By ROBIN POWELL
There are very few human activities in which those with no expertise and no previous experience can outperform highly paid professionals. Investing happens to be one of them. If that sounds a little unlikely, take a look at a new academic paper called Hogwarts Finance. It’s written by a very successful and highly respected investment consultant called Richard Ennis.
In it he examines the investment performance of the Chief Investment Officers and consultants who manage assets for America’s largest financial institutions and pension funds. They have a huge responsibility. Between them they oversee about US$10 trillion. It’s a staggering sum. And yet, between them, these highly paid professionals have been outperformed by simple low-cost index funds since the global financial crisis of 2008-09.
This underperformance has averaged between one and two per cent a year. That might seem like a small amount, but, compounded over time, it makes a huge difference.
The problem, says Ennis, is a lack of intellectual rigour in institutional fund management. “The professionals,” he writes, “are ignoring their canon. Lawyers coming before the bar are expected to know the law. Physicians, conspicuously, in my experience, attempt to adhere to the best medical science. Engineers do not improvise when designing bridges. But the people managing institutional assets behave like they attended Hogwarts School of Witchcraft and Wizardry.”
Here are six examples Ennis gives of the way those professionals are failing in their duty to the people whose money they are supposed to be managing.
They conflate investment strategies and asset classes
Institutional investors, Ennis says, mistakenly treat active investment strategies as if they were distinct asset classes like stocks, bonds or cash. Legitimate asset classes, the author argues, have inherent differences and are supported by laws, regulations, and market pricing, whereas active investment strategies are short-lived, based on subjective outlooks, and depend on selection skill or luck.
They misrepresent alternative investments
Ennis explains how CIOs and consultants have falsely attributed the characteristics of traditional asset classes to alternative investments like private equity, real estate, and hedge funds. They claim, for example, that alternative investments offer diversification benefits. But the evidence shows that, since 2008, they have in fact been highly correlated with the US stock market.
They underestimate the cost of complex strategies
One of the biggest drawbacks with investments like private equity or hedge funds is that they come with high fees that investment professionals often underestimate. These fees, the paper shows, act as a significant drag on institutional performance because they behave similarly to stocks and bonds and yet are many times more expensive.
They confuse alpha with beta
CIOs and advisors often claim to generate alpha (outperformance relative to a benchmark) when in fact they are simply riding the broader market’s beta (the return that can be attributed to the market’s overall movements). Instead of using actively managed funds, investors can capture beta far more cheaply and efficiently by using passive, or broadly passive, funds.
They compare their performance with the wrong benchmarks
Ennis points to a long-standing problem where CIOs and consultants avoid benchmarking their performance against simple, broad market indexes that match the risk level of the funds they manage. Instead they prefer custom benchmarks that are often opaque, overly complex, and likely biased to make their performance look better.
They overlook expenses when reporting returns
Finally, the author claims, some large public pension funds do not deduct all investment expenses when reporting returns, which departs from professional standards and overstates performance.
In his conclusion, Richard Ennis writes: “(In my paper) I have described just a few of the failings in the design, execution, and measurement of institutional investment portfolios. Fund management is riddled with them. I estimate the resulting economic inefficiency costs beneficiaries in the US at least $100 billion a year. Why does this persist? Is it not time to put the wizard’s grimoire aside and take the investment textbook down from the shelf?”
Sadly it’s rife in the investing industry — it has even infected the financial advice profession — and as research by psychology experts has shown, it’s frighteningly easy to manipulate the mind, and get it to believe the impossible.
The good news is that investors can ignore such wizardry altogether and focus on what the independent, time-tested, peer-reviewed evidence tells us.
So forget the wizardry. Invest instead in a low-cost portfolio of index funds. Focus on the long term, control your emotions during inevitable periods of market volatility, and resist the temptation to bail out or change course.
That way you can outperform the majority of investors — and yes, that includes the professionals.
If you want to learn more about Richard Ennis and his work, this recent profile of him is fascinating, while here is a list of his most recent research papers.
ABOUT THE AUTHOR
ROBIN POWELL is the editor of The Evidence-Based Investor. He works as a journalist, author and consultant specialising in finance and investing. He is the co-author of two books, Invest Your Way to Financial Freedom and How to Fund the Life You Want, and his company Regis Media provides high-quality video content for advice firms and other financial businesses.
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