February 23, 2003

No return in market of puffed-up financial fees

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The financial industry is paying itself handsomely for handling other people’s money.Go to any expensive restaurant at lunchtime. Get any business class flight out of Dublin airport. Check into any five-star hotel anywhere in the world and you will see them. The young men in smart suits and swanky ties, who work in the financial industry and pore over biased company research on red-eye flights, while busily spending your money. And my God, do they spend.

The avarice of the financial industry with its ludicrous fees, salaries and perks is at the root of the present market malaise.The greatest problem facing the financial markets is not Saddam, the war or the price of oil.

Nor is it the possibility of global deflation or the economy’s jitters. It is not the hangover following the huge excesses of the dot.com era or the billions of dollars wasted during the telecom boom. Financial problems are not simply a result of corporate greed, incompetence or massive company debts.

Even the weakness of the dollar,the US current account deficit, the overvalued property market or huge levels of consumer debts, do not explain the financial markets’ weakness. The fact that your pension is shrinking by the day can be explained by the fact that a bloated industry has lost touch with reality.

The nub of the problem is the low level of returns now expected by most investors. When expectations change, liquidity conditions change and the less liquidity, the lower the returns. The major reason that investors are getting such derisory returns today is due to the avarice of an industry that has grown fat on the bull market.The industry’s costs are totally out of line with its ability to deliver.

When I first worked in the industry, I was amazed at my own starting salary in comparison to my friends. On top of this were bonuses that ran into multiples of the average industrial wage. This was before the premium class flights, five-star exclusive hotels, open-ended credit cards and huge expense accounts.

Who paid for all this? You did. The investor, the pension holder and the life assurance policyholder fork out millions of pounds daily to keep these people in clover.That was back in the bull market and yet today in Ireland, we have fund managers still taking fees for losing their clients’ money.

Warren Buffett, the world’s finest investor, calls the excessive fees in the financial industry the `croupier’s take’, likening the investment markets to a casino.

The croupier takes from the client on three levels. First, the brokers need to be paid. Second, the fund manager takes his cut and third, listed companies have to be managed.

Let’s assume that the stock market will return 5 per cent a year on average over the next decade. How much of that 5 per cent will the average investor see? (5 per cent per year may well be too optimistic, but this is the figure many commentators appear to expect.)

On average, managed funds charge a 0.5 per cent annual fee for administration and the like. Quite what administration there is in a tracker or passively managed fund I can’t figure out.Surely,one letter ayear and a bit of basic housekeeping doesn’t cost 0.5 per cent of the principal, but there you go.

In addition,there is the commission from trading stocks on top of the spread between bid and offer prices trousered by the brokers in the industry.On average this is about 1 per cent to 1.5 per cent of the transaction. Already, the investor is down to a little less than 3.5 per cent of the likely 5 per cent increase in stock prices.

Before you can be sure of your 3.5 per cent return, what about the upfront costs? If you take out a retail fund today you are likely to pay a signing on fee. This varies, it can range from 3-6 per cent, but is typically about 5 per cent.

Given that we are all advised to stay in for the long haul, it is fair to suggest 1 per cent per year.The state also gets in on the act here with a 1 per cent stamp duty charged on each transaction. Therefore, the punter is down to 1.5 per cent return. Remember the rate of inflation is running at around 5 per cent.

Finally,what about the managers of the listed companies themselves? They need their shekels too, typically by way of stock options. Although the Irish executives may not be involved in this racket quite as much as their US counterparts, they take their cut.

Following the advice of financial market experts, US senior executives trouser 20 per cent of the increase in stock price by way of cut-priced preferential options (according to Standard & Poor’s).

So there goes one dollar in every five for the investor. Given the huge fees that corporate advisers generate for mergers and tactical financial advice, the industry reckons that about half a per cent of any upside in a deal
goes straight to the investment banker. That’s another 1.5 per cent taken off the pension holders’ return. Amazingly, the investor is left with nothing or next to nothing, based on the prediction that stock markets will rise by 5 per cent per year, as is the base case for most funds.

There is also a self-reinforcing problem here.The less the return, the less cash that will go into the market, forcing the return down again. Given the fee structure, investors will be getting negative returns for some time to come.

Obviously, we can tweak the numbers here and there a bit. However, the message is clear. Investing in a defined contribution pension in the stock market is not worth it because the financial industry takes all the upside to pay itself handsomely for doing sweet Fanny Adams.

I suppose someone has to pay for all those Reuters screens, boardrooms and lovely views from the IFSC over Howth, the Bay and the Dublin Mountains. And, absent a significant bull market in stocks, the punter is getting shafted. Even in a bull market, which is highly unlikely for quite some time, the croupier takes an excessive cut.

The bloated financial industry needs a reality check. We pay its bills. The industry operates as a middleman channelling national savings from your payslip to selected companies via the stock market. When you cut through all the glossy research, fancy boardrooms and marble foyers, that’s all it is, a handler of savings. There is no alchemy.

This raises the question, where is the industry going? Ryanair is a good model. There is now a great opportunity for a Ryanair-type outfit to come in and grab the industry by the scruff of the neck, offering the lowest prices, best deals and a decent basic product.

Until then, beware the snake-oil salesmen, their benchmarks, complicated charts and relative-value spiels.