You shall know false prophets by their fruits
The FCA are said to be unhappy with the results of its first round of value assessments. They could do worse than re-read the sermon on the mount and in particular Matthew 7 15-16. But more of that in a moment.
There seems to be a gap between what a consumer sees as good value and what fund managers do. To be blunt, consumers do not want to judge a book just by its cover. They want to know what really happened to the money they handed over and how it “did”.
These simple questions have to be the priority for value assessments, but once again financial services companies, left to their own devices have proven deficient in providing a common definition for value and too little practical help on working out what our funds are really costing us. The latter issue is particularly concerning for vertically integrated fund managers like SJP where the fund is paying for advice.
The lack of prescriptive guidance from the FCA on how managers should define value means that the first round of assessments vary widely from manager to manager. Why can’t they just tell us what we got?
Of course the absolute return of a fund is not the only standard by which a fund should be judged. If your fund claims to be invested for social purpose , you expect to see how that purpose was followed. If you decided to invest in technology , you want to know how you did compared with investing in the technology benchmark index. But the alpha and omega of value assessment has to be based on consumer “experienced” outcomes.
I think I speak for most consumers in saying that at the heart of any value assessment, we expect to see what we got for our money . The chief indicator of that is the internal rate of return on our investment over the period we gave our money to someone else to manage.
Beware false prophets
The review said the FCA was probing the process and governance behind the value assessments rather than the statements themselves.
And pleased to read co-founder of AgeWage, Chris Sier’s comment that that while cutting fees was eye-catching, it was only meaningful if accompanied by concrete steps to improve performance.
“Only if you do both will you get good value for money – cutting fees on an underperforming fund just makes a bad fund cheaper.”
The famous phrase – “you shall know them by their fruits” would seem to be one guiding principle the FCA could follow. As the FT points out
The fact that some managers with high-profile performance issues did not identify a single failing fund raises questions about whether some groups have taken a wide-ranging interpretation of what constitutes value. For example, Hargreaves Lansdown’s value report was blasted as a “whitewash” by investor campaigners for giving a clean bill of health to its multi-manager funds, despite their large exposure to the failed Woodford Equity Income fund.
Clearly many funds that failed to deliver rates of return to consumers in line with expectations they gave in their prospectus and marketing literature made claims that turned out, at least for the period of the assessment to be false.
Thinking about the context of “you shall know them by their fruits”, I went back to Matthew 7 and re-read the Sermon on the Mount
Here is verse 15 which warns of false prophets
Beware of false prophets, which come to you in sheep’s clothing,
but inwardly they are ravening wolves
and here is how you can conduct a value assessment
Ye shall know them by their fruits.
Do men gather grapes of thorns, or figs of thistles?
Value assessments on the consumer’s terms
For the consumer, the idea that a fund manager can set the homework , do the homework and then mark the homework, is difficult.
Currently only a quarter of the fund boards who do the value assessments are independent of the fund manager. Indeed, their independence is compromised by their being paid by the fund manager.
As with IGCs and commercial master trusts, the incentive to stand up for consumers when it puts at risk your burgeoning “portfolio career”, is greatly diminished.
The consumer is looking for a champion but the fund management industry seems reluctant. The Financial Times ends its report on this year’s assessment , quoting the CEO of the Funds Board Council (representing fund directors)
“The Cadbury report [on corporate governance reform] was published in 1992 and we’re still talking about it today. If we expect the fund industry to make such fundamental changes in the first year [of new rules coming in], we’re asking too much.”
Many will be reminded of the wayward prayer of a follower of Chris, St Augustine
Lord make me pure but not yet
Changing expectations in 2020
2020 has been a year when we have expected delivery on promises quickly and authoritatively. The pandemic, climate change and Brexit have made us less tolerant of prevarication and more definitive about what we want.
If fund managers think that the slow implementation of the Cadbury report can be considered a comparator for the delivery of proper value assessments, then the FCA should intervene.
I as a consumer have no difficulty in paying the right price for something, but if I can’t see what I’ve bought, how can I know if I paid the right price?
The process and governance of value assessments needs to meet consumer expectations and the value assessments I have read are simply not telling me what I paid and what I got.
We need a way to find out what we’ve got for our money and that means giving us access to our own experienced internal rates of return..the benchmark rate of return for our investment and a way to make sense of the difference.
Investors deserve no less.
Augustine by Sandro Botticelli (1480)
I ‘discovered’ compound interest ( basically percentage calculations) for the first time quite late, having been a dunce at school maths, and now still delight in IRR and other compound interest outputs (like RIY) as exciting new insights. IRR for funds is backward looking. For decades the regulators have tried to relegate actual performance to a footnote on the basis that it is “no indication” of future performance. But performance sells and fund managers are keen to use it. Many a survey has shown that consumer understanding of any percentage number is low so fund managers like benchmarks, especially when their fund is better than a benchmark, or league tables, when their fund is near the top (dangerous, because retail customers then want to know what is top).
Fund managers were once keen to use “illustrations”, a compound interest calculation of potential future value. When unregulated, this simply resulted in an illustration race as the “adviser” knew that the highest illustration would win (a practice which begat the endowment mortgage “scandal”). Regulation reacted to this by decreeing that all illustrations should be the same and indicate a range of returns using the same net rates of return, low, medium and high. That is “net” of actual expenses, like commission, which resulted in a commission race and more and more expensive investments. Then came RIY as a means of cost comparison. I remember doing an early RIY comparison (before becoming compulsory) for one popular 10 year (endowment) “savings” plan and it was over 6%. Their ‘illustration’ looked good because it assumed 10% increasing contribution each year. The management claimed to be “unaware”.
RIY has been with us for a quarter of a century as a regulatory requirement to disclose before every new investment contract is completed and is very informative on the effect of costs and charges (including advice charges, if any) with the one criticism that not all are included. The big omission is share dealing charges, although these have reduced dramatically and no fund manager wants to pay more than necessary in the hunt for performance. Yet RIY remains largely ignored. The financial press seem to have no understanding which probably explains why the consumer has no idea either. Surely “value for money” assessments should be harder for high cost (high RIY) propositions. Also, a fund sold through an IFA using a platform will have a high RIY but the value for money assessment will only include the fund and not the IFA or the platform, despite these combined charges dwarfing the fund charge.
It seems that further development of the “value assessment” concept is required, especially creating a level playing field.
I agree with all this Stanley
At the risk (deliberate on my part) of linking two separate discussions – here on IRR and RIY and over there in DB-land about expected future returns – I sympathise with a DC framework which asks you to assume investment returns will be the same over three bases: lower, intermediate and higher, while costs will tend to differ.
The FCA sets the maximum percentages to be used for DC returns, just as TPR now seems to be wanting to do for DB, perhaps without allowing “intermediate” and “higher” options to DB trustees.
My understanding is that since 6 April 2014 these FCA DC prescriptions have reduced from 5%, 7% and 9% for pensions and ISAs to 2%, 5% and 8% per year, and from 4%, 6% and 8% to 1.5%, 4.5% and 7.5% per year for other investments?
But what’s wrong with asking managers (DC or DB) to explain separately: their current or initial yield, if any (which will tend to be a trailing yield, rather than a prospective one); their expected growth in yield, if any; and other sources of expected return, including negatives (like trading skill, RIY costs, other costs not captured by RIY, currency, etc.)?
I’ve seen some platform managers attempt this, then reducing their estimates of expected gross return to the FCA cap, depending on whether their product is considered to be lower, intermediate or higher “risk”.
The numbers illustrated should also be slightly higher or lower depending on whether the investment manager retains yield so total expected returns should be multiplicative) or pays it out (in which case total expected returns will be additive, or subtractive from the investment, manager’s perspective).
Most of us know, I think, that total net return is a composite of actuals, which is why I’m suggesting we all need to shine more light on decomposition of expected returns. These can then be compared with subsequent actuals to explain what worked (met or exceeded expectations) and what didn’t (the unexpected).
George, only one IGC has set its provider a target – CIP +4 net – from Prudential. Recently the IGC has got a new chair, I hope that they will persist with the targeted approach. We’d like providers and IGCs to target IRRs rather than what’s reported from fund managers- which is only indicative of what people actually ‘get’. Until we look at reporting on people’s experience, people won’t take much notice.
CPI plus 4% isn’t really what I mean, Henry. That’s a target or a hurdle rate. It doesn’t decompose expected returns or facilitate retrospective analysis of actual returns in the way I mean. I’ve collected a few better (and some worse) examples over the years.
Here’s a better example from a real investment manager looking back at their first ten years:
“When pressed [in 2002], we would deploy the back-of-the-envelope calculation that, for any period, our total return should equal:
a) the dividend yield at the beginning of the period +/-
b) the change in the price/dividend ratio (the reciprocal of the dividend yield) between the beginning and end of the period +/-
c) the change in dividend, minus
d) fees and expenses.
“The portfolio’s end-2002 yield (based on dividends received over the previous 12 months) was 3.0%. [a=3.0%]
“We assumed the price/dividend ration at the end of the period would be the same as at the beginning. That is, we weren’t counting on any upward or downward revaluation of the portfolio [b=0]
“We assumed the portfolio’s ordinary dividends would grow in line with annual growth in the nominal free cash flows of the underlying companies, which we pencilled in at 4% to 8% annually. [For our expected return] we used the mid-point, 6.0%. [c=6.0%]
“Our annual fee was, and remains, 1.0%. We assumed custodial and administrative expenses of another 0.1%. [d=1.1%]
“The sum total on the back of the envelope [a+b+c-d] was an annual return of 7.9%. [I might have suggested a multiplicative 8.2%, but it wasn’t my envelope to suggest that.]
….
“Ten years on, how is our forecast of 7.9% annual return holding up? It fell well short of the actual ten-year performance …. which was 13.2% annualised, measured in US dollars. Our forecast came much closer to the 7.5% annual return of the MSCI World Index.
“Our expectation of an unchanged dividend yield (or price/dividend ratio) was met. The portfolio’s trailing dividend yield was roughly 3.0% at the end of both 2002 and 2012. (Admittedly the yield got as high as 3.6% in the depths of the bear market in early 2009; fortunately, that wasn’t the occasion of our tenth anniversary.)
“Our projection of 6% annual dividend growth was too low. We calculate that the actual growth in ordinary dividends, measured in US dollars, was closer to 11%.
“We had been too conservative in our expectations of revenue and free cash flow growth. Payout ratios increased for many of our companies over the decade, so dividends grew slightly faster than free cash flows. The growth was magnified again, slightly, by weakness of the dollar against the currencies in which some of our companies pay their dividends.
“Beyond this, our actual return was boosted a bit by factors (mostly special dividends and other corporate actions) that aren’t captured by our back-of-the-envelope formula.
“What we completely failed to understand is the bond market. The seemingly long-in-the-tooth 20 year-old bull market of 2002 grew into the 30-year-old bull market of 2012. The 4% 10-year Treasury yield we had once thought to be low enough had declined to less than 2% …. In bond bull markets, to paraphrase Barton [Biggs], there’s no yield so low that it can’t be chain-sawed in half.
“Interestingly, being wrong about the bond market did not prevent us from being right in our assumption of an unchanged dividend yield for our portfolio. Ordinarily, you might expect a halving of the “risk-free” Treasury yield to exert a gravitational tug on the yield of an equity portfolio. But these are not ordinary times ….”
I believe these principles can be applied to any portfolio, whether of equities, gilts and other bonds, rental property or whatever you prefer.
It’s a form of decomposition analysis, not the over-used “attribution analysis”, which tends to focus on relative returns not absolute returns.
And no, Henry, I do not buy some of the back-of-another-envelope calculations used by some investment consultants who used the following formula (these three examples are from the beginning of 2017):
Gilt yield 2.0%
Equity risk premium (whatever that means) 4.0%
Expenses (0,5%)
Expected equity return 5.5%
or cut this way:
Expected inflation 3.4% [presumably RPI not CPI]
Real yield (1.6%)
Equity risk premium (whatever that means, again) 3,7%
Expected equity return (what happened to expenses?) 5.5%
or even this other way:
Expected inflation 3.4% [they seem to agree on RPI]
Real equity return (with lots of margin left in for expenses) 5.3%
Expected gross return 8.7%
Unfortunately there is confusion over what illustrations of future value are for. The regulator thinks they are to help the investor in their future cash flow planning, whereas in practice they were mainly used by advisers to make cost comparison between competing funds. That only works if all gross return assumptions are the same. The introduction of variable gross return assumptions at the discretion of the fund manager (even if subject to a cap) destroyed that. When questioned, the regulators said “tough”.
Performance attribution (was it the market or the fund manager?) can be done reasonably by benchmark comparison. The lack of performance attribution is the main fault of the current dealing charge disclosure method. The important question is not “what were the dealing charges” but “how good were the dealing decisions, did they improve or detract from net performance”. Of course, that does nothing to explain if it can be sustained. IMHO the question has always been not “what is the performance” but “why is the performance”? That is complicated and includes; the fund manager got divorced or has a new bonus package or has been doing nothing different for years but now his way of thinking is fashionable/out of fashion in this market.
In the days when I met fund managers, I remember one industry stalwart who was a permanent bull. But there were subtle degrees of nuance and variation in his bullishness which were worth taking notice of.
Expected rates of return normally are by reference to long term rates of return and make an assumption of “return to mean”. This is bad news for asset allocators as there are plenty of studies to show that returns are sparse after a period of high returns and vice versa. Most markets are now high as a result of over a decade of quantitative easing and zero interest rate policy. Who wants to be told at near market peaks that the 10 year outlook is now for poor returns, based on previous performance over many decades? That conclusion has been the same for several years but those who acted would have been wrong, so far. Government economic policy interfering with normal market dynamics is the new normal. Basically a giant experiment and nobody knows the final result.
There is a lot to be said for managing expectations but any target can easily be cystallised as a promise – which is why people shy away from projections.
Should funds show target returns? George’s analysis – which I just about follow – is there to be challenged. The past has to be some guide to the future but right now we struggle to find what actually happened when the funds we employed were put to use.
Any analysis of funds in a modern DC context, must take into account the cost of delivering the fund to the consumer and the impact of all costs, including the buying and selling of units. This can only be really measured by inputs and outputs.
My final word on this one, Henry.
They’re not using much past history to forecast expected future returns. They’re starting from now, using either trailing yield or current yield, and then factoring in a realistic, but not excessive, assumption about average future growth, looking forwards, not backwards.
Investment managers having made their forecast at the beginning, a customer then has the ability to compare what actually happened with what they said might happen. They’re also not using “the markets” as a crutch, as they weren’t counting on “any upward or downward revaluation [by the markets] of the portfolio”, which some investment managers and/or consultants call “re-rating”. If/when that happens, they have some explaining to do, as with their comments on US Treasury bond markets, from which you can read across to UK gilt markets.
Past Performance
I had an appointment with a consultant ophthalmic surgeon last week (cataracts). At the end he asked if I had any questions – his explanations had been exhaustive. I asked about his track record of deaths and complications (None and less than 1%). I know that it tells me nothing but it did add to my confidence.
On fund managers – would anyone really want to choose the incompetent? It seems to me that while asset returns may not be forecastable with any meaningful accuracy, the costs and afees and charges of a manager are highly predictable.
We should not expect price behaviour to shift, no matter how much analysis we conduct. In the short-term speculation and the whims of market participants should continue to dominate. However the long term may be a different matter. There it appears that factors such as growth and demographics really do matter. However, what seems to be absent is a role for past market performance other than perhaps in the wake of the excesses of bubbles and routs.
It is rather interesting that the Pensions Regulator is setting itself up as an arbiter of future returns in its proposed prescriptions under the new Funding Code. I have recently been looking for empirical studies of long-term forecasts and have so far not found any other than those based on economic and demographic variables. One thing that we can be certain of though is that gilts yields are hopeless as forecasts of future returns, other than for gilts.
Back in the day when I was a fund manager, we used to do a detailed performance attribution every six months; the only thing we ever found recurrently was a tendency to be overly bullish or bearish in those industries we knew best.
This, long-term, is also a topic where the wisdom of crowds is likely to mislead us – that is conventional wisdom. It will certainly be late for turning points. Lower for longer is now conventional wisdom for gilts. With that in mind Charles Goodhart’s latest book The Great Demographic Reversal is well worth reading – that foresees higher inflation, higher rates and slow growth over the coming three decades.
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