Secrets Of Success: Investment professionals? No, just profit-hunters

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The Independent Online

I was glad to see the great Charlie Ellis was over from the United States a few days ago to stir up our investment community with a provocative speech at an industry awards dinner in London.

As well as being a gentleman of impeccable manners, Mr Ellis is an acute observer of the strengths and follies of the investment management business. His book, The Loser's Game, remains among the classic guides to the realities of the investment business.

It was on the loser's game theme that Mr Ellis concentrated in his speech at the Financial News awards dinner. The difference between a winner's game and a loser's game, he noted, is the difference between the way we play tennis and the way the Williams sisters play the game.

The sisters win points by the strength and brilliance of their strokes. For the rest of us, forget the brilliance. Whoever manages to get the ball back three times in a row is the one most likely to come out on top.

Games in which minimising mistakes tend to produce the ultimate winner are losers' games. Golf and many card games are good examples.

The most extreme example is warfare. Mr Ellis said: "AJP Taylor proved from his study of history that most wars are begun by the ultimate loser and every war is a loser's game, though sometimes there is enough losing to go round for all sides to claim complete defeat." (This is a message George Bush and Tony Blair might profitably have paused to consider before their Iraqi adventure.)

What is it that makes active investing also a loser's game? One reason is that the nature of the investment markets has changed out of all recognition in the past 30 years.

The people who go into the investment business these days are amongst the best and the brightest of their generation. Mr Ellis says investment management today attracts "the most gifted group of people gathered together in any line of work anywhere in the world".

All these talented people work incredibly long hours. They have access to the best research information money can buy. They are all committed to the same objective, which is to justify their existence by doing better than the market index.

Some 80 per cent of all transactions in the markets today are made by professional investment institutions, a reversal of the situation in the 1960s, when individuals still accounted for 80 per cent of the daily volume of business.

Yet the result of all this supreme effort is usually, and indeed inevitably, disappointment. At least 60 per cent of investment institutions in every major market of the world consistently underperform the market averages while advertising that they can, in fact, do better than the market.

The figures are worse for individual investors. Transaction costs and management fees eat heavily into potential returns; though not large in absolute terms, they are high relative to the marginal benefits that they are capable of generating.

The reality, Mr Ellis says, is this: "Every time you buy and sell securities, the odds are four out of five, or 80 per cent, that you're buying from or selling to a professional who has equal information to what you have, equal ambition to what you have, equal talent to what you have, equal education to what you have and equal resources to what you have. The resources and the talents are superb but they are evenly matched."

The result: a world where index funds consistently end in the upper half of the performance tables and the high hopes of investors, forever fanned by the beguiling promises of industry providers, are persistently confounded.

It is a loser's game because for your stock selection or choice of fund manager to be right, some other equally smart investors must be wrong. How likely is that?

This is a gloomy picture in one sense, but not without its positive aspects. (I am frequently struck by how unaware ordinary investors are that a combination of technology and science now offers everyone, in the shape of a low-cost index fund, a chance to capture the lion's share of the market return for minimal cost, something that was not open to them a generation ago.)

The one thing that all of us can do with profit, Mr Ellis says, is make sure we spend our time concentrating on the elements of investment decision-making that will, in practice, make the most difference to our lives, and where the perils of the loser's game are least visible.

He listed five stages of the investment process: setting long-term objectives, deciding on the right mix of assets, implementing that decision (which includes deciding on an active or passive approach), picking an investment manager to do the job, and selecting the individual stocks for the portfolio.

Think about these decisions for a while and it will not take you long to come to the conclusion that the first two decisions are by far the most important to get right," Mr Ellis says. "If you get that decision right, the managers can come and go, the securities can come and go, and it doesn't much matter. If you get it wrong, you are in for a long-term destiny towards doom."

What is more, the loser's game is concentrated on the two last elements in the chain: picking managers and picking stocks. These activities are also the ones that are going to cost you the most money.

The most important decisions - deciding what you are trying to achieve with your investment programme and picking the right asset mix - may benefit from advice but they do not need changing very often, and to the extent that you can do it yourself it ís "near on dirt cheap".

So for most of us the winner's game is "to find the right long-term purpose and find the right means by which it can be executed at the lowest cost". Giving advice on that, Mr Ellis says, is the direction in which a far-seeing investment profession should be headed.

At present, commercial imperatives are still the driving force, and investment remains what it has been for some years, a profit-seeking business, not a profession in any meaningful sense of the word.

I can think of only one thing to say about this wise and accurate description of the investment world: "Amen."

jd1@intelligent-investor.co.uk

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