The fallacies of institutional investors

As the collectivisation of middle class capital accelerated, a multiplicity of managed fund choices emerged to confuse the investor. There are active funds, passive funds, index funds, hedge funds, specialist funds trading in commodities, shares, junk debt, securitised rubbish, mortgages, small cap shares, large cap shares, contrarian funds. 

You name it, there is a manager out there for every conceivable flavour of investment approach and every conceivable investment asset. In addition you can buy ethical funds and green funds to tap into the social issues, which by the way underperform but we feel better somehow. (Ethical funds seem to outperform but this is more to do with the weight of money argument (see below) than the underlying performance of the assets).

Broadly these funds fall into active and passive categories and the funds are either open or closed funds, the variation of theme in each is as varied as the variation you find in companies.

In NZ such funds are usually constituted as unit trusts and are now normally confirmed as PIEs (Portfolio Investment Entities).

These funds are quite different to companies in terms of the governance arrangements they have with the owners of the capital. In companies, at least at law and in theory, owners have the right to hire and fire directors. They have the right to call meetings and the right to submit business to the meeting and they have the right to question management and examine records. With unit trusts the fund is run by a manager, supervised by a trustee, with those who appear to be directors actually being directors of the management company and not strictly accountable to unit holders. Unit holders' only right is to sell or redeem their units.

As the collectivisation of middle class capital accelerated, a multiplicity of managed fund choices emerged to confuse the investor. There are active funds, passive funds, index funds, hedge funds, specialist funds trading in commodities, shares, junk debt, securitised rubbish, mortgages, small cap shares, large cap shares, contrarian funds. 

You name it, there is a manager out there for every conceivable flavour of investment approach and every conceivable investment asset. In addition you can buy ethical funds and green funds to tap into the social issues, which by the way underperform but we feel better somehow. (Ethical funds seem to outperform but this is more to do with the weight of money argument (see below) than the underlying performance of the assets).

Broadly these funds fall into active and passive categories and the funds are either open or closed funds, the variation of theme in each is as varied as the variation you find in companies.

In NZ such funds are usually constituted as unit trusts and are now normally confirmed as PIEs (Portfolio Investment Entities).

These funds are quite different to companies in terms of the governance arrangements they have with the owners of the capital. In companies, at least at law and in theory, owners have the right to hire and fire directors. They have the right to call meetings and the right to submit business to the meeting and they have the right to question management and examine records. With unit trusts the fund is run by a manager, supervised by a trustee, with those who appear to be directors actually being directors of the management company and not strictly accountable to unit holders. Unit holders' only right is to sell or redeem their units.

Passive funds collect money and endeavour to track an index. Some will attempt to mirror the top 10 companies. Others the top 50 index and others the mid cap stocks and so on. The object of these funds is not to actively pick investments but just to buy every asset in the index to replicate the performance of the index. Each quarter these funds sell down stuff that has gone up and buy stuff that has gone down to endeavour to rebalance to the index. They do no analysis of what they buy, and worse never attend meetings of shareholders and virtually never even fill in proxy forms.

Since the PIE regime and related fund management tax rule changes came in this has improved. I kid you not, when I challenged these idiots on this  approach to management and governance their defence for not doing anything with the stock they owned was that if they activity managed their assts, i.e. voted their shares, the IRD might treat them as a share trader and tax them on their investment gains. What rot. Anyway now institutions are all treated as non taxable in this regard.

Active funds actually try to pick profit making opportunities. They sometimes do this by momentum trading as Falafulu would advocate i.e. a mathematical analysis of market dynamics and others try to stock pick businesses they like, for example Fisher Funds Management fancies itself as a stock picker.

Active funds charge more in management fees on the basis that they cost more to run, i.e. they are doing more work, but perversely even these funds rarely challenge the boards of the companies in which they invest. At least this was the case until around 6 years ago when The Shareholders Association raised this issue with them and said: "You are charging money to manage assets, yet you don't vote your stock, have you failed in your duty of care?"

Now to the concept of closed funds. These go out to the public and ask for a pool of money to play with, say $500m, they issue a prospectus, tell the unit holder what they plan to do, raise the capital they want on the terms they want, issue certificates and then get on with it. Often these funds also have a finite life, 5 or 10 years, and sometimes they are perpetual just like a company.

The do not take any more money in and they have no obligation to pay any money back either, unless there is a fixed wind up date. If an investor wants to get out they must sell their units on the market. Sometimes this will be at a discount to asset backing and other times at a premium, i.e. just a normal market and in essence these funds are just another share. This is the structure used by the UK funds management industry and these were traded and listed on the NZX until the stupid FDR (Fair Dividend Rate) regime was introduced and these funds effectively lost their NZ investor base and delisted.

An open fund is one that has no secondary market, the fund manager values each unit on a buy and sell price and if you want to invest and give them some more money to play with they take your cash at the sell price and if you want to get out, they buy you back at the buy price pocketing the spread as exit or entry fees to the benefit of the manager. This is the normal structure for NZ managed funds.

Now these structures have a significant effect and a distorting one in a small market and in NZ these funds hold over a quarter of all shares issued.

Let us start with the impact of passive funds. Each quarter they endeavour to rebalance their portfolio, selling assets that have risen and buying assets that have fallen. Sure, the manager doesn't do it all on one day but it is a quarterly wave pattern of activity, and thus affects market liquidity. So depending on the size of the re-balancing, sometimes these movements can affect price.

One could argue that this discipline of selling rising assets and buying falling assets is good for the market as it balances out the manic nature of the market. This would be true if it was a conscious decision but it is not. Also the size of the funds will have a bearing, and with open funds these funds can get very big on a bull market.

Active funds are not into re-balancing, they target to do what they do and make money.

All funds have their unit prices published for buy and sell rates at least weekly. The table in the Herald shows the short and long run return to unit holders. Thus these funds can be ranked in order of performance over the long and short-term. Most financial planners will weight to managers that have demonstrated historical success, and this is the nature of those who invest in these funds directly.

Thus over time the small funds shrink, and the good funds get more cash and grow bigger. The more assets these funds have the greater the rebalancing act at each quarter for passive funds, and the harder it gets for active funds to move their investments around. Think of it this way, if you had $50m to play with, your biggest active investment might be $15m.

If you get sick of that investment and want to sell it down you are less likely to affect the market than a fund that wants to exit $200m.This is true in all markets but particularly true in NZ as our liquidity is almost non existent. In the words of James Slater, A UK investment banker: "Elephants don't gallop".

So inevitably successful funds attract more money, and equally inevitably they cease to act as traders out of the simple reality that the weight of money they are managing stifles that, and progressively active funds become passive funds.

Now when funds are successful and they are attracting more money, and most funds win in a bull market, they have to invest this cash, as the trust deed requires it. Further they must invest it in the same shit that made them successful in the first place, and of course why wouldn't they? So in an illiquid market like NZ the only way they can buy more stock is to push the price up, thus making them look even smarter and thus attracting more money. So in a bull market institutions in essence push the manic behaviour even higher, because of the way they are funded.

Most fund managers in NZ are paid fees based on the assets under management, not on the performance of the fund. Thus if they perform they get more money so indirectly the fees are based on performance. So fund mangers want to perform so that they have a case to attract more money from the public. This creates a moral hazard to fund managers, being the window dressing of their performance. It is not uncommon to see in the last week of a quarter a share price move suddenly and without any economic foundation up or down by a significant amount.

The volume builds gradually and it is pretty obvious that someone is pushing the price up or down, and once an agreed price is reached an off market transaction occurs that window dresses someone's balance sheet. Off market transactions may be common between institutions: "I will sell you my crap at a price and buy yours at a price and Bob's your uncle, we all win." Does this happen? Who knows? NZX is supposed to monitor for this type of stuff and now has a fund manager itself that wants to look good and attract the public's money.

These institutions attracted more money over the bull run than they could ever sensibly invest as an active trader, as they were all winners. As their resources became bloated they worked out that their capacity to move assets around and do a "Wall Street walk" when they were unhappy declined. And that they needed to drive companies to produce better performance and hope that the share market prices rise to reflect this.

This made their objectives very short-term, they directed boards to maximise short-term profit performance. No wonder research and development is declining, no wonder expansive mid-term capital expenditure is hard to justify, regardless of the theoretical economic value added. They did this with the weight of voting power that they collected.

The number of board members I talk to who say some institutional fund mangers had become uninformed short-term bullies that are confusing the role of owners, board and management is frightening. If they were long-term owners it would be different. These funds are mostly short-term players who want to do what they have to, to get to the top of their league table and attract more money and more fees.

In a bear market the reverse happens. The mum and dads want their money back and redemption requests rise. Fund managers don't hold much cash so they have to sell down assets to generate cash and in quite big lumps at a time when buyers are staying on the sidelines. Thus share prices fall dramatically and portfolios get screwed. In a bear market index funds don't sell down to retain portfolio balance. They do what we do, - they sell anything they can find a buyer for. Active funds likewise, - they sell what they can. Usually it is their best investments and their speculative dogs will want for a buyer, any buyer, so the fund winds down quickly.

Good assets are sold and the unit holders who hang in there are significantly prejudiced. Not only do their unit values decline, inevitably the quality and liquidity of the assets they are left holding gets compromised. Sometimes the only way out for these hapless fund managers is to dump quality assets in off market transactions with rich investors who have been sitting and waiting. Rod Duke managed to pluck a big slice of Pumpkin Patch off Fisher Funds in this way.

Eventually when it gets so bad that redemptions run at a faster rate than the ability to sell down, or when the manager calls a halt to redemptions out of fairness to those who are still in the fund, all pretence of liquidity evaporates and the investors can't get cash for love nor money. If they owned shares directly they could always make these decisions for themselves and get something if they really had too.

These funds all emerged on the back of demand created by portfolio theory mismarketed to the masses, and misapplied  either intentionally or out of the simple reality that the theories of Harry Markowitz are just that, -  theories that work in aggregate and over a very long time line. But they don't work in practise or over short time lines.

The effect of these investors is significant. Market distortions occur on periodical gaming, and on bear and bull runs the manic behaviour of the markets is exaggerated, reducing the theoretical efficiency of those markets. While no one losses in a bull market, including the direct investor, in a bear market the losses to investors who use these structures are considerably greater than those endured by direct investors. The ultimate loss of liquidity is the final punishment to the hapless mum and dad investors who then can't get cash when they need it. And worse, the impact of these investors on the companies they invest in is mostly negative in the long term to the cost of all shareholders.

The lesson for investors is this. Small is beautiful, it is easier to move small parcels than big parcels, and the dead weight cost of these funds is enormous with very little ultimate gain. If you want to buy shares, buy shares and reduce to the minimum the level of cost and bullshit between your investment and you.

By the way not all fund mangers are the same. Some are honest and hard working. But buying via a fund manager is just the same as buying a share so buy someone who is hard working, intelligent and who has integrity.

Disclosure of interest.... I have never put anyone between me and my investments.

Next Blog: Revelation, the fight between good and evil is upon us. Some of the foreseeable consequences of this nonsense.