The fallacies of institutional investors

Last updated 14:42 24/08/2009

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.

BullActive 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.

BearThe 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.





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Roger Witherspoon   #1   04:47 pm Aug 24 2009

Wonderful stuff Bruce. It is music to my ears.

Virgil Tracey   #2   04:33 pm Aug 25 2009

Good article Bruce. One question that begs an answer is what of an investor who wants exposure to equities, but has not time/knowledge/expertise/confidence in doing this for him/herself. Do you see a place for the fund management industry in this situation? However, it is hard to argue with what you are saying, but not sure what a response is for someone who has time on their hands to invest, but has not the skill to do this for him or herself. "Staying in cash" is probably not the correct response right now

Bruce sheppard   #3   05:43 am Aug 26 2009


If the choice is a fund manger or cash, choose cash.look at the results over the short and mid term. If an investor has no time,or interest, stay with cash. If someone has time but no skills, get skills and stay in cash until you are confident.

In earlier blogs I have outlined how to approach equity investing (in my veiw) I will pull together some thoughts on how to do this in a series of blogs on how to invest ingoring the crap. One thing though Virgil, if you do buy equitis, buy equities, not a manageed fund.There are believe it or not some financial planners and Stock brokers who do a good job in designing a direct potfolio of equities, This siad they do end up buying to many different shares rather than picking a small group of performers. ( or losers) because they to adopt portfolio theory, at least as they understand it.

Falafulu Fisi   #4   10:12 am Aug 26 2009

Bruce, another excellent post and again well done. It is good that you bring these issues out because our so called financial/economics journalists don't cover them.

However, I want add and clarify some points. Since I am an advocate of theory-based investment methods, they are very useful, but these methods still have to be used together with human common-sense, ie, you can override the models decision if it seems ridiculous. They are not to be treated as be all and end all for doing investment but their usefulness is undeniable.

You stated that "mathematical analysis of market dynamics and others try to stock pick …, eg, Fisher Funds Management fancies itself as a stock picker", which may be true in the semantic of the words, but I believe that Fisher Funds don't do mathematical analysis at all, I think that they do descriptive statistical analysis (and may be some classical models, perhaps?) and I am happy to be corrected. It doesn’t mean it’s bad; it’s just that they have limitations.

Note, that numerical mathematical financial analysis is a different beast all together from doing just descriptive statistical analysis of market data. Mathematical analysis is quite deep, similar to a magnifying glass which you can see things much clearer (again this ability doesn't guarantee 100% that their decisions or what they see will always lead to a win, but on average, such capability will win more often in comparison to those who don’t). The other analogy is a prism or night-vision goggle. People think that white light is one colour (primary), but in reality it is not. A person with a prism can see that white light is made up of 7 primary colours. So, mathematical analysis is similar, it is like a prism. When mathematical models are applied to the data, you can see things that others can’t.

I want to stress again that portfolio theory (PT), rests primarily on risk-return optimizations and any analyst that doesn’t stick to this formulation is in fact not using PT at all. So, you have to differentiate between portfolio management (PM) and proper PT, because once you’ve got more than one assets to form a portfolio and manage it yourself, that’s PM, irrelevant whether you use PT optimization or not. When you’re doing PT, then in fact you’re simultaneously doing PM as well, so stock-brokers are doing PM not PT.

Falafulu Fisi   #5   11:52 am Aug 27 2009

Since many are just reading and not commenting, I'll add some points here, so that Bruce's readers can understand more about portfolio theory (PT).

Bruce, the portfolio rebalancing (PR) that you have touched briefly on your article, is again a concept that can be done under proper PT. Some analysts just do their PR based on gut feeling or may be some very simple rule of thumb of their own (perhaps company policy). If PR is done under proper PT, ie, under the framework of risk-return optimization (BTW, optimization is a formal branch of mathematics), then this rebalancing under PT framework, is the proper way of doing it. What I mean by this? It is always efficient (ie, rebalancing using optimization - PT framework) compared to another portfolio that contains exactly the same assets but not optimized. The optimized portfolio and optimized rebalanced portfolio will outperform the one that is not optimized (most of the times), ie, both with exactly the same assets.

I once talked to an analyst before, where he does his allocations via optimization (ie, proper PT), but then he rebalances by not using optimization. I asked him why, he said that the software he was using didn't have optimization rebalancing function available. I told him that once he rebalanced a portfolio in a non-optimized way, it immediately destroyed whatever the efficient asset weights/proportions of the optimized allocation he used to design the portfolio at the beginning. In other words, once he rebalances via non-optimized way, then the whole portfolio becomes non-optimized, which defeats the very purpose of PT which is to reduce risk and simultaneously enhancing return gain.

I believe that most analysts are still doing rebalancing via non-optimized way, so these individuals are called “satisficer”, which is a person who adopts a decision-making strategy that attempts to meet criteria for adequacy, rather than to identify an optimal solution.


There are different techniques used today in doing optimized rebalancing and linear programming optimization technique is quite popular, such as described in the following paper:

"Comparative Analysis of Linear Portfolio Rebalancing Strategies: An Application to Hedge Funds"

These techniques are only good approximation which is still much better than guess work , gut feeling or using one’s own designated rule of thumb that is not based on optimization, because rebalancing involves some costs where some (not all) models don’t include those costs.

bob   #6   06:28 am Aug 28 2009

I have money in a couple of different active funds, which over the last 10 years have managed a whopping 2%. Term deposits in the bank beat this. My property over the last 10 years has doubled in value. My shares about 6%.

I am still working out the next investment strategy, but it still looks like property is the goer, as much as I would like to invest in something more worthwhile.


Duncan W Boswell   #7   10:52 am Aug 28 2009

Bruce it seems you are a disciple of the late Benjamin Graham who was Warren Buffett's mentor in Buffett's early years. Question; Why should anyone entrust their hard earned savings to a group of "directors/advisers".

How much of their own money do they have invested in the fund/unit trust/etc they are they are promoting and is their money permanently invested in that fund? What are the fees...anything over 1% is too much. What exactly are the funds them.

I'm certain you can enumerate many other considerations to be satisfied before recommending investment in a particular fund or trust. Duncan Boswell

Richard James   #8   01:39 pm Aug 31 2009


Do you have any empirical or research evidence to substantiate your statement...

"While no one losses (sic) 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"

If one reads the FundSource fund performance tables it is clear that, in NZ at least, local equity funds have in aggregate beaten the market by a meaningful margin over the past 1, 2 & 5 years, implying that, contrary to your assertion, direct investors must have correspondingly underperformed over each of those periods.

While your statement may be conveniently supportive of your central theme it is patently wrong. Unsubstantiated hyperbole does not make a useful contribution to investor edification.

Regards Richard James

Disclosure of Interest. I am the CEO of NZ Funds. Our Dividend Yield Trust outperformed the NZX50 Portfolio Index, after all costs, by 3.58% over the 12 months to 31 July 2009. We aim and expect to continue to do so.

bruce sheppard   #9   05:13 pm Aug 31 2009

Richard all that is relevant is the last year.

When you disclose your loss numbers how about you break it down between cash loss and unrealised loss and also disclose your redemeption rates. No there is no research. But the big difference between funds and individuals is the chioce of when losses are taken. My bet is you are down around 25% in last 12 months. I was down 50% a year ago, and am up 30% now, but I have been buying in this market you may not have been.

Greg   #10   10:16 pm Aug 31 2009


I cannot be certain, but it certainly seems like you have not had the opportunity to study Finance as an academic. I won't point out all the statements that troubled me, but I will say that the difference between active and passive is not exactly as you described.

I would highly recommend reading: 1.Sharpe, W.F., (1991). The arithmetic of active management. Financial Analysts Journal, Vol. 47, No. 1 2. Brinson, G.P., Singer, B.D., Beebower, G.L., (1991). Determinants of portfolio performance II- An update. Financial Analysts Journal, Vol. 47, No. 3. 3. Ibbotson, R.G., Kaplan, P.D., (2000). Does asset allocation policy explain 40, 90 or 100 percent of performance? Financial Analysts Journal, Vol. 56, No. 1 4. Fama, E.F., French, K.R., (2009). Luck versus skill in the cross-section of mutual fund alpha estimates. 5. French, K.R., The cost of active investing.

The first three are quite light reading. You should be able to find them through Google Scholar. I would love to see you write a column about active investing in a NZ publication.

Best, Greg

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