Good Piece on Finance

by Chris Sturr | November 04, 2008

In the UK monthly, Prospect. It covers the whole shebang, from the Efficient Markets Hypothesis to more mundane things like:

A Greedy Giant Out of Control

Jonathan Ford, Prospect, November, 2009

We used to think that finance performed a useful role, shunting capital to the most profitable outlets. Its growth was thus a function of success. But after the crunch, a new generation of critics, such as Paul Woolley, are challenging this thesis

Let’s look more closely at the croupier’s take–the amount raked off each year by intermediaries as investors’ money is shuffled. The starting point is the real returns earned on stock market investments. Of course, those are a bit sick right now, but over the long term they are between 5 and 6 per cent a year.

The first croupier to appear on the scene is not a financier but a corporate executive. In 2002, for instance, the compensation of US executives in the form of share options was equivalent to 20 per cent of reported profits, according to Standard & Poor’s. Bang goes one percentage point of the stock market return, even before the financiers arrive at the table.

Dock another half a percentage point off for the fees paid by companies to investment banks for mergers and acquisitions and other services. Then one must not forget the costs of trading. These include commissions to brokers and stock exchanges, and the “spread” between the bid and offer prices of shares. Take these to be roughly 1 per cent of transaction value in aggregate. Thus, a fund manager with an average holding period of one year (meaning 100 per cent turnover of holdings each year) accrues annual costs of 1 per cent to clients. After this, returns fall to a mere 2.5 to 3.5 per cent.

But things get even worse for retail investors. They must pay up-front charges when buying mutual funds of up to 7 per cent and higher management fees, averaging 1.3 per cent. Then management and administration fees take total expenses to about 2 per cent. In addition there is taxation to consider: in Britain stock purchases attract 0.5 per cent stamp duty and in US mutual funds pay capital gains on their trading profits. Once that lot is taken into account, returns can shrivel to less than 1 per cent.

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