The financial industry doesn’t magically make our money grow. After fees and charges, it makes it shrink. Lavish City bonuses are therefore out of all proportion — and they need paring back.
With the likelihood of a UK General Election before the end of the year growing on an almost daily basis, the prospect of a Labour government is coming into sharper focus.
Given what Labour has had to say about the City of London, there must be many in the Square Mile who are viewing current political developments with some trepidation. According to a poll this week, City workers would prefer a no-deal Brexit to a Corbyn government by a margin of 54 to 46%.
Until now, the City’s concerns have focussed largely on what a Labour victory would mean for business. What’s bad for business is usually bad for the markets. But there are now more pressing issues occupying the minds of those who run our biggest financial services companies.
What would a Corbyn government mean?
Labour revealed two years ago that it was planning to raise at least £4.7 billion a year with a new financial transaction tax. Despite widespread criticism, not least from Mayor of London Sadiq Khan, the policy looks set to be included in the party’s election manifesto.
Last month, shadow chancellor John McDonnell announced that a Labour administration would launch a year-long public inquiry into “corruption” in the financial industry. Set up under the 2005 Inquiries Act, he said, the inquiry would take evidence under oath. “It will put the facts on the table, get immoral and unlawful practices out in the open, and make clear what needs to change for finance to serve people and the wider economy.”
Then, last weekend, the FT added to the City’s worries with another interview with Mr McDonnell. This time the shadow chancellor warned that would place severe restrictions on awarding bonuses, and perhaps an outright ban.
A reflection of “grotesque inequality”
“(Bonuses have) become part of the culture,” he told the paper, “and it is so separate and distinct and isolated from the real-world economy… It’s a reflection of the grotesque levels of inequality that people now find so offensive.”
It’s certainly true that bonuses have risen steadily over the last decade, thanks in part to the long bull market in global equities. According to the Office for National Statistics, they now account for almost a quarter of pay in the financial industry.
Quite how a Jeremy Corbyn-led government would make good on its pledge to restrict City bonuses, I am not sure. In practice, I suspect, it would be very hard to impose lower levels of overall pay. But is Labour serious about trying to curb bonuses? I’m certain it is, and this Corbyn sceptic for one would have no complaints if it did.
Patrick Hosking said much the same thing in a recent piece in The Times, a paper not known for its Corbynite sympathies either. September, he explained, is the beginning of Christmas bonus season in the City, “when the speculation, the politicking, the boss-ingratiation, the anxieties and hopes really begin to kick in for City workers.”
For Hosking, City bonuses raises an important question: How is it that the City generates the profits that fund this jackpot machine in the first place?
It amazes me that this particular question is not asked more often. Take asset management as a specific example. So many people, including intelligent ones, still seem to think that the investing industry somehow makes our money grow. It doesn’t. Once you factor in fees and charges, it actually makes it shrink.
Simply no magic
As Warren Buffett explained in his 2005 letter to Berkshire Hathaway shareholders, the amount of money that companies can generate for investors is finite. “The most that owners in aggregate can earn between now and Judgment Day,” Buffett wrote, “is what their businesses in aggregate earn.
“There is simply no magic — no shower of money from outer space — that will enable them to extract wealth from their companies beyond that created by the companies themselves.”
Of course, it is possible for active managers to generate wealth for their investors over and above the market return, and indeed, over short time periods, they often do. But the overwhelming evidence is that, in the long term, on a cost-and risk-adjusted basis, they very rarely outperform a comparable low-cost index fund.
The SPIVA analysis produced by S&P Dow Jones Indices shows, time and again, that only a small fraction of funds are able both to survive and beat the market over periods longer than 15 years. But it’s not just the SPIVA people saying this. Morningstar, for example, has just released an update on active versus passive fund performance in Europe over the last ten years, and it reads like a cricket score. Out of 66 categories analysed, actively managed funds outperformed their average passive peers in only two.
It’s consumers who pay
“The suspicion,” writes Hosking, “is that supernormal profits are being made at someone else’s expense.” Of course they are, and that someone is the consumer. Millions of UK investors are paying for active money managers to try to beat the market, and almost invariably those managers are failing. Billions of pounds that could be going into people’s retirement pots is being siphoned into the pockets of financial professionals. And, by professionals, I don’t just mean fund managers, but researchers, brokers, investment consultants and all those other intermediaries who feed off active money management.
Why are we even paying bonuses to asset managers? It’s their job is to beat the market. That’s what they’re paid to do. Of course, by the law of averages, every manager is going to outperform from time to time. But if they can’t do their job consistently, and over meaningful time periods, why are they being paid at all?
The answer, of course, is that managing other people’s money is awesomely lucrative. There’s plenty of money to go round — not just for fund managers, but also the shareholders and the senior staff. BlackRock chief executive Larry Fink, it was recently revealed, has received around $411 million in pay and bonuses over the last ten years.
Have we reached “Peak Gravy”?
Thankfully, it’s no longer just commentators like Hosking, pressure groups like the High Pay Centre and blogs like The Evidence-Based Investor who are asking awkward questions about City bonuses. There are calls for reform within the industry too. A paper called Riding the Gravy Train, published earlier this year by the Edinburgh-based fund manager Baillie Gifford, argued that we have now reached “Peak Gravy”.
“The financial industry itself creates little of value,” said the study’s author Tom Coutts. “It is a facilitator, a lubricant for the economy, helping savers to earn a good return on their money and providing financing for investment opportunities. Those of us who work within it should be humble about the role we play.”
Over to you, policy makers
Asset managers, of course, are not renowned for their humility. After all, they need to exude confidence to keep attracting assets; they have to convince investors, and indeed themselves, that they can overcome the odds and deliver long-term outperformance. Realistically, we can’t expect the industry, voluntarily, to reduce the bonuses on offer.
As usual, it falls to policy makers, including the regulators, to sort this problem out. To date they’ve shown a singular reluctance to do so.
Whoever forms the next UK government, the issue of City bonuses needs addressing. The unseemly ritual of six-figure bonuses being lavished on asset managers who can’t beat the index is a Christmas tradition we can do without.