In praise of Buffet, passive funds and illiquidity

On Friday 21^st April, Britain went a full day without using coal to generate electricity for the first time since the Industrial Revolution.

The world's first centralised public coal-fired generator opened in 1882, at Holborn Viaduct in London, and only now, 135 years later, have we managed to go a full day without it.  This is perhaps not too surprising, as coal remains a very effective form of energy production, and having relied on it for over 100 years our energy infrastructure is only adapting very slowly to embrace change. The driver of this change being both economic and attitudinal; coal mining is no longer economically viable in the UK and environmental concerns rightly necessitate the use of cleaner energy. 

Similar economic and attitudinal changes are being thrust upon other slow moving industries having to adapt to match changing consumer requirements.  The infrastructure of UK retail focused financial services has historically been built upon the activity of asset management firms managing the wealth that financial advisers direct towards them on behalf of their clients.

The economic barrier to change in financial services is centred on asset management fee structures. In their Market Study report last November the FCA have firmly set their sights on changing this, providing extensive evidence to show that actively managed funds rarely outperform passive funds once fees are taken into account. 31st December 2017 will mark the final day of a ten year $1m bet between Warren Buffet and Protégé Partners, a high-powered New York hedge fund. Buffet bet that over ten years the performance of a completely unmanaged, broad-market low-fee index fund, the Vanguard S&P 500, would beat the gains earned by Protégé Partners. By the end of 2015 the Vanguard fund was firmly ahead with a gain of 65.7% to Protégé’s 21.9%, rather proving the point. It’s not that fund managers are bad at picking investments, but because the fees they charge for their trouble considerably reduce investment returns. The Vanguard S&P 500 Index Fund has a total expense ratio of 0.16%.

The attitudinal barrier to change in financial services comes from the financial advisory industry, a sector struggling with two challenges; their symbiotic relationship with actively managed funds, driven by fee structures, and an aversion to illiquidity. The aversion to illiquidity is a belief in the necessity to remain 100% flexible in order to be able to protect client assets. This is muddled thinking and not borne out by the facts as they stand. It pre-supposes that the financial adviser can successfully pick his or her moment to move client money in and out of the market to optimise market exposure risk. Once you understand that this means moving that money in and out of actively managed funds, which themselves have proved inept at timing the markets, then the fallacy becomes clear. Buffets $1M bet evidences this, as more recently do the market movements immediately post the Brexit vote. The answer lies in tying investment advice much more firmly to a financial planning process which should clearly determine required financial objectives and then allocate client funds accordingly. If the lessons above can be learned then long term growth capital should be held in passive investments which enjoy the dual benefit of low costs and liquidity. In March of this year, Weatherbys, the private bank established in 1770, actively recommended that clients allocate their investment to passive funds. They could be the first of many to do so. 

For everything else advisers should consider specialist managers and not be afraid of illiquidity, after all as Warren Buffet also said – “Our favourite holding period is forever.” Allocating smaller pots of client money to achieve specific aims whether they be for yield, tax efficiency, or specialist market exposure, is a challenge that advisers need to embrace if they are to adapt to changing client needs. Doing so will allow them to continue to justify fees for conducting the research inherent in making these decisions and managing the subsequent investment processes. There is a wide choice of highly professional alternative asset fund managers who have been successfully managing specialist investments for many years but who struggle to get themselves on the adviser’s radars due to the smaller size of assets under management or the illiquidity of their products. Neither of these should be a challenge for advisers if portfolios have been properly constructed to allow for the client risk profile and investment return needs.

CoInvestor is a platform where sophisticated investors, and their advisers, can review alternative asset managers and gain a better understanding of the choice of investment products available.

 By Charles Owen, Founder and Director of CoInvestor