What is winning?  And how can you ‘win’?  Marketing billions are spent persuading the public that ‘winning’ covers (a) Making money of any sort (not making a loss), or (b) Making a loss that is smaller than that made by a XYZ alternative.  That’s quite a low bar.  Inflation makes £1 today worth rather less than £1 twenty years ago, and re-defining a small loss as a ‘win’ calls to mind Lincoln’s ‘How many legs does a dog have if you call his tail a leg? Four. Saying that a tail is a leg doesn't make it a leg’.  

Lets define ‘winning’ as making enough money , after all fees & costs, to pay you for deferring your enjoyment (not just splurging on a Rolls Royce today) and to justify the risk you have taken (if you bet on the toss of a coin, and risk losing all your stake, you want to at least double your money if you win).

To have a reasonable chance of ‘winning’, it helps to know the nature of the games being played by those whom you encounter on your investment journey.   This applies both to the individuals that you meet, and the business models of the companies/organisations in the sector.  If you need to buy car insurance, or a flight, or get a rental car, by all means look at  ‘free’ price comparison / review websites, but be alert to how they make their money: usually by selling advertising to insurers/airlines/rental companies, in which case, at best, you will get ‘the best deal being promoted by their clients/partners’ rather than the best deal in the market .  I say ‘at best’ because, lets say that there are 40 possible providers; going to a comparison site that covers 75% of the market and so gives you an honest review of the 30 companies that advertise on the site, can be quite useful.  A less scrupulous site may simply be promoting the company that pays it the biggest fee, or may be entirely ‘captive’.  If you have ever been in a bar or a club and seen a chap with a pack of cards offering to ‘tell the fortune’ of a pretty girl, you probably suspect that, whatever sequence of cards arises, the conclusion will be a version of ‘your destiny is to come home with me tonight’.  If you have been that chap, perhaps you already work selling financial products.  If not, perhaps you should consider doing so.  As an investor, you are the pretty girl, and your interests are unlikely to be served by being credulous.

When it comes to investments, the stakes are usually much greater than when buying insurance, or renting a car.  Most people have a working life of perhaps 50-55 years.  One of the few UK employers, other than the government, to offer a ‘final salary’ type pension is the Church of England. Unlike the government’s ‘chain letter’ approach to pensions (putting nothing aside & just expecting them to be paid by taxes received in future years), the CofE funds its pension liabilities, and has to spend >50p on pension contributions for every £1 of salary costs.  If you followed their example, your pension would receive about 18 years of your work.  But you probably won’t exercise the same level of discipline as the clergy.  Lets assume that most people will neglect investment in their teens and twenties & so save only the legally required minimum (in the UK, c8% of qualifying earnings going into a pension), that people may save c10% in their 30s, and c15% in their 40s, and 50s, and c20% in their 60s.  Even on this basis, by the time they are 70, they will have devoted over 6 years work just to funding their pension.

How long do people spend on choosing where to invest those 6-18 years of their working lives? Those bored by investments (in the UK, probably about fifty million people), may spend under an hour choosing a pension fund into which they will pour the proceeds of several years work.  That hour may be spent with a financial advisor whose own success has precious little to do with how well their pension performs, and the pension may be managed by a company & staff who are able to thrive even if the pension does badly.

The boredom induced by the subject of investments, (and/or my prose style), may mean that you do not finish this book, so I start with the area that is most important if you are going to delegate management of your money to someone else: recognizing conflicts of interest.

In the first half of the twentieth century, most investments were held privately, so one could imagine a market in which professional money managers outperformed lay investors.  Whether that outperformance exceeded the fees charged is another matter, but, while they were a minority of the market, there was at least the mathematical possibility of pre-fee overperformance.  With institutions now handing >90% of investments, there are hardly any ‘outsiders’ left for ‘the professionals’ to beat.  87% of drivers rate themselves as ‘above average’, when we read about such studies we laugh at our own ability to kid ourselves.  The world of professional money mangers is similar: they are all holding themselves out as ‘above average’ when, statistically, this can’t be true.

Most fund managers ‘underperform’ relative the overall index covering their area (eg FTSE 100, S&P 500, DJIA, NASDAQ, DAX, Nikkei, Hang Seng, Morgan Stanley Capital International (MSCI) World index, etc), yet the big names in fund management are always running expensive advertising on billboards, the sides of buses, and glossy magazines.  They highlight a fund that has performed well.  How do they manage this year after year?  While the branding (fidelity, invesco, etc) may be constant, if you look closely, the names of the individual funds they are citing tend to change.

A big fund manager may launch several funds each year.  The overall average performance of the funds will almost certainly be worse than that of the index (ie they will be below average  ‘drivers’ of your money), but, in three or five years time, at least one of them is likely to have done well.  The fund management company highlights the performance of the ‘good’ fund, and quietly discards the under-performers (eg by merging them into another fund).

Imagine going into a casino where, round the roulette table, are some people in gaudy jackets.  One says ‘BlueMountain Black strategy’, another ‘BlueMountain red strategy’, one ‘BlueMountain odd strategy’, ‘BlueMountain even strategy’, and one ‘BlueMountain special numbers 23, 18 & 0 strategy’.   You are invited to invest with one of the players; the payers doing well have screens above their heads showing their performance.  BlueMountain also has some glossy publicity handouts with biographies of their ‘stars’ and, perhaps, interviews with some people who have made money by backing them.  BlueMountain also explains that it has been around for decades and is an established/trusted name in fund management.  As a retail investor, you are invited to believe that, although ‘past performance is no guarantee of future results’, you would be smart to put money into one of the BlueMountain strategies, and that in doing so your money is being managed by a smart guy (it usually is a guy) within a venerable institution.  But neither the institution nor the player’s success is dependent on the performance of the strategy/fund you choose.   Actually BlueMountain just owns the casino.  Every time the roulette wheel spins, it makes an average 2.7% (lets be kind and assume that this is European Roulette with a single ‘0’).  There will always be a place for the guys in the ‘BlueMountain Black strategy’, and ‘BlueMountain Red strategy’ jackets (lets call them closet indexers – see on), and, as for the ‘BlueMountain special numbers 23, 18 & 0 strategy’ guy, if he loses lots of money for his backers, he is re-deployed / re-branded to be ‘BlueMountain fibonacci  1, 2, 3, 5, 8, 13 strategy’ and keeps collecting his (rather large) salary.

You don’t need to know anything about investments to understand that people & companies tend to act in their own interests.  If the 'grown ups' running your cash have interests that are not aligned with your interests, then you can be pretty certain that they are not going to achieve the performance that you need: because they are not even trying to do so, they are focused on something different.   When it comes to fees, their interests (fee maximization) are directly opposite to yours (minimizing fees), but even setting aside the impact of fees on performance, there are lots of multi-billion dollar fund management businesses out there whose interests are not those of their clients.  On the whole, clients are unaware of this, which is just as the industry likes it.

If you are going to put your money into an actively managed fund, it seems best to look for an investment manager who has a single strategy and the majority of their family’s money in their fund.  They have ‘skin in the game’, as Naseem Taleb would put it.  Taleb became famous in 2008 when the financial crisis made his 2007 book “Black Swan” seem remarkably prescient: the book dealt with game changing  ‘improbable events’, such as the sighting of the first black swan, which required re-defining what a swan was: hitherto being white had been considered to be a key property of all swans.  His other books also include several instances of that rare talent: stating something new that is immediately seen as not only right, but so obvious that one is left wondering ’why didn’t I think of that’.  Such as 'Watch what people do, not what they say’ : They say that they want restaurants that are quiet (so it is easy to talk), uncrowded, and without a queue.  The actually choose to go to noisy, overcrowded ones with big queues.

One of the UK’s biggest firms of ‘independent financial advisors’ markets itself by claiming that they track the individual money managers that make the decisions for large funds, and, when one of the managers they like moves company, they move their clients’ money so that it follows the genius investor to the his/her new home.  The hook is to say that while the regulators require them to point out that ‘past performance is no guarantee of good future performance’, common sense dictates that if a fund has done well when managed by Mr Genius, when Mr Genius leaves, you want to move your money so it is still looked after by Mr Genius in his new home.   Aside from the fact that taking money out of the ‘old’ fund and putting it into the ‘new’ fund, involves costs all paid by you, why on earth would you put money into a fund whose own manager regards running the money as just a temporary job, until someone else offers him a £10k per month (or £10k per week) pay rise to move.   It is madness squared to pay an advisor more than 2.3% per year on top of the fees (up front and annual) charged by the funds, in order to follow some money managers whose lack of skin in the game makes them here-today gone-tomorrow hirelings.

At the other end of the spectrum, consider RIT Investment Partners:  an investment trust, launched in 1961 by Jacob, Lord Rothchild to look after family money.  In 2019 Lord Rothchild remains involved, as President, and the Rothchild family still own c21% of the c£3bn fund.  If you want to ride on the Rothchild coat tails, you don’t need a financial advisor, you can just buy RIT shares.  This is not the place to discuss whether RIT Investment Partners is a good investment, though it may well be worth considering, rather, my point is that it is a fund overseen by someone who has every interest in ensuring that it prospers.  In future, they might fail, despite their best efforts, but when the president of the company has been involved for almost 60 years, and has >£600million of his own family money invested, you probably don’t need to worry that he is recklessly speculating in the hope that a year or two of good performance (achieved through leverage or other risk amplification approaches – see on) will burnish his CV. Factors mitigating against include a c9% premium to net asset value (at the time of writing), and the fact that its holdings include various funds, so giving it ‘fund of fund’ drawbacks (multiple levels of cost), but you may feel that these points are not necessarily decisive when set against a highly aligned management with a demonstrated long term focus.

Don’t be tempted to think that regulators are ‘The grown ups’ that will look after your interests.  In the west, it is relatively rare for regulators to engage in the third world socialist favourite trick of directing investment managers to make ‘patriotic’ investments in the country’s government bonds that are crashing because international investors have finally realized that default is on the cards.  But, as with most bureaucracies, the main business of a regulator is the employment if its staff.  What those staff need to do to justify their existence is usually to prove that they have ‘learned the lessons’ of the last disaster.  At best, a well intentioned regulator will be filled by civilian generals preparing to re-fight the last war.  Regulators are also prone to the law of unintended consequences.  Start with the reasonable idea that a fund should be diversified, and so should not put more than 10% of its assets into a single stock.  When a fund manager thinks that a stock is a great investment, and puts 10% of his assets into it, if the manager is right, and the stock doubles in value (thereby making it worth over 18% of the fund [The initial 10/100 (ie 10%) turns into 20/110 (ie 18.18%)], if nothing else has changed),  is it helpful to force the fund to sell half of its winning position, presumably so that the cash can be re-deployed into the less well performing parts of the fund’s portfolio?

Regulators are not known for being nimble and proactively responding to a changing investment environment, valuations which are out of line with historical averages (the values to which things have tended to revert), or changing economic fundamentals.  And they are, if anything, even more prone to groupthink than fund managers.  John Maynard Keynes’s observation that “it is better for reputation to fail conventionally than to succeed unconventionally.” still rings true.   Look no further than the regulators approach to government bonds to see how their choices can be based on an unwavering faith in a set of assumptions that are a long way from reality.  Walter Wriston, Chairman of Citibank from 1967 to 1984, observed that "Countries don't go bankrupt,", and so went on to lend vast sums to Latin American governments, only to find out that a government bond can be a bad debt just as much as a loan to an individual or a company.  The 1980s Latin American debt crisis, which was estimated to have caused US banks losses equal to their entire cumulative profits since the end of World War 2 in 1945, did not prevent regulators in the EU, UK, and elsewhere, classing all Euro-zone government bonds as ‘safe’ investments involving almost no ‘Value at risk’.  In the run up to the 2008-9 financial crisis, Greek government bonds were not only deemed safe investments for fund managers, but also for banks in meeting their capital adequacy requirements.  In mid 2018 we find the San Francisco Federal Reserve stating ‘Low (credit) risk assets, like cash or U.S. Treasury securities, have a 0 percent risk-weighted capital requirement. In contrast, claims on commercial companies and real estate investments have a 100 percent risk weight’.  In 2008 regulators were applying that same 0 percent risk weighting to Greek government debt which went on to be subject to a 50% haircut having, for a time, traded at notional yield of >35%.  DIW Berlin provides some helpful tables


<Apologies if you are reading this on a phone, when I check on my iphone, the tables below do not appear, but they do work on a desktop>

A screenshot of a cell phone

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A screenshot of a cell phone

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Where does one begin here?  It is bold to suggest a 0% risk of disaster for anything.  I asked the founder of one finance house who was explaining one of his company’s products, what would happen if the futures exchange became insolvent (as had happened in Hong Kong in 1987): ‘You can’t worry about that, If that happens we all have to pack up and go home’ was his reply. I don’t like the approach, but it is widespread.  Perhaps financial history is not your bag, and it seems that only nuclear war, or a vast asteroid strike will cause an AAA rated government bond to default, so, to make calculations easier, you assume a 0% risk weighting on AAA rated government bonds.  I don’t agree with the approach but sometimes the intellectually lazy shortcut actually works out OK, so lets move on.  But, even if one wants to accept 0% risk for AAA rated government bonds, how does it make sense to keep a 0% risk weighting when an AAA bond is downgraded to AA+, and downgraded again to AA and downgraded a third time to AA-?

Even in 2014, regulators considered lending money to the governments of Italy, Spain & Portugal to involve half the risk of lending it to private companies such as Coca Cola or Berkshire Hathaway.  Coca Cola may be a tooth rotting bane of childhood health, but, despite having to take Cocoa out of its secret formula (yes, coke is named after the same Cocoa leaf that is refined into cocaine), it has a very long track record of prospering from dissolving enamel and providing its caffeine boost.   Coca cola started in 1888, just eighteen years after France had (in 1870) introduced its third republic following the collapse of its second empire during the Franco-Prussian war.  In the intervening 132 years France’s third republic collapsed in 1940 when France was defeated by Hitler’s Germany.  After the war France established its Fourth Republic (1946-58) which was in turn succeeded by De Gaulle’s Fifth Republic (1958-present).  And France is one of the more stable continental European jurisdictions.  There are a lot of countries whose governments are a worse bet than the Coca Cola corporation,  but don’t expect a regulator to admit it.  If you want to make it personal, would you rather lend money to Berkshire Hathaway for Warren Buffet to invest, or to the Prime Minister of Spain to spend on repaying the interest due on earlier borrowings, or police overtime so they can beat up Catalan grandmothers trying to cast their votes in an independence referendum?

Aside from their tendency to underestimate the risk of government bonds, Regulators have also failed to respond to the impact of Quantative Easing on government bonds.  Bond pricing & risk is covered in another chapter, but at this stage, suffice it to say that ‘good credit risk’ government bonds are being issued with a negative absolute yield, that is to say they guarantee that an investor will lose money if they hold them to maturity, and vast numbers of corporate & secondary government bonds yield less than inflation. Warren Buffet’s description of bonds as now representing ‘return-free risk’ is spot on, so why would anyone choose to buy them?  Many managers and banks have no choice, because regulators tell them that they must.   The last three decades, during which nominal interest rates have declined from 1970s highs, have been kind to most bond investors, and Quantative Easing’s initial impact has been to boost the capital values of bonds, but bonds now offer no prospect of a reasonable return (rates can hardly fall much from 0%), and, in the case of long dated bonds, a significant risk of permanent capital loss.

The inclination to have a ‘re-fight the last war’ approach to risk is not confined to regulators, but the reasons for not relying on the regulator to be the ‘responsible adult’ who has ‘got your back’ go way beyond that.  Financial Regulators are no less prone than any others to ‘regulatory capture’ by the industry they are supposed to regulate.  How else does one explain their long toleration of things like ‘soft commissions’?   For more than a decade, if you or I have wanted the price of a stock, we have looked online and got a price feed ‘delayed by 15 minutes’, if we wanted some number crunching that has been pre-done by someone else, Yahoo finance is a free resource.  Professional fund managers don’t want the 15 minute delay, and may want some more powerful analytics, so they turn to firms like Reuters and/or Bloomberg that happily provide data terminals for the modest fee of £2,000 per month per terminal.  A firm can face annual bills measured in millions, and common sense says that those are costs of being in the fund management business, costs that, like salaries, one would expect a fund manager to pay from their 2% annual management fee.   But then brokerage firms started saying to fund managers ‘If you give us all your business, we will give you your Reuters terminals for free’ - great news, that’s a million or more to add to the bottom line of the Fund Manager.  But data terminals ‘for free’ is not the whole picture: instead of paying eye watering Reuters or Bloomberg bills, the fund manager now gives a bit more money to their broker on every trade.   This is done in two main ways: Fees & ‘Spreads’.

Fees are easy to understand.  If the cheapest broker in the market charges a £4.95 fee, but the broker that provides a ‘free’ data terminal charges £6.95 every trade, then that is £2 a time extra.  Those £2s add up when a fund manager places lots and lots of trades (as they tend to)

The Spread is the difference between the buying price (bid) and the selling price (offer).  When you go to a currency exchange booth at Heathrow Airport, to exchange some British Pounds for US Dollars, you may see them offering USD1.27 for one pound.   After your US trip, if you have too many dollars, you may want to change them back to GB Pounds.  The currency exchange booth may even have offered you a ‘zero commission’ service to change your money back.  But, you will need to spend US$1.33 to get a pound.  Here the ‘mid market’ price is GBP 1 = USD 1.30, but if you want to sell pounds you get 3 cents less (1.30-0.03=1.27) and if you want to buy pounds, you must pay 3 cents more (1.30+0.03=1.33): The ‘spread’ is 6 cents, or about 4.6% of the 130 cent ‘mid market’ price.  A 4.6% spread could be likened to a 2.3% transaction tax.   If you need not a few thousand dollars for a trip, but a few hundreds of thousand dollars to buy a vacation home in Florida, you won’t want to pay the currency booth’s 2.3% tax, and will probably go to your bank, who, if you are lucky will have a ‘tighter’ spread, perhaps with an offer at 1.29 and a bid at 1.31, ie a 1.54% spread or a 0.77% ‘tax’.   And if you are foreign exchange trader dealing in millions of dollars, you will probably face a spread of 1.29995 to 1.30005  ie ‘one pip’ or 1/100th of a cent difference which is 0.0077% or a ‘tax’ of 0.0038%.

When it comes to our investments, we want our fund manager to be using the broker that quotes the tightest possible spreads.  The one that has a tax of 0.0038% rather than 0.77% or 2.3%.  But, when they are locked in to a deal with the broker that gives them the ‘free’ Bloomberg or Reuters terminal, the fund manager cant look for the best price, they just go to their friendly terminal-provider.  And, that broker offers a slightly worse price.  Probably not astronomically so, but it all adds up.

Whether it is due to a larger ‘spread’, or a higher fee per trade, it comes down to the broker recovering the cost of the terminals, and a bit more, by making an extra few pounds several times an hour.  Those few pounds extra don’t come out of the fund manager’s annual fees.  The lucky retail client who has invested with the fund gets to write a cheque not only for the annual management fee to the fund manager, but also to the broker for every trade.  Don’t look to the regulator to solve the problem, and remember that even when you drill down to get a fund’s ‘Total Expense Ratio’ which covers commissions / dealing fees as well as the fund management fee, this ignores the cost of the spread [And of electronic front running – see on].   Move along, nothing to see here,…..

Equitable Life

If Mr Regulator is generally a bit grown up, and not entirely dishonest, then you might think that they would keep you safe from obvious disasters, even while giving the industry a pass for ‘the usual swindles’.  Unfortunately, even when they have identified a big risk that needs to be removed, Mr Regulator is, at best, focused on the sustainability of the system, rather than fairness or justice for any particular individual or group of individuals.  He is certainly not an arbiter that tries to hold institutions to the old City of London maxim ‘Dictum meum pactum’ (‘My word is my bond’).  The failure of UK Life Insurance / Mutual Fund company Equitable Life shows Mr Regulator’s approach to his work.

Equitable Life pooled the cash it received from investors, and gave them ‘a ‘terminal bonus’ supposedly based on the investment performance achieved by the time of the policy matured in eg 20 years time.  However, the return was not an objective number based on what the investment actually achieved.  Mr Regulator allowed firms like Equitable Life discretion to declare an arbitrary performance figure, the main justification being to allow firms to smooth the returns by holding back profits in good years and using them to top up the profits made in poor years, so that if there happened to be a bear market just as you were retiring, you did not lose out so much.

In the 1950s Equitable Life began to sell policies by offering a Guarenteed Annuity Rate on maturity.  The Guarentees were intended as a marketing ploy, but not intended by the company to offer any real extra value to investors, or seen as a commitment worthy of an aligned investment strategy (the exposure could probably have been hedged [When a risk or liability is ’Hedged’, the person or company with that liability arranges with someone else to taken on some or all of the risk/liability.    The chapter on derivatives gives more details] relatively cheaply in the high-inflation high-interest rate environment of the 1960s, 70s & 80s when most of the policies were sold).   For decades, the Guarentees were hardly relevant as double digit market rates were, at or above the levels of the guarantee.  When interest rates started to fall in the 1990s, the Guarentees became valuable, or should have done.  Equitable Life responded by using its discretion to declare much lower terminal bonuses for investors with a guaranteed annuity rate, in effect removing the benefit of the guarantee by applying the high guaranteed rate to an artificially under-stated number.   [Lets say that the ‘terminal value’ of your policy was going to be £100,000 and that the market annuity rate is 8%, without any guarantee you would get £8,000 per year.  If you had an Equitable Life Guarenteed Annuity Rate of 12% you would expect the guarantee to boost your annual income and make it £12,000.  But, because they had not hedged the exposure, Equitable Life could not afford to pay £12,000 a year, so they (ab)used their discretion to declare that the ‘terminal value’ of your policy was only £67,000 rather than £100,000.  They then awarded you your guaranteed 12% pa, on the £67,000, ie £8,000 .  Hey presto, the annoying guarantee is no longer a problem for Equitable Life]

In 1993, when Guarenteed Annuity Rates first started to exceed the market annuity rates, Equitable Life immediately told Mr Regulator that they would deploy this chicanery to obviate the impact of Guarenteed Annuity Rates.  Mr Regulator did nothing to stop this blatant fraud, which continued until the House of Lords (de facto the UK Supreme Court at the time) ruled on the matter in 2000 [Equitable Life Assurance Society v Hyman].  The House of Lords left Equitable Life with a £1.5 billion hole in its balance sheet.  Having failed in its attempt to walk away from the guarantees it had offered, Equitable’s new strategy was to raid the investments of policyholders without guarantees to subsidize the guarantees it was now, if reluctantly, trying to honour.   As it was no longer viable, Equitable was trying to sell itself to another financial institution: the proposition to the buyer could be summarized as ‘You will lose money on the Guaranteed Annuity Rate business, but can make up that loss, and more, from customers without guarantees’.  Mr Regulator had actually been worried about the solvency of equitable life since 1998, and with the July 2000 House of Lords judgement, it was clear that Equitable Life was doomed, but from July to December 2000 Equitable continued to market itself to new customers with the full support of Mr Regulator [https://www.economist.com/britain/2000/12/21/trust-betrayed ]  whose priority was preserving the illusion of viability while the company looked for a buyer, rather than ensuring that new investors were not suckered into doomed funds.

Hong Kong 1987

Nor did Mr Regulator stop the Hong Kong futures exchange blowing up in the 1987 crash: margin levels were set too low to handle the volatility during that turmoil, because loosing investors had losses greater than the collateral they had put up, those with ‘winning’ positions could not be paid out and the exchange was put into administration.  In fairness, the resolution process was pretty successful and winners were eventually paid out.

MF Global – financial fiction

There was a time when the Booker prize was re-branded ‘The Mann Booker prize’ thanks to some large sponsorship cheques by Mann Financial. In 2007 Mann Financial, with the brilliant timing often shown by insiders in the year or so before a big crash [In this case, the 2007 Mann Financial spinoff IPO before the 2008 crash, other examples include Goldman Sachs, which had been a partnership for 130 years, floating itself in May 1999, conveniently before the 2000 crash 10 months later.], span off its brokerage business as MF Global (known as MFG). MFG served investment funds and (mostly large) individual investors, providing them with brokerage services and bank-like safe custody boxes for holding gold etc. They also followed the usual process adopted by professional firms, such as lawyers, accountants & architects, of using a dedicated client account for cash held on behalf of clients. So far, so good. Unfortunately for their Clients, MFG did not confine itself to providing a service. It also placed big bets on its own account. For a while those bets were (on balance) winning bets, and gave the owners and management of MFG a tidy boost to their profits & pay. Then the bets started losing, and MFG started to dip in to the cash in their client accounts.  Clients’ shares/bonds held by MFG were also sold, often to MFG-controlled companies (ie not even on an arms length basis). When the moment of truth arrived, one might have expected the regulator and an insolvency practitioner to come in, return client assets / cash to the clients concerned, and, if the system allowed bailouts, then to use bailout funds to make good the funds stolen from client accounts, and then throw the book at the managers and staff who had used client cash/assets for their bets.  Instead, MFG staff were not prosecuted, nor were they required to repay the bonuses or vast salaries paid to them on the strength of prior ‘good performance’ (ie when their bets had ‘won’), and the insolvency practitioners went out of their way not to question nine figure last minute payments to politically well connected counterparties.   Hundreds of Millions (of client funds) were paid by MFG to JP Morgan two days before MFG folded; the payment looked to most people like the repayment of a loan taken out by MFG.  There are strict rules about bankrupt entities making such payments (if a company owes £100 billion and has £10billion of assets, then the rules say that fair thing is for all creditors to get 1/10th of what they are owed, rather than allow the £10bn to all go to select creditors with ‘friends on the inside’ of the bankrupt company, leaving everyone else to get nothing).   But JP Morgan is a big, rich politically well connected company, so, despite the extra fact that the payment was made with client funds (ie not cash owned by MFG), the authorities did not want to claw the money back to be returned to clients, or shared by all the creditors (ie including the politically not connected ones).  How did they achieve this?  Its easy with a little mental gymnastics.  If the starting point is that MFG has borrowed money from JP Morgan, and US$109 million of that loan is repayable on Wednesday, and on Wednesday MFG transfers US109million to JP Morgan.   You and I would probably assume that the US$109 million was repayment of the loan, but the regulator did not want to make that assumption.  Its not that there was compelling evidence to show that the $109 million was paid for an identified reason other than the loan repayment (such as the purchase of shares or another asset).  Just that Mr Regulator didn’t want to make the common sense assumption when that assumption would have helped the little guys.

MFG was a slightly higher tech version of a rogue solicitor holding the deposit for your house purchase, deciding to bet the money on a hot tip for the Grand National, expecting to win & pocket the profit without you knowing, but ending up loosing & hiding the fact until the day you are due to move into your new home when you discover your money isn’t there.  How on earth is Mr  Regulator not 100% on the side of the clients?  Given that 2009 saw multi-billion pound bailouts of those on the wrong side of financial decisions, why does such abuse of trust by a regulated firm not warrant the victims being given top priority to be bailed out?   Alas, clients of such malpractice come way down the pecking order for bailouts: that order is typically correlated with political connections & lobbying budgets.

The www.zerohedge.com coverage at the time was prescient:

Imagine for a moment that MF Global was your bank. One day you woke up and discovered that the account holding your college savings was gone. Poof! The money in your retirement accounts and related checking accounts had just been “vaporized.” You go to ask the bank where you money is and you are locked out of the bank while strangers who are not depositors are allowed to enter and take assets from the bank, including the contents of the "safe" deposit boxes. You finally hear from the bank and the authorities, who essentially say that while they can see all the transactions of the bank over the last month, for some reason, there is just no longer any trace of the money, and no explanation of what happened. The funds just “vaporized.”  And after a few weeks of minimal information dribbles, you hear the search has gone cold.  You are told the money disappeared in a chaotic tsunami of transactions and there is no evidence of any criminal actions.  But, if money happens to get found, you might get some of it.  Oh, and the contents of your safe deposit box are going to be auctioned off, with only a portion of the funds returned to you (this was the fate of the unlucky souls who held gold and silver bars on deposit in their own name with MF Global).  That’s all...talk to you later. Good bye and good luck.
See also:


Financial Journalism

If you can’t rely on fund management companies, or the regulator, what about journalists and financial commentators?  Are there wise grown-ups there to help you? The best financial journalists are engaging to read, & would probably be fun to meet over a drink, but let’s set conviviality aside, and get down to brass tacks: the interests of those involved, and how closely they correlate with your own desire for good long term returns.

The purpose of a paper/journal is to sell copies/subscriptions, and to sell advertising.  Aside from the fact that someone possessed of amazing insight and analytical ability can probably make much more money by trading/investing than by writing, our inclination to read articles is usually driven by the quality of the prose [And/or the extent to which the writer’s prejudices are similar to our own.  As with political journalism, we tend to gravitate to columns by financial journalists that confirm / reinforce our pre-existing views], which is readily apparent, rather than the accuracy of their predictions, which is not known at the time.  Financial journalists tend to be, first and foremost, journalists, not financiers [The financier as writer manque, using their success in investing to get a gig in journalism is a seductive idea.  The colourful Jim Slater whose Slater Walker PLC bloomed in the 1960s, only to crash & be bailed out in the 1973-4 crash, was a keen writer, of children's stories, as well of financial stories.  Hi book ’The Zulu Principle’ is certainly far more readable than the (possibly deliberately opaque?) scribblings of George Soros, whose success was not followed by a crash.  But, when a fund manager has a regular column in the investment pages, the cynic in me suspects that their motive is probably marketing: a fund manager who raises their profile improves their chance of attracting clients].     They may give you an idea that is worthy of following up with your own research, but it would hardly be wise to outsource your thinking to them.  And that is before one considers the impacts of Public Relations departments and ‘advertorials’.

What about your employer?  This publication’s genesis is the frustration I endured when trying to set up a pension scheme for Dynamic Futures, an IT consultancy with a cohort of relatively highly paid, and relatively young, staff.   I faced two main problems.

a)  Under UK ‘auto enrollment’ rules, a Small/Medium sized Enterprise employer is not allowed to set up a staff pension scheme in which the default fund is classed as ‘High Risk’, which was all very well until I found that the investment management companies I spoke to seemed to define ‘risk’ in a way that made no sense to me.  Their definition (no doubt courtesy of a well meaning regulator) entirely disregarded price. At time when valuations are at historic highs: almost all government bonds were, as an asset class deemed to be ‘low risk’ (presumably because the possibility of absolute default was deemed to be low) even though any reversion to a normal interest rate environment (ie the sort of nominal, or real, rates that the Bank of England details as having prevailed in the 5,000 years prior to 2009) would see longer dated government bonds loose considerably more of their value than eg UK equities did during the 1987’s ‘Black Monday’, and such a loss, unlike that suffered by 1987 equity investors, would be likely to represent a permanent capital loss.   [My own frame of reference at the time was decidedly more limited, and focussed on England since the eighteenth century.  Tim Price’s excellent ‘Investing Through the Looking Glass’ (Harriman House, 2016) highlighted the BoE figures going much further back  https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/growing-fast-and-slow.pdf?la=en&hash=621B4A687E7BC1FE101859779E1DFFE546A1449F]
b) Because neither I, nor the company, were accredited by the regulator, even talking about the subject was a regulatory minefield.  I wanted to say, at least, ‘the Company has placed its own money with xxxx’.  Even saying that much could have got us into hot water as it could be interpreted as financial advice that it would be illegal for us to provide, unless we became regulated.  One of the reasons for writing this guide has been to equip Dynamic Futures staff with the knowledge needed to make informed choices, because, even if they wanted to, they could not outsource the thinking to their employer!

If you prefer to entrust your investment choices to someone you regard as bright and better qualified than you are, it is not necessary to understand finance, but it is worth trying to ensure that they have your interests at heart.  Either because they are a trusted relative that loves you, or because they are a professional with integrity and whose own interests are aligned with yours. Its no use, in fact it is worse than useless, to be dealing with a bright guy, or girl, whose interests diverge from yours, because you can bet that their brilliance will be directed at making money from you rather than making money for you [see 'Where are all the customer’s yachts’ by Fred Schwed, first published in 1940: these problems are not new!].