Why you can’t trust investment advice. Brilliant insights from Steven Nathan

We're often chastised by the so-called money experts for not investing enough. But the truth is that, when we do set aside hard-earned funds, snouts in the financial services feeding trough are eroding our savings. Steven Nathan, CEO of 10X Investments, says an entire investment advice industry has grown up around us on flawed foundations. The consultants we are paying are unlikely to succeed in helping us grow our wealth, and they know it. They tell us this, yet we continue to trust them with our money. Steven's piece, first published on the 10x.co.za website, demonstrates why the world is increasingly turning to passive investment options. In South Africa, we're a bit behind the curve in cottoning on to how fees can ravage our returns, but we are expected to slowly-but-surely catch up. – JC

By Steven Nathan*

Three people share the 2013 Nobel Prize for Economics. Among them is Eugene Fama, whose 1960s research set the premise for index funds by concluding that trying to beat the market was an exercise in futility. More recent (2010) research concurred: only 3% of active fund managers demonstrate skill and it is near-impossible to consistently pick the winning fund managers ahead of the time.

Every investment professional knows these fundamental principles. But unlike other professionals, such as doctors, lawyers and engineers, who operate within the natural and scientific principles underlying their discipline, most investment professionals choose to ignore them.

And who can blame them? After all, it is far more lucrative and exciting to pick stocks, talk to CEOs, visit companies around the world and play fortune teller on CNBC than it is to implement a dull but sensible long-term investment strategy that benefits clients. I know this because I have done both.

Trustees also hunger for this excitement. At quarterly board meetings they lap up the pearls of wisdom offered by fund managers explaining how the US Government shut-down or the Fed quantitative easing program impacts their portfolios. That is far more entertaining than comparing actual and benchmark returns or quantifying the long-term impact of fees.

But ignoring fundamental principles does not make them go away – beyond all the industry noise, investors are still not able to pick the future winners.  Ironically, this opens the door for another lucrative industry: investment consulting.

Accepting that it has no special powers to predict future winners, this industry has carved out a multi-billion rand living identifying past winners. This is the de-facto business model of asset consultants who largely select funds on historical results even though independent research concludes that this usually leads to sub-optimal future performance. Yet this hindsight consulting model succeeds (for consultants not investors) on the basis that "nobody gets fired for hiring IBM".

Unfortunately, trustees rely on these consultants to invest billions of retirement fund savings on behalf of millions of employees. The majority are unaware that the consultants' business model ignores all empirical research showing that most fund managers underperform, and that investors would be better off using dart-throwing monkeys to select their funds (the monkeys are no better at picking future winners, but at least their fee is peanuts).

The Nobel Prize committee has done a huge service to retirement savers by rewarding research that promotes sensible long-term investing based on index funds and low fees rather than stock picking and market timing.

The retirement fund industry continues to send the opposite message. It encourages trustees and investors to pick funds, time markets and ignore fees. To this end, it spend billions of rand (investors' money) incentivising advisors to sell their expensive funds and on marketing a few winning funds, while ignoring the hundreds of underperforming funds.

For far too long, this marketing and distribution racket has drowned out the voices of reason. But the tide is turning. Over the last five years there has been a consistent outflow from high-cost actively managed funds – globally around $500 billion – and an almost equivalent inflow into low-cost index funds.

South Africa lags this trend, due to the influence of consultants and the apparent inability of savers and trustees to understand the risks associated with active funds. Can this be overcome? National Treasury is now encouraging retirement funds to embrace low cost index funds and public awareness around the 2013 Noble Prize may also prompt people to question the value of actively managed funds. But is this enough to withstand a large and powerful lobby intent on retaining the current high-cost, complex and opaque investment industry structure? I have my doubts.

According to Pravin Gordhan, our former Finance Minister, only one in 10 South Africans can look forward to a decent retirement. Ultimately, it is up to savers and trustees to empower themselves to make informed decisions; otherwise the great majority will continue to receive poor value for their retirement savings and this shameful statistic will persist.

This blog is published here with the kind permission of 10x Investments. 

* Steven Nathan, CEO of 10X Investments, is a former Managing Director of Deutsche Bank in Johannesburg and London. He was the top-rated Banks and Life Insurance analyst in South Africa for a number of years, and was also voted the best overall analyst in SA and EMEA (Emerging Europe, Middle East and Africa). During his time as Head of Research, the Deutsche Bank team was consistently rated no.1. Steven was a member of Deutsche Bank's executive management committees for the SA Equity Business and the SA Global Banking Business. He subsequently gained international experience as head of Deutsche Bank's Global and European banks research teams.