tim's experiment

Much discussion lately about the Mandatory Provident Fund, because of the Consumer Council’s rather unsurprising discovery that many funds charge high management fees. The basic reason for this, say some, is that the funds are chosen by the employers, not the people whose money is at stake. So the choice is done rather badly, and may be influenced by factors like the desire to get a discount on other services from the same bank. Other suggestions are that the fund managers have ways of boosting their take surreptitiously, or that in the absence of real competition they do not try very hard. The council suggested putting a cap on fees. The fund management industry queried this as an impediment to market forces and a blot on Hong Kong’s (totally undeserved) reputation as a place where such forces roam unchecked. They also suggested, hilariously, that some fundees might wish to pay more for a higher quality service.

The point totally ignored in all this is that the fund management industry is a con. Repeated experiments have proven beyond the slightest doubt that investment pickers of this kind have no actual expertise at all. You can do just as well, on average, using a pin. I am amazed that nobody seems to have noticed this small point. After all you hear occasional mutterings about chiropractic, or Chinese medicine. But customers of these cures do at least feel better. This may be entirely due to the placebo effect but at least they are getting something for their money. The fund management guys are not even making you feel good. This has been known in social science circles for some time. Some of the experiments were rather entertaining. They pitted professional stock pickers against monkeys using a pin on the Business Section, or toddlers dropping darts from the top of a step ladder. Others simply compared the results of the fund or funds with what you could have got from mimicking your local index. The result was the same. On average these people add no extra value to your investments at all, and if they trade actively – as many do – they are depleting your savings with trading costs.

That is not to say that a fund cannot beat the market. The problem is that doing this is achieved through luck, not science. The easy way to have a market-beating fund is to start 32 of them. At the end of the first year 16 of them will have beaten the average. The losers are closed. At the end of the second year you will have eight winners and at the end of the third four funds will have beaten the market three years running. No skill is required to achieve this – it is simply the law of averages. These funds can now be marketed as having an impressive track record. As they should, on average, equal the index in subsequent years their flying start should make them look an attractive prospect as long as you start you assessment of the results with the first three years.  At the end of the first five years one of your funds will have beaten the average five years running. The person running this fund will be hailed as an advisor of great sagacity and forsight. He will be showered with bonuses and interviewed in the business press. The following year his chances are exactly the same as everyone else’s.

Another way of looking at the question of skill is to consider whether in fact some people do get better results than others. This can be tested qite simply by comparing the results from one year with the results in the next, and repeating this for a large number of years and people. Do some poeple consistently get better rankings, as they do in, say, golf or poker? No they do not. At all.

Investors should also be warned that the pretence that some funds are riskier than others is based on a flawed model which understates the risk in both categories. Modern portfolio theory was more or less invented by a bunch of economists who founded Long Term Capital Management to show everyone how it should be done. The company achieved one of the most spectacular bankruptcies in financial history. People are free to overlook the obvious implications of this episode, but do you want them in charge of your money?

So what is to be done? People with money in the MPF do not need a range of funds to choose from. They would be better off if the money was all just put in the Tracker Fund, or – politics permitting – in a group of similar funds including overseas ones. The fees for running index funds are commonly a fraction of those for fancier investments and the returns, on average, are the same or better. The MPF, as originally designed, was just another of those lucrative gifts from the last government to its business friends. People do not need the assistance of fund managers if they wish to lose money. Those who wish to do that can go to Macau and at least have fun in the process. The rest of us should not be delivered up bound hand and foot to a bunch of legalised financial vampires.