Why Active Investing is a Negative Sum Game

In this article well known academics Eugene Fama and Kenneth French reflect on Nobel Laureate William F Sharpe’s 1991 article on the arithmetic of active fund management. This has already been discussed on this blog and you can see a copy of that article here

Cutting through the slightly complex jargon that is used by Fama and French,the essence of what they are saying is that the combined portfolios all active investors have the same weighting in shares as the market as a whole. This means that the combined portfolios can only perform the same as the market, less their costs. It also means that the only way in which an active investor can outperform the market is to do so at the expense of other active investors.

In contrast, passive investors also all hold the same weighting in shares as the market as a whole. This means that their portfolios should perform the same as the market, less their costs. However, as their costs are less than those of active investors, passive investors as a group must outperform active investors.

This article does not seek to deny that some active investors do outperform the market. It is just that their gains have been made at the expense of other equally clever active investors. Other research has shown that winners tend not to repeat and that on the whole, they do not tend to remain winners for very long.

When considering whether to invest actively or passively you have to answer the question ‘Are you feeling lucky?’ For active investors the answer must be ‘Yes’ – in the face of the evidence. For passive investors the answer is ‘No – but at least I will be assured of returns that essentially replicate the market less my costs which are substantially less than for active portfolios’.

From a financial planning point of view, investing should not be seen as a game. Investments are not an end in themselves. Instead they are the means by which individuals fund for the serious financial goals, which they need to achieve in order to lead the future lifestyles that they desire. Speculation on which fund manager is likely to provide better returns than another, in the face of evidence that this is likely to be an unsuccessful strategy, has no place in this process.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Importance of Costs

In this article Morningstar have coommented on the importance of costs on fund performance. This is a subject about which I have made a number of posts (see: Hidden Cost of Investment posted here in March 2008.

Investors should be wary of excessive costs. Not just the TER (which is the total published expenses of the fund) but also the effect of portfolio turnover as this is not disclosed in a way that is easy for most investors to understand and can act as a significant break on performance.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Half of all UK adults are making no retirement savings

A recent survey commissioned by the BBC suggests that half of all UK adults have made no pension savings. Only 36% of under 30’s make any contributions and only 45% of 41 to 65 year olds contribute. Most cite lack of affordability but others expressed concerns about pensions given recent stock market falls and the well publicised failure of companies such as Equitable Life.

This is not as straight forward as it seems. For many on low earnings it is arguable that they are quite right in not making private pension contributions as this is simply likely to tip them over the threshold for state benefits of far greater value than the pension which they will receive. The UK government has tried to remedy this effect by introducing Pension Credits. You can find our more about Pension Credits here If you know what your expected private and state pensions are, you can can obtain an estimate of your entitlement, if any. It would be sensible for anyone on low earnings who is considering making private contributions to check whether they will actually be better off.

The FSA consumer website Moneymadeclear also provides a great deal of useful information, not only on pensions but other aspects of financial planning.

Whilst I recognise only too well that younger people can only afford very limited contributions, it is worthwhile mentioning that if an early start can be made with retirement planning a respectable level of retirement income can be built up at an affordable contribution rate. The opposite is also true. If contributions are left too late, it will be nearly impossible to make them up. In this table the FSA have shown estimates of the levels of pension which can be expected given different levels of contributions and starting ages.

For example, a 20 year old contributing £50 per month could expect a pension of £238 per month when they retire at 65. They would need to live just under 8 1/2 years after retirement (i.e. to age 72 1/2) which is within most people’s life expectancy, i.e. they are likely to get their money back.

Of course, other assets can be used such as properties and business sale proceeds. These need to be factored into retirement planning. The key word here is ‘Planning‘. In order to ensure that you are able to achieve the level of income in retirement which is needed to maintain your standard of living, you need to have a plan which is updated regularly. The plan should be based on cash flow modelling as this is the only effective means of analysing the impact of different types of assets as well as changing levels of requirement.

Government Restricts Higher Rate Relief on Pension Contributions

In today’s Budget the Chancellor has restricted higher rate tax relief on employee contributions to pensions where the employee earns £150,000 or more and makes annual contributions of £20,000 or more.
For further details see this

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Government Restricts Higher Rate Relief on Pension Contributions

In today’s Budget the Chancellor has restricted higher rate tax relief on employee contributions to pensions where the employee earns £150,000 or more and makes annual contributions of £20,000 or more.

For further details see this

Good news ISA allowances have been immediately increased to £10,500 for the over 50’s and for everyone from 6th April 2010.

Is Higher Rate Tax Relief On Pensions Under Threat?

A number of commentators have suggested that The Chancellor will abolish higher rate tax relief on pension contribution in The Budget on 22nd April.

Financial Times

Yahoo Finance

These could just be ‘buy now while stocks last’ rumours but there may be some truth in them, given the financial pressure, which the government is under.

If in doubt, it would make sense to bring forward contributions to prior to the Budget. It is unlikely that any changes will be retrospective but this can not be ruled out.

If tax relief is removed, this should not be a reason to stop making savings for retirement. After all, at some stage, like it or not, employment and the earnings associated with it will cease. When that day comes, there needs to be a replacement source of income. This does not just need to be provided by way of a pension but as long as there is some tax relief on contributions they probably have the edge on other methods of saving. See my last blog for more information on this.

Can investors trust what they don’t understand?

In this video Tim Haywood, chief executive of Augustus Asset Managers argues that investors should place the same level of trust in fund managers as they do in manufacturers of high performance cars. In essence, do not try to understand what goes on under the bonnet.

In general derivative based funds, using options and futures and other complex financial instruments are difficult to understand for most investors and it is arguable that even the fund managers do not exactly know what levels of risk they are entering into. In addition, many tend to be based in offshore locations and lack proper transparency.

Are Pensions Not Fit for Purpose?

In this Article published on Citywire Lucien Camp argues that pensions are not fit for purpose. He suggests that there is a birth date lottery, which affects the level of income, which you can expect when you retire. He implies that a tax free savings vehicle such as an Individual Savings Account (ISA) would be a more effective method of retirement saving. He also suggests that their annual contribution limits are more than enough to cater for most people’s funding needs. Let us examine whether either of these propositions is actually true.

Before doing so, it is worthwhile comparing the two types of arrangement:

Pension Contributions: Paid net of basic rate tax relief at source. Higher rate tax relief is also available. This means that basic rate taxpayers pay 80p for every £1 invested. Higher rate taxpayers only effectively pay 60p for every £1 invested. Respectively they have immediately made a 20% and 40% return on their contributions.

ISA Contributions: No tax relief is granted. Contributions are paid out of income on which tax and National Insurance have already been paid.

Pension Income: Taxable. Paid net of tax at your highest rate.

ISA Income: Tax Free.

Access to capital: Pensions – 25%; ISAs – 100%

Which will provide the better retirement income?

Let us consider, given the same cash outlay by a basic rate taxpayer, which of the two is likely to provide the greatest income on retirement at age 65. For this purpose, I have assumed that the full value of the pension or ISA fund would be used to provide an income. In both cases the fund has been assumed to grow at the same rate (a conservative 5% pa), since the same investment choices are available to each. Contributions of £7200 (in terms of the cash paid out by the pensioner) have been assumed to be made for 20 years. This means that the pension contributions will be increased by tax relief to £9,000 per annum. The ISA investments will be £7200 per annum, as they do not benefit from any tax relief.

In the case of the pension fund, I have assumed that a level single life annuity payable for a minimum of 5 years (even if the pensioner dies) is purchased. For the ISA I have assumed that the fund would be run down over 25 years (i.e. until the pensioner is aged 90, by when most people have probably died).

When the pensioner is aged 65, he/she will have a pension fund of £297,593 or an ISA fund of £238,074. This represents a difference in the accumulated fund of £59,518.

The pension income would be £21,027 per annum gross, based on current rates. After tax, a basic rate taxpayer would receive £16,821 per annum. The ISA fund would provide a tax-free income of £16,087 per annum. The pension income would be guaranteed for the life of the pensioner, however long they live and would not be dependent on future investment returns. The ISA income would be dependent on both the future growth of fund and the life expectancy of the pensioner. If investment returns are less than I have assumed or, should the pensioner live more that 25 years after retirement, the ISA income may be reduced or stopped.

In this example the pension income, which is payable for life would exceed the ISA income by over £700 per annum. If the pensioner were a higher rate taxpayer whilst they worked and a basic rate taxpayer in retirement, the difference would be £1847 in favour of the pension fund. This assumes that they make pension contributions, which ultimately net down to £7200 per annum.

Note that non-taxpayers still benefit from basic rate tax relief at source on pension contributions although they may only pay £3600 per annum (equivalent to £2880). It is also possible to provide for a fully inflation proofed retirement income or draw an income from the pension fund (i.e. similar to that assumed for the ISA) instead of buying an annuity.

The conclusion as to which can provide the best level of retirement income, all other things being equal is that a pension fund is likely to beat an ISA in most scenarios. This is without taking into account the fact the pension funds sit outside your estate for inheritance tax purposes and are not accessible to creditors, should you become bankrupt. Bear in mind, despite the adverse and ignorant press to which they have been subjected, that pensions are designed to provide a retirement income. Their tax breaks give them the edge over ISAs. This is not to say that ISAs are not useful. They are more suitable for medium to long-term savings, perhaps to meet a specific objective, such as education funding. In reality the perceived flexibility of full access to the capital is somewhat illusory because if fully encashed and spent early on in retirement, there will be nothing left to live off later on.

Are ISA maximum contribution limits sufficient for most people’s needs?

In order to examine this it is necessary to factor in the effects of inflation. If inflation of say 3% per year is deducted from the assumed investment return of 5% per annum, this gives a ‘real’ return of 2% in round terms. On retirement, the ISA would generate an income in today’s terms of £8478 per annum. The average wage in the UK to April 2008 equated to £24,908. This means that the prospective ISA income amounts to just over 35% of pre-retirement income. It also assumes that on the above level of earnings the pensioner was able to fund ISA contributions of £7200 per annum, equivalent to 28.91% of earnings.

Assuming that the same person instead pays £7200 net into a pension fund, on retirement they could expect a real income of £9884 if they are a basic rate taxpayer whilst working and in retirement. If they were a higher rate taxpayer, obviously earning more than average earnings, their real income in retirement would be £13178 per annum.

It is obviously somewhat improbable that a person on average earnings will be able to afford maximum annual ISA contributions. However, this illustration has shown that for a person on average earnings they are unlikely to provide a pension that is anywhere near previous earnings.


In both of the above examples (where the same investment return assumptions have been used for both pensions and ISAs), pension arrangements appeared to be the most effective method of retirement funding. On balance, if funding for retirement, a pension should be used. If funding for a medium to long term financial objective an ISA would probably be more suitable since all of the proceeds can be accessed.

The Arithmetic of Active Management

In the video featured below, Professor Kenneth French mentioned the paper written by Nobel Laureate Economist William F Sharpe. Well here it is.

This type of information needs to be seen in a completely different light to what those of us who are more enlightened call financial porn because it is the informed view of a very highly rated and acclaimed academic. Unlike fund management companies who pump out marketing material designed to entice unwitting investors to part from their money William F Sharpe and others like him have spent decades trying to get to the truth. They have no axe to grind.

The question you have to ask your self is, Do you want to be one of the (as William F Sharpe puts it) “individual investors … foolish enough to pay the added costs of the institutions’ active management via inferior performance“. Of course there is also the famous Dirty Harry saying “What you want to ask yourself is … Are You Feeling Lucky?

For more information on William F Sharpe see this