Why most managers take bigger risks with your money, than you’d expect.
The story of Tony Dye
In this extract from chapter 5 of my book ‘Who misleads you about money?’ I explore the story of Tony Dye to help you understand why most fund and wealth managers will always take bigger risks with your money than you might reasonably expect.
Dye was the chief investment officer at Philips and Drew when they were the UK’s largest fund manager. And he lost his job for trying (and succeeding) to do the right thing!
How bull markets end
Towards the end of a bull market, a good many leading fund managers in the mixed-asset fund sector will necessarily hold a high proportion of high risk/high return assets in their funds.
It’s only by holding a lot of these assets that they can (ordinarily) have outperformed their competitors during the bull run.
Fund managers who reduced their holdings in risky assets during the later part of the bull run will have underperformed their competitors. And most fund managers do not like to risk underperformance for fear of the consequences (see below).
This means, just like our economists from earlier in this book, that a lot of fund managers of mixed asset funds converge towards a single view.
They end up with very similar (maximum) holdings in risky assets, right at the most dangerous of times.
Of course, this is not what most of us might expect from a balanced managed (or mixed asset) fund. But you’ll recall from earlier chapters how the ‘perfect markets’ theory will tell the fund manager that all asset prices are always generally about right. So, he/she doesn’t need to worry about these risky times or that a bubble might have blown up and be about to burst.
In the land of perfect markets, bubbles don’t exist!
What happens when reality clashes with the theory?
So, what about the odd occasion when, as we all know, reality gets in the way of this theory?
What happens when Mr Market decides to misbehave, and a bubble does inflate and bursts and blows our funds away in the process.
Well, by sticking to the theory, the fund manager can simply blame market failure.
And that’s certainly a lot less painful (for them at least) than taking any responsibility for misjudging market values.
You see, most of these fully invested mixed funds will fall at a similar rate to each other during a market crash.
So their position, relative to the other funds in the same sector, isn’t much affected by it.
They all go down together – which means there’s very little incentive to ease out of risky assets whilst markets are booming.
Are you waiting for the last dance?
Jeramy Grantham, who set up GMO asset management and has a decades-long track record of ‘calling’ asset price bubbles – put it like this in his note, ‘Waiting for the last dance’ of January 5 2021.
Don’t wait for the Goldmans and Morgan Stanleys to become bearish: it can never happen. For them it is a horribly non-commercial bet. Perhaps it is for anyone. Profitable and risk-reducing for the clients, yes, but commercially impractical for advisors.
Their best policy is clear and simple: always be extremely bullish. It is good for business and intellectually undemanding. It is appealing to most investors who much prefer optimism to realistic appraisal, as witnessed so vividly with COVID. And when it all ends, you will as a persistent bull have overwhelming company.
This is why you have always had bullish advice in a bubble and always will. However, for any manager willing to take on that career risk – or more likely for the individual investor – requiring that you get the timing right is overreach. If the hurdle for calling a bubble is set too high, so that you must call the top precisely, you will never try. And that condemns you to ride over the cliff every cycle, along with the great majority of investors and managers.
And this was exactly the same logic offered by Chuck Prince (former CEO of the Citi Group) when he made his infamous remark to the Financial Times in July 2007 that,
When the music stops (in liquidity terms), things will be complicated,
but as long as the music is playing, you’ve got to get up and dance.
We’re still dancing.
Mr Prince was answering questions about potential problems in the US subprime mortgage market.
The subprime loans were those made by irresponsible banks to very low-income borrowers who never stood a chance of making the repayments.
When those loans – which by clever packaging into securities had been spread around the world’s banking system – started going bad, there was a worldwide collapse in those banks and the whole world economy was brought to its knees.
Not knowing that we’re taking too much risk with a mixed-asset fund in our investments may be less serious for the world economy, but it’s still a big issue for our personal finances.
Okay, so we’ve just seen how mixed-asset fund managers have an incentive to increase risk levels on their funds during market booms. Indeed such behaviour is generally accepted (by industry insiders) as the market rule.
You may find that hard to believe but it’s perfectly true.
Let me tell you what happened to one of the UK’s most respected fund managers when he went against that rule.
The sad but true story of ‘Dr Doom’
Tony Dye was the Chief Investment Officer of Phillips & Drew, one of the largest UK pension fund managers, between 1985 and 2000.
He was a well-known figure in the investment industry and held strong and controversial opinions about the outlook for global stock markets.
In the mid-1990s those markets were soaring, but Dye was convinced that they’d become overinflated and that the bubble was going to burst.
His views, not surprisingly, put him at odds with much of the rest of the investment management community, earning him the nickname ‘Dr Doom’.
In 1995, as the FTSE 100 approached 4,000, Dye started making the case that markets were becoming too expensive. Then in 1996, he began to move large sums (tens of billions of pounds in today’s money) of his pension fund clients’ money out of equities and into safer assets – cash deposits and bonds.
In the three years after 1996, stock markets continued soaring higher, driven by optimism about the new millennium and the potential for enhanced company earnings from the latest new technologies.
But Dye stuck to his guns and shunned the high-growth, high-risk internet stocks, keeping large positions in those safer assets. Because of this, his funds started to underperform their more fully invested rivals; by 1999, this previously leading fund manager was ranked 66th out of 67 institutions in the performance tables.
Dr Doom was sacked
Phillips & Drew were losing some very big clients who were tired of the underperformance of their pension funds and bored by Tony Dye’s doom-laden predictions.
In February 2000, just weeks after the FTSE 100 index had broken through an all-time high of 6,900 points, Dye was sacked.
Days later, his prophecy came true: stock markets started a three-year slump, which took more than 50% off global values.
The Phillips & Drew funds were well protected at this time of course, as they held a lot of those safer assets.
And his funds returned to the top of the tables
So, as many other funds saw their values cut in half by market falls, the Phillips & Drew funds climbed straight back to the top of the performance tables.
More impressive still was the fact that the Phillips & Drew pension funds had risen steadily between 1996 and 2006.
Sure, they grew more slowly than other funds in the final burst of the stock market bull run up to 2000, but then they didn’t crash when the others did.
Tony Dye’s predictions of a market crash were right – and whilst he was about three years too early in calling it, he might well have been proved right much earlier.
A crisis in Asian economies in 1997 and then a collapse of a multi-billion dollar hedge fund – Long-Term Capital Management (LTCM) – in 1998, hit the world’s stock markets so hard that central banks decided to rescue the situation by slashing interest rates to record lows and arranging a rescue of the LTCM fund.
This saved stock markets from immediate collapse and delayed the inevitable correction to their wildly overvalued prices.
So Dye had to wait until after his sacking in 2000 to be vindicated.
Dye’s other early calls
After leaving Phillips & Drew, Dye continued offering apparently controversial views on market valuations.
At the end of 2002, he wrote to the Financial Times predicting a house price crash in the UK, on a similar scale to the house price slump of the early 1990s, saying that at least 30% would be wiped off the value of the average residential property.
Falls of more than this figure did occur in the USA and other countries, but only after that asset bubble had inflated for several more years up to 2007.
His prophecy for correction in house prices has yet to come true in the UK, but it might just do so when our interest rates return to more normal levels.
Tony Dye was right about bubbles blowing up and their subsequent bursting, but because he called these events too early, he lost his job.
Why most fund managers won’t reduce risk at risky times
Fund managers know this story and very few are about to vote for their own dismissal by being out of risky assets in a raging bull market.
And in fairness to fund managers,
it’s difficult to operate any other way.
Think what would have happened to Tony Dye’s remaining clients if he’d been wrong: if markets had, like the theory says, been correctly priced throughout those boom years and hadn’t crashed in the early 2000s.
Phillips & Drew clients would have been stuck with poor performance relative to the herd and would probably have all gone to other, more aggressive, fund managers.
This, after all, is what was already happening in the run-up to Dye’s sacking. Phillips & Drew were losing clients in the late 1990s due to his cautious approach.
So I’m not sure we can expect many fund management groups to behave the way we’d like them to, and to take some risk off the table on their mixed-asset funds when markets are booming.
Some good fund managers are brave enough to do so, but most are not.
Ultimately, this is our fault
Fund managers are caught between a rock and a hard place.
And, to mix my metaphors, it’s because we want our cake and to eat it too.
We demand strong performance at all times when the stock market is racing up.
We are not interested in modestly good performance at these times, and this is not a new phenomenon either.
So, if this is how we choose to think, we must be ready to accept only cake crumbs on our table if markets collapse while we’re fully invested.
Am I suggesting you don’t invest in the stock market?
No, not at all.
However, I am suggesting that, once you’ve found a good value investment or pension wrapper and before you get into the grisly detail of fund choice, you should consider these four factors to decide how much investment risk to take – on each of your financial life goals.
- Your general attitude to investment risk – sometimes called your risk tolerance.
- Your need for investment risk, on each of your financial goals.
- Your capacity for investment risk, on each of your goals.
- Whether your chosen investment assets (Shares, Bonds, Property for example) are especially expensive, or cheap, compared to long-term average ‘value’ measures.
It’s important to pay close attention to all four points, but if you use a financial adviser/wealth manager (which I’d encourage most people to do) be sure to check that your adviser is considering all four of these points too.
Sadly, not all of them do – especially around points 3 and 4 in that list, and it’s point 4 that we’re concerned about here.
So, be sure to factor that last point into your investment thinking – at least at times of market valuation extremes, like now.
And remember what Warren Buffet said,
And I’ll leave the final thoughts on all this to others.
Thanks for dropping in,
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