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March 1, 2016

5 lessons learned on the sell-side

Lists aren’t just for David Letterman or Buzzfeed. A list can focus the mind in ways that text alone cannot. In that spirit, here are the 5 most important things I have learned while working 15 years for Credit Suisse in London and Hong Kong in equities and high-yield bonds covering institutional clients. If you would like to know how we can help you to improve your investment strategy, please do not hesitate to get in touch.

  1. Beware the marketing machine
  2. Bankers are overpaid – but fund managers even more so
  3. Hedge Funds are status symbols
  4. Complexity is the enemy
  5. Yourself too

Marketing sells – but maybe you shouldn’t buy

Investment funds don’t get bought, they get sold. For the average investors it is very difficult to understand the difference between the thousands of products out there hence marketing plays a major role in attracting new money. Studies have shown, that funds that invest in marketing, attract on average 20% more assets than similar funds without advertisement.

The key question is: does the fund performance differ before and after the marketing push? It is not surprising that the funds that receive a big marketing push have better performance data than comparable products or an index. Asset managers will obviously try to market the most successful product. However, studies show that after the marketing push, the previously noticed outperformance disappears. Worse, there are studies that even show a negative effect (alpha) after the marketing push.

The business model for an asset manager thus becomes clear: launch 10 different funds and one will likely (=randomly) show strong outperformance after a 1-3y period. Then market the hell out of this product. Three years later another fund will have produced stellar results and then this product receives a heavy marketing push. Wash, rinse, repeat. Beware the marketing machine: fund makers market what is hot, not what will perform well in the future – because nobody can reliably predict which fund manager will outperform going forward.

Bankers are overpaid – but fund managers even more so

Banker bashing is widespread and in many respect well deserved. However, maybe the public is going after the wrong target? As The Financial Times has recently reported, asset managers are about to be paid more than investment bankers. The pay for the asset managers is coming out of the pocket of investors and that would be ok if the fund managers would deliver satisfactory results. But study after study shows that over the long-term, more than 80% of the fund managers fail to beat their benchmark.

The numbers involved are staggering: The average compensation per employee at global asset managers rose 22% between 2006 and 2014 to an estimated $263,000. There seems to be virtually no limit either: Richard Woolnough at M&G, earned GBP 17,5 Mio in 2013.

Hedge funds are status symbols

Here’s a conundrum: hedge fund performance has consistently been very disappointing but they continue to attract more assets.  In 2015, the HFRX Global Hedge Fund Index returned -3.6% compared to +1.2% for the S&P 500 (incl. dividends). For the 10-year period ending 2014, the HFRX Global Hedge Fund Index returned just +0.7 percent, underperforming not only every major equity asset class, but even virtually risk-less one-year Treasury bills. This type of performance is the reason behind the famous aphorism that hedge funds aren’t investment vehicles, nor are they an asset class—they’re actually compensation schemes.

Why do rich people pour money into them? Probably because hedge funds are status symbols („I belong to a special club“).  Nobel Prize winner Eugene Fama provided this warning about investing in hedge funds: “If you want to invest in something [hedge funds] where they steal your money and don’t tell you what they’re doing, be my guest.” Rex Sinquefield, co-founder of Dimensional Fund Advisors, went much further, calling hedge funds „mutual funds for rich idiots“. Those words are probably too strong, but we agree, investors should think twice before putting money into hedge funds. The last 10 years have shown one thing with regards to investing in general and hedge funds in particular: the more you pay, the less you get back.

Complexity is the enemy

If you don’t understand an investment, don’t own it. Volatility ETFs are poor buy-and-hold investments; not coincidentally, the prospectuses approach rocket science. The same goes for esoteric asset classes — a credit-default swap ETF, anybody? If you can’t understand how an ETF will perform in good times, you’re really going to be in for a surprise in bad times.

We are not just worried about increased risk that goes with higher complexity. The other problem is that higher complexity enables the financial industry to hide more fees. Intransparency is never in your favour.

Activity is overrated

Here is another enemy: yourself. As a private investors, you have the ability to wait and you also do not have to be constantly active. Don’t overtrade. You are not a fund manager that is under constant scrutiny from his board and investors and who cannot be seen as doing „nothing“ (i.e. not constantly buying and selling). Maybe it pays to heed the words from some of the most famous investors.

Warren Buffett keeps repeating that inactivity has been a key contributor to his investment success:

  • „Inactivity strikes us as intelligent behavior“
  • „Lethargy bordering on sloth remains the cornerstone of our investment style“

Jesse Livermore, one of the most successful traders of the early 20th century, also frequently highlights his mantra that less is more:

  • „It was never my thinking that made the big money. It was always my sitting.“

Most investors should simply find a strategy, pick investments and come back once or twice a year at most for a check-up.

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