How the fund managers sold dreams and delivered nightmares

Inadequacies of a 'cottage industry' exposed by the worst bear market in living memory
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The Independent Online

The author of a hard-hitting investigation into the UK fund management industry claimed yesterday that the cult of the equity, which has dominated the City for the past 50 years, has been a huge mistake.

The cult of the equity was initiated by the late George Ross Goobey, then manager of the Imperial Tobacco pension fund. Most such funds were invested in British government stock, known as gilts, because equities were regarded as too risky. But Mr Ross Goobey argued that that risk could be reduced by investing in a wide range of shares, so that it would not matter if one or two failed.

Professor Amin Rajan of Exeter University, who runs the think-tank Create, said: "I am attacking the cult of the equity. Many of today's problems have been caused by pension fund trustees who didn't realise that they were trying to balance long-term liabilities by putting members' money into a risky class of assets, equities. ...You cannot reduce risk by spreading risk, you can only reduce risk by investing in absolute-return products, capital guaranteed products and bonds."

The major accountancy group KPMG has joined forces with Create to produce a report, which says that fund management is "a cottage industry in which over-rapid growth concealed many structural weaknesses. The worst bear market in living memory exposed fault lines, which shattered consumer confidence."

The consequence was that since the dot.com bubble burst in 2000, European company pension funds have suffered a €500bn (£350bn) shortfall and individual investors have run up losses of €250bn. Their American counterparts have suffered similarly, but on a larger scale.

This has been echoed by the Financial Services Authority, the industry's principal regulator, which is telling life insurance companies that they are being too optimistic about the standard rates of return they are using to calculate whether customers' policies will pay off their mortgages. The FSA concludes that existing rates could "lead a consumer to an incorrect conclusion that an endowment policy is on track or to underestimate the extent of a projected shortfall".

Fund managers have been widely criticised for doing little more in many cases than tracking the main market indices, whilst charging for in-depth portfolio management. Their usual yardstick of success or failure has been not whether they have made money for consumers, but whether they have beaten an index such as the FTSE 100. By March this year that index had more than halved from its peak of 6933, reached in December 1999.

Two years ago the former head of Gartmore Investment Management, Paul Myners, said that pension funds' performance was hampered by a lack of expertise, and the fund managers employed were more interested in outperforming each other, rather than ensuring that the funds met their promises to pay pensions.

In contrast to Professor Rajan's criticism, Mr Myners found that the main problem arising from this collective shortfall was that pension funds were not exposed to some of world's most exciting investment opportunities, including the domestic private equity market.

But in an orgy of breastbeating, 185 leaders of the UK fund management industry, representing €19 trillion of investors' money, have opened their heart to the authors of the KPMG/Create report in a series of damning self-assessments. Anonymously they say: "In the 1990s even a monkey couldn't fail. We sold dreams and delivered nightmares. Clients fall into two categories: frustrated and horrified. We all know what should be done, but don't have the will to do it."

Professor Rajan said: "There have been several causes of this state of affairs. There has been too much reliance on equities when we are in a low nominal-return environment. Many firms didn't realise that planned liabilities have got to be accounted for in their balance sheets. Governments encouraged people to plan for their retirement without ensuring that their funds had the capacity to deliver. And investors themselves thought they were on a one-way bet, whereas they are in a casino with a zero-sum game: you lose only because I win, like a game of poker. We have so much froth in the system, which is taking a while to clear."

The authors recall that the euphoria of the 1990s attracted a huge inflow of funds, thanks to the dot.com mania and the growth of defined-contribution pension schemes. This produced a new generation of "buy and hold" investors, who because they did not sell their investments fuelled the biggest bull market in 70 years.

The bursting of the dot.com bubble turned into a rout, made worse by the Enron, WorldCom and Marconi scandals and the 11 September terrorist attacks. The authors conclude: "The results were catastrophic. Never have so many lost so much in such a short time. The breadth and depth of the resulting disillusionment ... has no precedents in the post-war period. It was the crushing end of a dream for a generation that had been enticed to believe that stock markets had magical powers."

The report says that fund managers have suffered from lack of focus, "an unclear value proposition", undue emphasis on the size of funds managed, an inability to benefit from economies of scale, lacklustre performance and inflated egos.

The authors say: "Investment professional developed a hugely inflated sense of self-worth as indices rocketed, with more loyalty to their craft than to their customers or employers. Being intrepid job hoppers, they could only be retained through equally inflated and, in many cases, guaranteed bonuses."

Alastair Ross Goobey, George's son, who ran the Hermes Pension fund, said: "The industry has a lot to answer for, particularly not seeing how the nature of savings would change in the 1990s and not positioning itself appropriately for that. Consequently, we had almost no innovation then."

Investment trusts are major users of fund management skills, and Daniel Godfrey, the director-general of the Association of Investment Trust Companies, believes that increasing competition has made many fund managers go for the safe option to protect their jobs.

He said: "Every generation produces a handful of exceptional fund managers such as Anthony Bolton of Fidelity or Ian Rushbrook of Personal Assets Trust, but increased competition has bizarrely worked to drive everyone towards the mediocre. Everyone has been fighting for market share, but managers feel that they are going to be sacked for underperformance, so they make sure they don't underperform by tracking the index. The investment trust industry has taken steps to become more professional in its assessment of fund managers. We encourage our member trusts to review the performance of fund managers and take action, either to shore up performance or move the contract elsewhere if necessary."

But Dick Saunders, the director-general of the Investment Management Association, replied: "I find the whole report rather strange. Every fund manager I know has been cutting costs like crazy for at least a year. There is a lot of re-engineering going on to reduce costs by straight-through processing. People are thinking seriously about their back-office costs."

The report's authors recommend that fund managers should deliver on their promises, draw up coherent strategies, run the business like a business, go for disciplined growth and provide effective leadership.

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