goal of achieving long-term outcomes expressed in terms of purchasing power, the basic building blocks that are easily and cheaply accessible are equities and index-linked gilts. Other 'real' assets like property and commodities are desirable but not necessary. Non-inflation indexed bonds are useless in these terms. Only very wealthy people can afford to fund their goals with no market risk and no inflation risk, by preferring index linked gilts over equities. This applies to the new low-cost pension accounts as well as to final-salary schemes. Both are being pushed towards traditional bonds, which are neither risk free nor a good risk, by the false economics of 'fair value accounting'. We cannot avoid equity-type risks so we should try to understand them better.

Asset wars #1: Who's telling the truth about equity risk?
Equity risk does not reduce with time, as many professionals wrongly (naively?) claim, but how the equity bet meets investors' risk tolerance is definitely time-horizon dependent. The problem for the consumer is that professionals don't differentiate between path and outcome uncertainty when advising about the equity bet. This debate is long overdue.

Equity risk and time
The FT's weekly fund management supplement, FTfm, carried a version of this in its Talking Head column on 2nd may 2005, under the title 'Let battle commence over equity risk'. It was prompted by the criticism by leading 'fair value' accountant John Ralfe of Adair Turner's comments on equity risk in his preliminary report on pensions for the Government. Turner laid himself open to criticism by repeating a 'howler' but his argument has merit nonetheless.

What (little) pension trustees should know about investment
Pension trustees are being placed in an impossible position, under pressure to beef up their competency to take responsibility for high level investment decisions when logically the regulatory changes separating investment stratgey and contribution adequacy mean they should not be taking these decisions at all. The underlying principle is risk utility functions - something they may usefully learn about at summer school even if it brings home to them the fallacy of what they are being asked to do.
Stuart Fowler on 03.04.05 @ 06:59 PM GMT [Updated index for: Accountants v actuaries">link]

Updated index for: Active v tracking

Does Fidelity Special Situations Manager Anthony Bolton disprove active management sceptics?
The 'performance myth' gets its life blood from the emergence of a few outstanding managers, such as Fidelity's Anthony Bolton in the UK. I thought it would be interesting (though quite technical) to show you how he looks when put through the same tests we use on all active managers (as part of our wealth management process). He is good but not good enough to replace even 20% of a tracker. And his record has been so inconsistent over the years that investors or their agents may well have given up on him before they got the big payoff of the last few years. This is the fatal flaw, in practice, not theory, of active management.

More academic research on active management
New research from the University of Exeter makes too much of weak evidence of performance persistence over a short period amongst the best UK pension fund managers in their UK equity portfolios. This sort of research does more for the cause of tracking than researchers seem to realise.

Active management on the back foot
This 2002 article in Financial News challenged trustees to rethink why they hire active managers and, in the light of the Merrill Lynch/Unilever case, how they should write the mandate to control managers' active bets

The consumer impact of the performance myth
Slides used by Stuart Fowler at INQUIRE conference, Berlin, 2002. The presentation takes the theme of Chapter 11 of No Monkey Business: there is no evidence of exploitable performance persistence in UK equity funds. The effect of high fund costs is to turn an essentially random process into a bad bet. Concealing the nature of the bet is an integrity issue for an industry that spends massively to perpetuate the myth that consumers can pick the adviser who can pick the manager who can pick the stocks that outperform.

Dogs stay dogs - or do they?
This feature was on the old No Monkey Business website soon after the book was published and focused on research arguing that poor performance persists. The truth is, sometimes it does, sometimes it doesn't - that's the problem with active management. Since they probably didn't look like dogs when bought, it is a reminder that the problem of dog funds arises only because people buy funds with good past performance. Over long periods, even stars usually look like dogs somewhere along the way, so how do you then tell the difference between a star and a dog

Poor research on good performance
In a briefing to financial journalists in October 2002 Stuart Fowler counters the claims made by Charles River Associates (in a paper commissioned by industry body IMA) that past performance is weakly predictive. IMA's agenda is to stop the FSA using its influence to wean the public off an obsession with past performance. As the FSA (and many academics) went on to show, the CRA research is deeply flawed but, even if it were not, the conclusions do not alter the practical outcome: picking active funds is a mug's game.
Stuart Fowler on 03.04.05 @ 05:59 PM GMT [Updated index for: Active v tracking">link]

Updated index for: Cost wedge

Costs kill
This summary of chapter 11 of No Monkey Business shows the different sources of investment cost, of which commissions are the largest and most discretionary part, and their impact on expected returns, expected risk premiums and hence the rationality of investors' choices. At the thin end of the 'cost wedge' are index-tracking funds. At the thick edge are funds with only a small chance of rewarding investors for taking equity risk. The cost wedge is inseparable from the issue of commissions and active funds vs trackers - each with their own topical index.

The cost wedge just got fatter
Several papers have recently reported the growing number of increases in annual management charges. This latest wave particularly affects funds combining equities with lower risk - and lower return - investments, increasing the chance of irrational selection by investors. The trend is ironically partly driven by investors avoiding front-end sales charges which means all actively managed funds have to rely more on trail commissions, whether the underlying real returns can suport their cost or not. Illustration of the cost impact for a personal 'balanced' pension fund shows that the cost of paying for advice by commissions is nearly 25% of potential fund value after 20 years of accumulation.

The Cost Wedge: an American perspective
An article by John Bogle, architect of one of the most successful US mutual fund groups, shows UK consumers are not alone in being ripped off by the investment industry just for trying to get our money to work in the equity markets. The exasperation of all decent professionals who understand this finds support in the radical core suggestion of the Turner Report on pensions: we need a public sector procedure for collecting savings and subcontracting management on tight terms if we are to prevent the Cost Wedge impoverishing retirees.

Stuart Fowler on 03.04.05 @ 05:31 PM GMT [Updated index for: Cost wedge">link]

Updated index for: Commissions

D(epolarisation) Day: what might have been
From 1st June we should be able to tell the difference between a fee-charging adviser, paid in a way that aligns their interests with ours, from a commission-driven salesman, with an agenda different from our own. We won't.

Response to ABI's 'Paying for Advice' consultation
No Monkey Business Limited's response to The Association of British Insurers' consultation paper on ways to pay for advice. Still in denial about commission bias, insurers are worried that 'depolarisation' will not improve the public's mistrust of them. Too true: it required much more radical action to correct a market failure.

Insurers say 'no commission bias OK?'
The industry is relying on doubtful research to argue that there is no evidence of 'systemic' commission bias. Don't believe it.

Commissions: what's not on the menu
Stuart Fowler's FT article (March 2004) gives an insider's view of how the new forms of disclosure about how - and what - IFAs charge will not stop them pulling the wool over customers' eyes, by concealing the vastly higher cumulative cost of commissions compared with aying a fee for advice.

Response to FSA 'menu' consultation
Response to FSA consultation paper on commission 'menu' argues the proposals will not achieve their limited objectives nor will they contribute significantly to the original objective of the status distinctions between ‘authorized’ and ‘independent’, based on how commissions were dealt with, as proposed in CP121.
Stuart Fowler on 03.04.05 @ 05:22 PM GMT [Updated index for: Commissions">link]