Friday 4 April 2014

If fund managers are overpaid then so are chefs (not really)

There is pretty clear evidence that financial investment products do not justify the performance that they offer versus the fees they charge. Generally this is attributed to the greed of overpaid fund managers (and to declare an interest, I was a member of that tribe until last year). It may surprise people to learn that forcing fund managers to earn the same income as say a nurse would not make a huge difference. To realise why we need to think about restaurants instead. 

(I can promise that this bizzare analogy will make sense in about 2 pages time but you are just going to have to trust me until then)

The rip off restaurant meal

I took my wife and children out to a restaurant for mothers day. I can't remember exactly what the bill came to; it was a niceish place in the outskirts of London but we only had a couple of glasses of wine between us so probably about £20 per head. If we had gone and cooked that same meal at home it would probably have only cost two or three pounds a head to buy the food. Were I to be a really ruthless economist and factor in the cost of gas, elecricity and a prorata share of the cost of our mortgage.... it would still be a lot short of £20 per head.

You might assume that the reason it costs so much is that there is a greedy overpaid chef in the kitchen. My brother in law works as an executive chef and whilst he does okay, last time I checked he did not have a second home in the Swiss Alps or a helicopter (He does work ridiculously long hours so he has that in common with at least some people in the finance industry). In fact the hospitality industry is notirousliy badly paid and the proportionate cost of the Chefs wages in that restaurant would only have been a small fraction of my £20. So then the meal was a complete rip off wasn't it?

Its the frictions, stupid

To get back to that £20 a head we need to factor in rent, business rates, VAT, the cost of other staff both front and back of house, deprecation, national insurance, insurance insurance, stationary, all kinds of costs you only find out about once you have run your own business.... and a profit to the owners of the restaurant that might just stretch to £1 per head (although possibly not even that). The difference between the cost of paying the chef plus the pure 'raw' cost of the food, and the total cost of the meal, might be described as a frictional cost.

You might conclude then that it makes no economic sense to pay anyone to do anything, and indeed for it to happen there must be something else going on.

Firstly we could need to bring in the concept of additional utility enjoyed from not cooking the meal yourself. You may enjoy an activity more if someone else does it for you or it may be that the person doing it enjoys it more than you (or at least dislikes it least). Before you start sniggering I am not thinking about what you are thinking about. I am thinking of things like cooking (nicer if someone else does it or the cook may be very passionate about doing it wheras you just want to eat) or plumbing (plumber may dislike it less than you).

Secondly clearly for people who have very high incomes (like greedy fund managers), or for above average income people buying a service provided by somone with a very low income does make economic sense; i.e. there are favourable pay differentials.

Also if you are buying something you simply cannot do yourself then it would make sense to buy it in of course. Like fixing a dishwasher - something most people cannot do. If you are a dishwasher engineer reading this right now, presumably from the comfort of your yacht in the cote d'azure, allI will say is I hope your bilge pump fails so you know how it feels.

(Readers should know by now that by examples are entirely arbitrary and totally unconnected to my real life. And that I have a very highly ironic tone of writing.)

A weaker form of this is that the service is something you can do, but the other person can do better than you. Many other forms of DIY fall into this bracket, at least for me. Painters and decorators all over the country are not worried about not getting my business. I can lift up a paint brush and move it over a door frame but the end result is not attractive.

Finally there are often what economists call economies of scale – it is often cheaper to provide things on a larger scale. Buying 25 kilos of prime steak every day for your restaurant will give you a lower price than buying a quarter a kilo a week.

Lets be honest this is a terrible analogy

Okay the fund management industry is not the same as running a restaurant. When you buy an ISA you are never offered a bread roll or a little bowl of olives. Also in the fund business the amounts of money are larger in absolute terms. A michelin star chef can only deal with a couple of hundred covers before the quality starts to slip; a top fund manager can look after hundreds of millions of pounds as easily as looking after ten million. More of the revenue does to go pay staff, and that revenue is shared more disproportionally than in the restaurant business with fund managers, traders and other big swinging dicks getting a large percentage than the head chef of a restaurant normally would.

So there are even now far more people in finance earning six, seven, eight and very occasionally nine figure incomes than in restaurants (discounting the celebrity chefs who do little actual cooking and so can 'run' a dozen restaurants; and even Gordon Ramsey would not break into a list of the top 100 wealthiest hedge fund managers). This is not then a case of favourable pay differentials except perhaps for the ultra high net worth customers.

Let us take a very simple financial product as an example, an index tracker. This is the most simple product that exists; the equivalent of a salad or pate on toast. To cook this particular dish at home you need access to information about the index, eg the FTSE 100. You need to know what shares are in the index and in what weights. This is available for free on various websites if its for personal use. You then need to buy the shares; and every quarter when the index is changed you might need to buy or sell a bit. You can get an online execution only broker to do this for you for between £5 and £15 per trade and perhaps a similar sized quarterly account fee.

To pay someone to do this for you wouldn't cost that much; its only a few hours a year and frankly it isn't rocket science – you can do this yourself. However arguably not everyone is a finance geek like me and so there may well be additional utility from paying someone else.

The other problem with doing this is that unless you have a lot of money you will need to hold very small, uneconomic amounts of the very smallest companies in the index; where it would cost you a very large proportionate amount to trade them each quarter. So there are economies of scale to outsourcing this activity unless you have a certain minimum level of wealth.

(You could just hold the top 30 shares of course and still get very similar performance, or hold them in equal weights and get better performance, but that is for another post and still requires larger amounts of money to invest than most people have)

So instead you go and buy a FTSE 100 tracker, eithier as a unit trust or ETF. The people running it will try and introduce some rocket science; algorithims to reduce tracking error and 'smart' execution benchmarking against VWAP and other such nonsense. You might have half a dozen people working on this 'alpha generating' activity all pretty well paid. It is all a bit futile since tracking an index of this nature is like joining a queue of people all trying to get into the same shop at the same time and a bit of jostling in the queue isn't going to help. Its better to join a different queue entirely, but thats another story. I don't think then personally that this is something the rocket scientists can do a lot better than Joe Public.

However spread over a several hundred million pound fund these extra rocket scientists are hardly going to add very much to the cost of the fund. If anything there should be some further economies of scale savings since the institutions will be paying lower dealing commissions (though due to their size their total execution bill might be higher). But then we do have that huge slew of frictional costs.

There is a lot of administration in looking after other peoples money; and admin doesn't automatically scale well to looking after larger amounts of money unlike the actual fund management activity. If all those accounts belong to smaller retail customers having a billion pounds than a million means 1000x more accounts; possibly not 1000x more staff but certainly a good deal more. Advertising takes up a big chunk although you wouldn't have thought a simple tracker would need to advertise much, but they still do. Then there are compliance costs; the greater the distrust we have in the finance sector the more people they need to employ to make sure the other people aren't breaking the rules. And they would also have to make a profit; though outside of hedge funds the profits in fund management have never been as good as in say the investment banking industry (rightly so they aren't committing their own capital but just earning off other peoples).

And its also about the intermediation, idiot

One category of costs to the fund management business we haven't talked about is what are euphimistically known as distribution costs. Many retail customers didn't directly invest in funds but went through financial advisors. Until the FCA reformed the industry rather than pay a fair price for this advice the funds paid commissions to the advisors directly, making it quite dificult for the advisors to work out which was really the best fund and which just paid the best commission. These are so called intermediation costs; the costs of not dealing directly with the fund manager but with some intermediary.

(I can show you with a few equations and some data that the best predictor of the performance of any investment are its costs, which are known with a much higher degree of certainty than any other variable. Therefore this was exactly the wrong thing to do. But you don't need the maths, this is common sense.)

Similar kinds of intermediation costs exist with funds of funds (funds that invest in other funds which exist in both the retail and the institional world), 'smart platforms' (that invest in index funds according to some algorithim), with institutional investment consultants, insurance companies, private banks and I could go on. This layering of intermediaries may be adding some value, but any value is dwarfed by the fact you have to pay restaurant costs to each layer. Each layer has their admin, tax, compliance and other costs to pay.

I won't bang on about it because there has been plenty of recent media discussion on this. If I can take just one example from the industry I used to work in; the systematic 'CTA' flavour of hedge funds. Historically these were mostly invested in by rich individuals who went through private banks, financial advisors and/or fund of funds. More recently 'normal' people have been going via so called UCITS funds which are essentially a loophole to allow people to invest in hedge funds except they are often very expensive (loopholes don't come cheap). These multiple intermediations were fine when the products were making outsized returns but once returns dropped (even if still relativelyattractive on a return:risk basis compared to other investments) they resulted in investors seeing poor performance. High returns (especially if they are mediocre returns in an enviroment of low inflation) have a great way of masking high fees.

So the cry goes up 'something must be done'. But what?


At least nothing by the government.

This isn't something the government can do for you, although there should be much better transparency around fees and fund manager fees. If you have been reading carefully you will see I don't think increased regulation is the answer. Regulation won't remove restaurant costs. If anything the government might need to think about removing regulations that encourage or force institutional investors to go through intermediaries that add no value.

I am wary of overburdening teachers with more iniatives but we don't help ourselves when we produce consumers that are not all comfortable with maths and have low levels of financial literacy.

The industry itself can also help by providing cheaper simpler more transparent products that do not involve intermediation. But they won't do that without pressure from customers; attempts by the government to force this through in the past have failed (does anyone remember CAT standards?).

It is something you have to do for yourself. Because people are getting older, because of the demise of the paternalistic final salary pension in the private sector; with the end to compulsory annuitisation and with the state pension unlikely to ever cover more than a very modest standard of living. These things all mean you are going to have to take much more responsibility for your own savings and investments. You need to do more stuff yourself, and only outsource when economies of scale really make it much cheaper or impossible to do yourself.

It takes much less time than you think. It is not as complicated as you think; much of the complexity that exists is unncessary. It is easier than you think- not as hard as fixing a dishwasher. And it is not as dull and boring as you might think. It might even be as much fun as cooking.

1 comment:

  1. Rob,
    This is a well constructed explanation and where you used analogies, very well done ones. And good explanations of the economics of multiple industries.


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