Responsible Investing Hypocrisy
Socially responsible investing (SRI) continues to gather momentum in the investment industry, and is becoming increasingly popular amongst private investors. The idea is that investors allocate their capital to socially responsible businesses. There is some subjectivity as to what constitutes social responsibility, though ESG scoring (environmental, social, governance) is one widely accepted approach. Consideration can also be given to broad themes such as investing in renewable energy or electric cars for example, or not investing in certain industries such as tobacco, oil & gas, defense, etc.
Since we manage individual portfolios, we engage with our clients individually in this regard, whilst taking an overarching view on the long-term viability of any specific business that we invest in. This is fairly straightforward and for us it makes more sense than taking a one-size-fits-all approach.
But underlying this SRI movement is an incredible hypocrisy. We have an industry that for decades has peddled opaque, complicated, unnecessarily expensive products, riddled with conflicts of interest, now preaching social responsibility to its clients. Many in the investment industry even see SRI as a marketing hook to sell more of the same products:
Fee pressure behind ‘push on ESG’ – FT Adviser (8 Jun 2020)
Firms see embrace of ESG as way to garner more fees – P&I (24 Feb 2020)
There’s also the issue of ESG window dressing to consider – a topic for another day perhaps.
At Bellwood, responsible investing starts at home with the way we treat our clients. There are three major areas where we differentiate ourselves from the rest of the industry: Transparency, cost-effectiveness and alignment of interests. Unless the rest of the industry addresses these issues properly, SRI will be just another marketing smokescreen.
Let’s examine each of these areas and provide practical examples of how they apply in day-to-day business:
Transparency: How many layers are there between you and your money?
For a South African, a typical foreign investment starts with your financial advisor placing your funds on a local platform that invests in a global feeder fund that invests in an offshore fund, very often a fund-of-funds, which invests in several other offshore funds, which finally invest in various stocks, bonds, etc. That puts four or five layers between you and your underlying investments. There are variations on this often featuring asset swaps, endowments, wrappers and other financial products. The result is complexity, lack of transparency, inflexibility, limited access to your funds, and excessive costs.
Here are some questions to ponder: Do you know what your underlying investments are? Do you understand the underlying investment strategy? Does your adviser? Can you speak to the person who actually makes investment decisions? Are you able to access all of your funds anywhere at any time? Do you know what fees you’re paying through all the layers, or do you just see the top layer? Is it necessary to have all these layers between you and your money? Do they add value?
More often than not, many of these layers are sold with only the supposed benefits in mind, and with no consideration of the added costs – call it cost-benefit analysis. When you apply cost-benefit analysis more layers always make sense. It figures.
So how do we do things differently?
For starters we do proper cost-benefit analysis for every potential layer between you and your underlying investments. As a result, we’ve generally found that fewer layers are better. For example: Does it make sense for a private investor to work through a local platform to make a global investment? It limits your investment options significantly, it means that you can only access your funds from South Africa, the platform charges an extra fee, and it automatically adds another layer for the global feeder fund. On the ‘upside’, it means you don’t have to go through the minimal admin of moving your funds offshore, and it provides your adviser with a convenience in terms of reporting, switching funds, charging fees, etc. It really makes more sense for the adviser than the client.
At Bellwood, our clients have their own direct offshore accounts. They can login and view detailed statements of exactly what their underlying holdings are, what transactions/trades have occurred, and so on. They can pick up the phone and speak to or send an email directly to the person who manages their portfolio, who can explain our process in detail (which is also part of our client take-on process), the rationale behind specific investments and transactions, etc. Our clients control access to their own funds without restriction. Our clients pay a management fee to Bellwood, and negligible trading costs to the underlying broker. Simple, transparent, flexible and cost-effective.
Cost-Effectiveness: Do you know what fees you’re actually paying?
Transparency and cost-effectiveness go hand-in-hand. Where there are more layers between you and your money, you will be paying more fees, and often you won’t know about them beyond the top layer because the underlying fees are simply lumped into the daily unit trust prices. With the platform-feeder fund setup described above, it’s common-place to pay anything between 3% and 5% per year once you add the fees for each layer, whereas a more transparent solution should result in fees of around 1% p.a. for a reasonably sized investment. These differences in fees are not insignificant! The following graph shows what $1m dollars invested in the S&P 500 20 years ago would be worth now depending on the fee being charged:
So how do investors wind up paying such exorbitant fees? Often it’s just that the numbers sound small – “0.5% p.a. here, 1% there, 2% for the fund, oh the platform only takes 0.25%” – so nobody really thinks about the impact that these fees make over long periods of time. Often investors don’t know – their advisor charges 50-100bps and they think that’s it.
Sometimes it’s a deliberate marketing strategy, usually in the area of supposed tax benefits (or deferral). This is a trap that catches so many investors and advisors alike because they don’t do the math properly! The tax numbers are big (often overstated) and applied once-off, or simply deferred more often than not. The costs are usually smaller numbers compounded over time, and because they’re small they’re often only mentioned in the paperwork. The headline numbers make for an easy sale. The reality is that in most cases, any supposed tax benefits are far outweighed by the additional costs involved, and they usually come with the added bonus of complexity, limited investment options and restricted access to your money.
We’re not saying there isn’t a place for these types of products, but that all too often these products are sold to investors that don’t need them.
At Bellwood, we do the math. Most of the time the math says the costs outweigh the benefits. But this is something we can assess properly on a case-by-case basis, with due consideration for other benefits and drawbacks, rather than touting some convenient headline numbers to sell a product.
Alignment of Interests: Make sure you’re not being sold!
“Show me the incentive and I will show you the outcome.” – Charlie Munger
The reason there is so little transparency and so much unnecessary expense is because the investment industry is riddled with conflicts of interest. The grotesque reality is that wealthy investors are a huge cash cow around which an enormous industry has been built to collectively milk it. So how do you guard against this? Understand the incentives of the people you appoint to manage your investments.
Here are three common practices to avoid:
1) Commission-based advice: Trusted advisers are the gatekeepers of their clients’ wealth. This puts them in a potentially lucrative position, especially when they have different ways to earn additional fees. Many advisers make their money through upfront and referral fees. If they were government officials it would be called bribery, but in the investment management industry it is fully disclosed and therefor legal and accepted practice. Many product providers will pay advisers large upfront or ongoing commissions (taken from their clients’ investments no less, and disclosed – it’s all above-board) for bringing clients their way. Others will add a small fee on top of their own fee to pay the adviser for the referral. Is this of ‘advice’ independent? Is it any wonder that advisers are all for selling more products and putting more layers between clients and their money?
2) The broker-manager: Stockbrokers generally make their money from brokerage and management fees. They are often given discretion to manage client portfolios as they see fit, and they charge a management fee for that, but they also make money every time they trade for the account. While all will profess to be honest and most probably are, the reality is that such a perverse incentive naturally makes honest people see more opportunities to trade than would otherwise be the case. More trading means more brokerage, which is more cost to the client, but more money for the broker. The number that gets put on the white board at the end of each day is brokerage generated – that’s the target. Portfolio performance is secondary. This arrangement is not in the best interests of the client.
3) Performance fees: Asset managers often tout performance fees as a way of aligning their interests with their clients’. The reality is very different. Performance fees are first and foremost an additional way to make more money – an added fee. Second, because they are generally asymmetrical (if we win we make way more money, if we lose we still make our normal fees anyway) they create an incentive for asset managers to take greater risks that have potential for huge payoffs, but also greater risk of loss. This creates a conflict of interest, not alignment.
What makes us different?
So how to we deal with these institutionalized conflicts of interest at Bellwood? We only charge a management fee and nothing else. We don’t accept referral fees, commissions, upfront fees, brokerage fees or charge performance fees. If you make more money, we make more money. If you make less money, we make less money. This incentivizes us to look for cost-effective solutions for our clients that maximize their wealth instead of looking for product providers that give us the best ‘rebate’. It also incentivizes us to focus on our investment process and generate real returns for our clients. We also invest substantial portions of our own wealth alongside our clients.
Simple, transparent, cost-effective and as aligned as it is possible to be with our clients’ interests – these principles should form the foundation of any credible responsible investing initiative.
Our clients and regular readers will recognize that we’ve invested a great deal into our investment process. We trust that you will recognize that as highly as we prize our professional capabilities, we esteem the value of our reputation and integrity even more highly.
“Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless.” – Warren Buffett