• A new deregulation gift from the Trump administration to Wall Street will hurt workers and increase their support for Trump
• Now private equity funds can prey on pension funds
• A decade ago Warren Buffett exposed the con used by money managers to exploit clients, now confirmed by an Oxford University study
It got little attention in the media, probably because it seems such a boring and inconsequential move. Just another deregulation of a consumer protection rule following a Trump executive order. Previously, pension funds were prohibited from investing in private equity funds; now the Department of Labor says anyone can buy shares in equity funds for their 401(k). David Pears, a former investment banker, tells me the financial advisors are really pushing these for 401(k)’s now.
Yet Another Rapid Upward Transfer of Wealth
Yes, it’s a big deal.
These private equity funds are already billionaire making factories for the managers.
In Financial Advisor Magazine, Tracey Longo describes their success: “The biggest winners have been the founders of Blackstone, Apollo, KKR and Carlyle — the four largest private equity managers. Stephen Schwarzman, Blackstone co-founder, is the world’s 29th richest billionaire with a personal fortune of $17.7 billion, according to the annual Forbes list. Leon Black’s $7.7 billion fortune ranks the Apollo founder at 63rd, while George Roberts ($6.1 billion) and Henry Kravis ($6 billion) come in at 108th and 112th” respectively. David Rubenstein, Carlyle co-founder, is in 275th place with an estimated wealth of $3.1 billion.
Longo quotes Professor Ludovic Phalippou of Oxford University who warns of the creation of even more billionaire on the way from this seemingly innocuous deregulation:
“This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance,”
Private equity funds were created so wealthy people could pool their money for better investment clout. Mitt Romney’s former Bain Capital is one of the best-known.
These private equity funds’ vaunted returns on investment are a hoax. Numerous studies have proved that they cannot beat the return on index funds for average investors. Equity funds tout their ability to pick killer investments that produce high returns to investors. Sometimes they brag about 20% or more per year. Indeed if the calculation is made on a couple of their good years, the data may support such claims. However that intrepid investor Warren Buffett exposed their lie. He challenged any of these fund managers to beat the returns of an index fund over 10 years. Only one dared to take up the challenge and lost.
Buffet reported on the results of his bet in his 2018 annual letter to shareholders beginning on page 12. In his words: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.” [His emphasis]
The situation is not new. There’s an old story called the stockbroker customer yacht story. Its use of ‘customer’ not ‘client’ shows how long ago this deception has been true: A stockbroker took a potential customer to the broker’s yacht club. He proudly showed his potential victim all of his partners’ yachts. The insightful customer asked,” But where are your customers’ yachts?”
Pears confirmed the ethic, “In my entire 35 years management never asked me how my clients were doing. Not once! But every day I got a report on how much I made for the firm.”
In the following years other studies, for example, one by Morningstar, confirmed Buffet. And coincidentally, two months before Trump’s administration made private equity funds available to money managers at pension funds, Phalippou had released an academic study proving, again, Buffet was right. The professor’s title says it better than I ever could: An Inconvenient Fact: Private Equity Returns & The Billionaire Factory
Index Funds: A Strategy Aesop Would Approve
There is no stock picking in an index fund. The ‘index’ refers to any of the stock market indexes such as Standard & Poor’s. If you try to choose the best individual stocks, you’ll probably have some winners and some losers. But if you look at the stock market in general, it usually goes up over time. If you could take a sample of all of the stocks on the index, the winners and losers would cancel out, but you would end up with a net gain. Buy and hold. It’s a tortoise rather than a hare strategy.
You would need a fair sum to buy an adequate sample. I doubt many readers of this article have a spare $50 million or so to properly execute the plan. However, an index fund is a type of mutual fund. When you buy into one, your money is pooled with other members so there’s enough money to buy an adequate sample of stocks on the index. There’s no stock picking; it’s completely passive. Much lower commissions, much higher net returns for you.
Active fund managers charge a 2% management fee, 20% of any gain and trailer fees — extra charges when you sell and want out.
Pears agrees that the active fund fees are excessive. He says, “I rationalized my fees on keeping my clients from making stupid mistakes, not from any brilliance or active management of portfolios.”
Fire All Pension Fund Money Managers
Now, that it has been proven well beyond any possibility of doubt that the fees paid to money managers are a complete waste of money, pension funds should fire all their money managers — but they don’t. In his paper, Phalippou gives one reason: the pension boards are embarrassed to admit they have been conned for so long.
A more urgent reason why worker pension funds should fire their money managers: there is an inherent conflict of interest. The money managers want to make the mostest the fastest for the sake of their commissions. They often invest in corporations that have been taken over by hedge funds. They know that these predators will strip the corporation by paying huge dividends and other tactics that will eventually put the corporation into bankruptcy. The corporate raiders will increase the amount available for dividends by underfunding worker pensions. (Note: they always fund the executive pensions).
The workers then have to make a claim on the state pension funds– which are now in jeopardy. Sears is a recent example where workers’ pensions were sacrificed to dividends. I explain how the hedge funds do this in my article How Greedy Investors Looted Sears into Bankruptcy.
Here’s How It will Hit You
Lawyers, accountants and doctors have a fiduciary duty. It’s a simple concept . They can’t use their professional expertise to take advantage of a client. The professional must put the client’s interests above their own. For example, if an accountant knows that a client does not understand how to read a financial statement and so doesn’t know the true value of their company, the accountant cannot buy the shares of that company below value.
You might expect if someone called themselves a financial advisor, like a stockbroker or a financial planner at a bank, they would have a similar duty — but they don’t. One of the reforms of Dodd Frank had put such a duty on financial advisors — but note this — only when giving advice about retirement investments.
As one of Trump’s first moves, he gave an executive order that led to Congress passing The Financial Choice Act which eliminated even this narrow fiduciary duty. Financial advisors once again have open season on unsuspecting clients. As these ‘advisors’ have no more obligations to you then a used car salesman, they can sell you products that yield the best commissions for them, not the best results for you.
Some financial advisors do accept a fiduciary duty, but you have to ask them if they do. It’s such a minefield that one investment group put out an ebook on how to find a fiduciary in the financial advice field.
One way to check out an advisor: ask them about index funds. If they disparage them, leave!
How It Will Help Trump
The unnecessary management fees, especially the surprise trailer fees, will eat into pension savings so the retirees well have a whole lot less then they could have. But they won’t know that until the distant future; and they probably will never understand how they could’ve had so much more. Even Trump haters will likely never see this upward siphoning of hard-earned income from their retirement savings.
Trump and the Republicans realize the the worse the economic times for the middle and working classes, the more they will blame what they can understand: jobs moving to China and immigrants coming to take their jobs by working for less pay and such.
Reform Won’t Come Easy
Phalippou shows an application of that famous insight by Sinclair Stevens that it’s hard to make a man see something if his income depends on his not seeing it. “Why are trustees, investment teams, external managers, consultants and others not seeing through this? Maybe because their livelihood depends on them not seeing it.” It would be career suicide for them.
What should pension funds and investors planning for retirement do? Buffet gives some sound advice. Here’s from page 20 of his 2014 annual letter to Berkshire shareholders:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers
In spite of the mounting evidence of the uselessness of money managers, pension fund boards are not going to get rid of these money managers. It will take a bottom-up workers revolt. That would take education on these issues — note how that is not happening!
Acknowledgement: Thanks to retired banker and senior OpEd News editor David Pears for his input.
Images from Pexel
Jan D. Weir is a lawyer who has advised international corporations, banks and accounting firms. He has taught business law at the University of Toronto, and is the co-author of The Essential Concepts of Canadian Business Law. Follow him for updates on laws that affect inequality @JanWeirLaw and at and Medium.com.