Someone educate Terry Smith please: quickly?

Smith, chief executive of the money brokers Tullett Prebon, told the Guardian his support was based on similar factors. \”I\’m in favour of some form of Tobin tax. There are elements of financial services that have become over-large and have no social purpose,\” he said.

Smith suggested these areas might include the sale of sub-prime mortgages – \”Broking mortgages to people who can\’t afford to pay them has no social purpose\” – as well as those parts of the City that devised complex derivatives such as collateralised debt obligations. He also suggested that fund managers who track indices have a similar lack of purpose.

Index trackers are absolutely not a group that add no value. They are in fact the group that provide some of the best value to the individual investor: this is an outcome of the eficient markets hypothesis which everyone is so keen to trash at the moment.

Note please that the hypothesis is not that markets are efficient: note also that it is not that markets arrive at \”the correct price\”. It is simply that prices in markets reflect the information available to the participants in the market as to what prices should be.

Yes, this is near tautological which is why there\’s so much puzzlement at those who scream that the EMH is dead, dangerous, the cause of our current woes and all the rest of it.

But a side effect of this EMH is that you cannot, on the basis of anything other than luck and or statistical swings (often very much the same thing), consistently beat the market unless you have information not already known to said market. And individual investors very rarely do have such knowledge.

Which means that attempts to beat that market by such individual investors are doomed to failure. Whether you\’re trying to call it by investing directly in individual stocks or by hiring an expensive fund manager (through actively managed unit trusts for example). Indeed, the dealing costs will almost certainly guarantee that you will lose relative to the market, far from beating it.

Thus, if investing in markets is what you want to do, you\’re best off simply sticking it into an index tracker fund. You cannot beat the market because you don\’t have that extra knowledge: and the fees you will pay on an index fund are lower than on an actively managed one.

All of which leads to: far from index funds being without social purpose they are one part of the investment structure that clearly and obviously has a social purpose.

One might also point out that Terry Smith, as well as not understanding the economics here, should be looking to saving his own arse. A financial transactions tax would kill the money broking business stone dead.

8 comments on “Someone educate Terry Smith please: quickly?

  1. I imagine Terry Smith does know a lot of this. I’ve never managed to work out what would happen if index trackers became a huge proportion of the market, would it mean no share trading and static prices? I guess as the share of index funds rose the market would get less efficient and active traders would do better, hence gain back market share?

  2. Also, I don’t think he is suggesting (at least from the quote here) that the index trackers themselves lack “social purpose” – it’s that fund managers tracking index trackers have no purpose. I would have thought that was trivially true.

    “Broking mortgages to people who can’t afford to pay them has no social purpose”.
    This is also true.

    However, if there _have_ been morons going around selling – to use Bremner, Bird and Fortune’s phrasing – mortgages to “an unemployed black guy sitting on a crumbling veranda in a string vest in Alabama”

    then it is, as you say, a very good idea to have the city spreading that risk. But we would indeed – howls of protest from the lefties notwithstanding – rather that credit was not advanced where it cannot be repaid.

  3. first, I’d be reasonably cautious about piling into Terry Smith – he’s been around the block, he’s got a pretty enviable track record of saying sensible things, and his book “Accounting for Growth” is required reading for stock analysts.

    second, active investment generates an information (pricing) externality that affects capital allocation decisions in the real economy. Index trackers just piggy back on active investors (and, I guess quants). There is a perfectly sensible case for taxing index trackers relative to active, to internalize the externality to active investment, and make it more worthwhile.

  4. Yes, attacking Terry Smith for his financial market ignorance is rather brave.

    On the EMH, it is simply a mathematical fact that the average dollar invested in the market will return the same as the average. What isn’t so discussed is surely the more important point of whether the average return is higher or lower due to active fund managers? A simple correlation of the % shares held by index funds and the market return would probably be negative, after all, given how lousy returns have been for much of the last decade.

  5. “…you cannot, on the basis of anything other than luck and or statistical swings (often very much the same thing), consistently beat the market unless you have information not already known to said market. And individual investors very rarely do have such knowledge.”

    I would argue that you need either knowledge or the ability to do something the average market member cannot do. Which leaves open a back door for small investors, who can trade in stock sizes below most market participants.

    Certainly I managed to average 20% between 2000 and 2007, which may have been luck or a statistical swing, but I would suggest it more likely is because I can take advantage of situations which large funds screen out during their first pass.

    Having said all that, the fact that trackers outperform managed funds on average surely proves Terry Smith is wrong – unless he was criticising the fund manager because all they do is run a computer program and then go to lunch.

  6. Mr Smith proposes a tax on index trackers. Mr Smith is smart. I wonder if he thinks to get more trade if index trackers decline?
    to get a return of 20% you have to be as good as Warren Buffet (congratulations Mr. Potarto). You also have to do a lot of research. If you actually enjoy doing this research then great- run your own portfolio. If you don’t, and you’ve a mere £10000 to invest you’d do better taking say a bar job and investing both the funds and the extra earnings in an index tracker.
    As for sub prime mortgages- are we to have the chancellor decide what is or is not a reasonable risk, so that he knows what to tax? Surely its simpler to insist that the risk stays with the lender. Do that and sub prime mortgages will disappear- as will most of the problems with CDOs- and they will be checked out far more thoroughly in future anyway- the buyers, once bitten, will beware.

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