Do you actually know what a watershed is? I suspect it’s not what you think. If you’re like me, you probably think the term refers to some sort of crest or summit, where the key point is that on one side water flows in one direction, while on the other side it flows in another. So the expression “reaching a watershed” means reaching one of these points at which water starts to flow differently.
Completely wrong. A watershed isn’t a point at all. It’s an area of land. Specifically, it’s an area of land where water all flows in a single, particular direction – typically into a single river, lake or sea. So you don’t really “reach” a watershed at all. It would be much clearer to say that you “cross” from one watershed into another – moving from an area that, say, drains into the English Channel into an area that drains into the North Sea.
So, using this correct definition of watersheds, it seems to me that this is a good time to wonder whether, or not, the Neil Woodford/Hargreaves Lansdown saga will turn out to be one. Or, more accurately, two – a pre-Woodford/Hargreaves world in which direct private investors’ money flowed in one direction, and a post-Woodford Hargreaves world in which it flows in another.
Let me explain, promptly abandoning my complicated watershed analogy before it starts making any kind of explanation entirely impossible to understand.
Pre-Woodford/Hargreaves, most direct private investments flowed towards star fund managers and star fund management firms. Woodford, first as a manager and more recently also as a management firm brand, has been pre-eminent among these for some years now. But only-slightly less-heroic examples have existed for years among managers – remember Anthony Bolton at Fidelity? Or Bill Gross at Pimco, Bill Miller at Legg Mason, or Terry Smith still flying high at Fundsmith? And among firms, both of John Duffield’s retail brands, Jupiter and New Star, stood squarely for manager-driven outperformance, and today so do boutiques including Neptune, Artemis and Octopus.
Most of these people and most of these firms are, or were, at heart, stockpickers, and their apparent stockpicking successes chimed with what private investors thought – and mostly still think – successful investing is all about: spotting the opportunity that the herd hasn’t noticed, piling in and making a packet when the herd eventually catches up.
Some other characteristics go along with this approach. Funds managed in this kind of way are expensive, because people with these allegedly-exceptional skills don’t come cheap – and anyway the charges don’t much matter given the kind of outperformance investors are anticipating. They’re fairly opaque: lists of their holdings may be visible, but they’re naturally quite hard to evaluate, because by definition they represent the star fund manager’s idiosyncratic views rather than the view of the market as a whole. They’re likely to be fairly concentrated, or at least not very diversified, because they’re limited by the scope of the star manager’s semi-supernatural powers. And, of course, when things are going well they’re likely to be able to point to a wonderful performance record, which proves the ability of the manager and sets the snowball rolling faster and faster down the hill, although when it comes to successful investing a snowball analogy only works if we imagine that snowballs can roll up hills.
When things are going well, those performance records and the individuals and firms achieving them are sure to get a lot of coverage. The firms themselves will bang the drum as loudly as they can, of course – and when it comes to coverage in personal finance media, both online and offline, they’re pushing at an open door. Everyone with a stake in the retail investment industry needs stories of profit and success: they may not sell quite as many newspapers as stories of catastrophe and failure, but they play a vital part in keeping the wheels turning.
And one final point: if you’re wondering how most direct private investors have come to believe that all this is what investing is all about, there’s a simple explanation: they learned it from the professionals. For reasons that could be the subject of a whole other article to do with the commission-driven pre-2014 world of financial advice, for many years the very large majority of investment advisers devoted most of their energies to this same pursuit of star managers and firms, and the results were reflected in the portfolios they recommended to their clients. Since most direct private investors either used to take investment advice, or (in most cases) still do, these professional role models have had enormous influence.
All of which would all be absolutely fine and would all make excellent sense were it not for one small but irrefutable problem: as an approach to investing, it doesn’t work. It’s not a good way – and certainly not the best way – for investors to make the most of their money.
When you think about it, you know all the arguments against it. This piece is not about shady or unethical practices, so I’m not going to touch on those: let’s stick to the mainstream investment considerations, of which the big four are as follows:
- No active manager outperforms indefinitely. The US equity manager Bill Miller achieved fame a few years ago as the only fund manager who had ever outperformed the S&P500 index fifteen years running: then he became famous as the fund manager whose flagship fund lost two-thirds of its value in the sixteenth year.
- Charges really matter. Over, say, twenty years, a difference of 0.5% p.a. can make a difference of well over 20% in the value of your investment. It takes a remarkable – and sustained – stockpicking ability to make up for that.
- By the time you’ve noticed, it’s already too late. If, say, you look for three years’ outperformance to confirm a manager’s exceptional skills, the chances that he or she will achieve a fourth year, let alone a fifth or sixth, are already vanishingly small.
- Diversification works. By spreading your money broadly, you gain far more in limiting the downside than you lose in capping the upside. If you don’t believe me, ask Warren Buffett,
Now of course it would be quite wrong to suggest that these four big, simple, long-established arguments are unknown among private investors, or indeed that there isn’t a large and growing number who fully buy into them and conduct their investing activities accordingly. They aren’t (unknown) and there are (a large and growing number.) The proportion of total retail investments held in low-cost passive funds of all shapes and sizes has been increasing significantly for years.
But it still has a long way to go. Arguably the lowest-cost and most flexible passively managed fund type, Exchange Traded Funds (ETFs) still account for well under 1% of UK investors’ retail investments in the FTSE-100 Index – a clear sign that this kind of investing still doesn’t represent the mainstream. To us retail investors (unlike our institutional counterparts, who are way ahead of us on this), hitching our investment outcomes and our long-term financial prospects to the performance of high-flyers like Woodford is still “proper” investing. Spreading our money across a bunch of very low-cost trackers or ETFs is…well, a bit second-rate, a bit of a cop-out – a guarantee of mediocrity.
Well, if what’s happened to Neil Woodford’s funds in the last year or two is an example of the alternative to mediocrity, then mediocrity is absolutely fine with me. Again leaving aside any rumours of hanky or indeed panky which have been swirling around the funds in the last few weeks, virtually everything that can go wrong with a star managers’ funds has gone wrong with Woodford’s. You can explain the crisis in rational investment terms – too many bad and under-researched stock selections, resulting in sustained poor performance, causing unexpectedly high levels of redemptions, creating pressure to dispose of many of the funds’ more liquid assets, resulting in an increasingly illiquid portfolio, raising eyebrows at the regulator, and so on and so on. But really it’s an emotional crisis, about a man who had too much money to invest too quickly, made a bunch of bad choices and has been chasing his losses ever since.
(A friend looking to finance a high-profile start-up pitched to Woodford in the great man’s firm’s early days. He was looking for £10 million. “I have billions to get away in the next few weeks,” Woodford told him. “For £10 million, I can only give you 15 minutes.”)
Which brings us back to that watershed again. I’m not suggesting that all direct retail investors are on the point of abandoning that quest for the outperforming superstar, any more than I’m suggesting that they’ve all been committed to that quest hitherto. But what I am saying – well, hoping really – is that forces are now at work which will create a New Normal – a change in our understanding of what’s the main thing we should be doing most, if not all, of the time.
And this is the point at which we arrive at a big and unexpected twist in this tale. What, you might be wondering, is that main thing we should be doing? Does it exist? And if so, where is it to be found?
Well, it seems to me that it does very much exist, and it’s to be found on the Internet – where, in recent years, a large tribe of fintech-driven start-ups have been building more or less exactly the kind of service that experienced, active smart direct investors really need: the so-called robo-advisers.
The twist is that very few of the young, entrepreneurial, idealistic teams building these online businesses had this target market – of experienced, active, smart direct investors – in mind at all. On the contrary. They all believed – and many had market research to confirm it – that this market was already very well served. Among suppliers to this segment, one name stood out head and shoulders above the others: it was of course Hargreaves Lansdown.
Challenging this established giant on its own turf seemed like a suicide mission. Instead, the robos concentrated on the next level down on the retail investor pyramid – younger, less experienced, less confident, less affluent people daunted by the jargon and complexity of Hargreaves Lansdown and waiting eagerly for a new kind of proposition which would combine low charges and simple, passive funds.
Somewhere between five and ten years after the emergence of the first robo advisers, we can now safely say that on the whole, this strategy has not worked well. Persuading these younger, less confident people to invest has proved difficult, and horribly expensive. Most robos have found their cost of acquisition far higher, and their revenue per investor far lower, than the numbers in their business plans. A few, especially those set up by big institutions with plenty of other strings to their bow, have already withdrawn from the market. One of these – and, worryingly, one of the few which was able to deploy a fairly chunky advertising budget to support its customer acquisition efforts – was said to have closed its doors having recruited a mere 2,000 customers.
All in all, in terms of business performance, the robo advice sector exists in a troubled and clouded landscape. A new strategic direction – in the words of Star Wars, A New Hope – would be more than welcome.
And amazingly – almost miraculously – here it is. The robos are perfectly positioned to provide a Plan B for plenty of those active, sophisticated former members of the Woodford/Hargreaves fan club (and by clear implication this isn’t just about Woodford, it’s about all those other superstar stockpickers wobbling unsteadily on their perches).
Let’s not get carried away. Even though an awful lot of these people were dreadfully badly guided, and have experienced truly dire performance, I’m not convinced that a large proportion of Hargreaves clients will turn definitively against the firm. Their bond is too strong – and anyway, there are still many who’ve done very well indeed out of Woodford and out of other funds on that HL 150 selected fund list (reduced recently to 60, although inexplicably branded the Wealth 50).
But while they’re likely to keep most of their assets with the devil they know, I’m sure there has never been a better time to make a case for switching at least a proportion into an alternative. And what better alternative than the robo-advisers’ very low-cost, passively-managed, highly-diversified bunches of ETFs?
They’ll need a bit of smartening-up to position them suitably for this segment: a bit less of the Janet-and-John language, a bit more Sharpe Ratios and Efficient Frontiers. But none of that’s hard (or expensive)
And they’ll need some clever marketing, too – marketing that successfully challenges people who are deeply set in their ways, and engages them with the possibility of an alternative. I’m tempted to think that this is one of the very few segments in one of the very few consumer markets where intelligent and considered argument could just be the best way to do it.
If all this is right in the end, and if this is the way the story plays out, it will only serve to demonstrate one of the greatest and most universal of principles in the field of marketing – that 999 times out of a thousand, when you’re trying to establish a new product or service, you have a better chance if you address people who already use existing products or services in your category and so who can recognise the core benefits.
But as proofs of that principle go, it would be an unusually dramatic one.