May 2012
Why do ships have lifeboats?In this centennial anniversary of the sinking of the Titanic there has been much comment about its lack of lifeboats. In fact the real question is why it had any lifeboats at all. The contract the majority of passengers had with the White Star Line was to get across the Atlantic as cheaply as possible. If, at the design stage, prospective passengers had been able to influence the designer, Thomas Andrews, they would probably have urged him to remove all the lifeboats in return for more berths and lower fares.
After all, the ship represented the peak of Edwardian technology. It had steam power, electric lights and wireless. Only a few decades before westbound passengers faced weeks of sailing into headwinds on a sailing ship heeled over with precious few creature comforts and no prospect of being able to radio for help.
This might seem far removed from the world of investing, but there are parallels. These days the mantra is to reduce the cost of a fund to the lowest possible level. The annual management charge, (AMC), the total expense ratio (TER) and the total cost of ownership (TCO) are pushed down by ferocious competition between product providers who use ever more sophisticated technology to reduce costs. It is routine now to use derivatives, synthetics, swaps and options to create something that looks and behaves like an index fund. Yet under the wrappers of some ETFs the contents are a long way from what it says on the tin.
All is fine of course in smooth waters. With no waves or icebergs these products happily sail on delivering the returns of the index they purport to represent. But this lulls the investor into the Titanic Effect, which is:
“One of a number of self-fulfilling behavioural biases where your expectations bias your behaviour and make it more likely that you’ll fall foul of the very problems you think you’ve overcome”
In other words you drive faster if your car has airbags which may increase the risk of an accident.
Modern, low cost ETF index funds use all sorts of techniques to reduce cost. But these techniques increase the risk of a mighty disaster if they hit a financial iceberg. Little regard is paid to the risk the counterparties in the transactions might fail and leave investors out of pocket. Of course if they don’t collide with a large object they have achieved the financial equivalent of crossing the Atlantic at great speed and at low cost and the lack of lifeboats made their trip cheaper. However, if the synthetic fund hits a monetary crisis the consequences could be dire. Will investors question what level of safety they require and, even more important, will they pay the extra?
Modern ships and aircraft don’t give you a choice. Cruise liners have enough lifeboats, even if the crew of the Costa Concordia didn’t know how to use them. Aeroplanes have more devices than you can imagine that prevent pilots doing stupid things. Though even these did not stop the co-pilot of Air France flight 447 putting the A330 into a stall at 38,000 feet and ignoring all warnings until it crashed into the Atlantic.
The world of investing is different though. Safety devices are not mandatory and, even worse, investors are not told they are optional extras, missing or not wanted on the voyage. These oversights are compounded by labelling that is positively unhelpful. Who would suspect that something labelled as a FTSE 100 ETF only has one UK share in it? The rest of the portfolio consists of Asian shares and sundry financial instruments. It is as if the Trades Description Act, so protective of pork pies, sundry cheeses and European dried meats, has no relevance to financial products whatsoever. If the things it owns are not stocks in the FTSE100 who knows what the real risks are? They are certainly not the same as a fund that holds the shares it says it does and has not lent them out.
It is not just increased risk that is being miss-sold. There are other knock-on effects of this disconnection between labels and contents. Complex financial products reduce the ability of asset managers to exercise their rights of corporate governance. How can they vote on takeovers and pay packages of companies that are ostensibly in their index if they don’t own the underlying stock?
Maybe passengers would still have boarded the Titanic if it had no lifeboats on the basis that the fare was low enough to take the gamble. But how many investors in low cost funds fully understand the hazards they run and would they like to be told? Do they want their funds to have so much risk with no safety net and do they have any appreciation of the counterparty risks they are incurring?
It took the loss of 1500 lives and a Board of Inquiry before it was mandatory for ships to sacrifice economics for safety and carry enough lifeboats. What kind of accident will it take before the FSA requires funds to do what they say on the label?
(The S & W Munro UK Fund is a physical long-only smart-beta fund that invests in the FTSE 350 Index and complies with The Stewardship Code.)