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Buttonwood

Voice in the wilderness

A veteran fund manager identifies the real sources of long-term returns

Sep 15th 2012







IN A world marked by high-frequency trading and billionaire fund managers, Jack Bogle ploughs an increasingly lonely furrow. He founded the mutually owned Vanguard group in 1974, with a remorseless focus on keeping costs down. Through its index funds, investors can own a diversified portfolio for a fee that is a fraction of a percentage point a year.




Mr Bogle is now 83, and his latest book* echoes many familiar themes (he even reprints a section of this column). But those themes are worth repeating, because they are too often ignored. Investors spend so much time chasing hot asset classes and hot fund managers that they end up buying high and selling low, all the while incurring transaction costs. In Mr Bogle’s words, “investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.”
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Although the cost of an individual transaction has fallen a lot over the past ten years, the volume of trading has risen in tandemso much so that Mr Bogle reckons Wall Street’s total commission revenues have doubled over the past decade. In aggregate, this reduces investors’ returns.




Small investors face a “double agencyproblem. Their money is entrusted to mutual-fund managers who place the proceeds with corporate executives. Those mutual-fund managers are pretty poor stewards, rarely voting against the actions of executives. And they have an incentive to expand the amount of funds they manage, even though such expansion has not benefited their existing investors.




The assets of the mutual-fund industry have risen from $5 billion in 1960 to $6 trillion at the start of this year, but the annual expense ratio of the average equity fund has risen from 0.5% to 0.99%. If economies of scale have been achieved, they have not been passed on to the individual investor.




Mutual funds turn over their portfolios more frequently than in the past. They are also more volatile. Neither attribute seems particularly beneficial for their clients. The proliferation of new funds lures investors into chasing star managers—with disastrous results, since investment performance tends to revert to the mean. Between 1997 and 2011, the average equity mutual fund returned 173.1%; the average investor (weighted by dollars invested) earned just 110.3%.



A further problem is that investors overlook the fundamentals. Mr Bogle distinguishes what he calls the “investment return” from equities, which is the initial dividend yield plus earnings growth, from the market return to shareholders.The difference between the two is driven by the change in valuation (which Mr Bogle dubs the “speculative return”) as investors become more or less optimistic about the outlook.


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In any given year, the market return and the investment return can be a long way apart: the gap for American equities was over five percentage points in 105 out of 125 years of trading. Over much longer periods, however, this gap tends to narrow.




In the 1970s, for instance, the investment return was much higher than the market return, as the oil shock and the subsequent years of stagflation caused a stampede out of equities. The 1980s and 1990s saw a boom in which share prices rose much faster than dividends; the market return was higher. In the first decade of the new millennium, the trends reversed again. But over the 40 years as a whole, the difference between the two returns was just 0.3 percentage points—the speculative element was virtually non-existent.



The American pension-fund industry has been particularly bad at understanding these long-run fundamentals. Many schemes assume, on the basis of past performance, a return of 7.5-8%, a figure that is highly implausible given the current low yields. (By contrast, in 1981, when Treasury bonds were yielding 13.5%, pension funds assumed a future annual return of just 6%.) Such rosy assumptions allow schemes to stint on their contributions, building up huge future risks.




Meanwhile, many employees in the private sector have been switched into defined-contribution schemes, where their retirement income is dependent on investment performance. But employees are not saving enough, are not allocating their portfolios efficiently and are incurring too many costs. It is hard to disagree with Mr Bogle that the “system of retirement security is imperilled, heading for a serious train wreck.” But will anybody listen to him, when they haven’t in the past?



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* “The Clash of the Cultures: Investment vs Speculation”, published by John Wiley & Sons




September 13, 2012 8:02 pm
 
China is losing its manufacturing lead as a production hub
 



China’s leaders are in the throes of an unusually edgy transition. So is the economy. Whether it has a “hard” or “softlanding, China is bound to become less investment and credit-centric. As the country ages and reaches the limits of physical labour and capital accumulation, its growth model will have to shift towards transformative technology and innovation.



Well-known stresses in the current model are becoming more apparent, including a downturn in total factor productivity, which is the vital, unmeasurable part of economic growth resulting from technological change and institutional efficiency. The transition will require difficult political reforms and an effective response to the competitive threat posed by advanced manufacturing, which is slowly tilting advantage back to the US in particular.



China’s attraction as a global manufacturing base has not worn off yet, but several developments are chipping it away. At home, these include rising labour costs and skills shortages, as well as discriminatory application of the policy of indigenous innovation, insecure intellectual property rights, weak rule of law and the stifling impact of state-owned entities on enterprise.



By contrast, the US is a clear leader in top-end manufacturing, the creation of “smartcompanies and in intricate touchscreen technologies. Even more important will be its competitive advantage in new shale oil and gas extraction technologies, and in the development of so-called additive manufacturing, or 3D printing, which is set to change the way we think about manufacturing.



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Additive manufacturing allows companies to produce locally and respond quickly to changes in demand, without holding large inventories. The advantages of flexibility and of proximity to one’s market and centres of technological excellence may then outweigh those of offshoring, and large-scale process manufacturing. These have made China the hub of global production, but its position is under threat.



Even if China matches advanced economies in additive manufacturing, it may no longer make sense for foreign companies to incur the cost of shipping raw materials and components in, and products out, over long distances. Shenzhen’s assembly lines, supply chains and economies of scale will be out; Silicon Valley’s knowhow, its integration of research and development with production, and its emphasis on marketing, sales and value extraction, will be in.



China’s competitive advantage in low labour costs is already being eroded; and its artificially low cost of capital and of borrowing will end if economic rebalancing is successful because of financial liberalisation.




Reverse offshoring” will follow, because additive manufacturing lowers all costs of production, from capital, labour and other inputs to packaging and distribution. Companies will want production to be close to design and to customers. Quality-control, protection of intellectual property and “after service” such as consulting and maintenancenot China’s strengths – will be even more important.



China’s manufacturing strategies will have to get smarter. Its 13 per cent of global R&D spending and prowess in incremental process innovation will have to focus more on product innovation, management organisation and the fusion of new information, biological, and materials technologies. Its prominence in patent registrations masks weakness in indicators such as cited patents. Chinese scientists and engineers are prolific, but their work is often viewed as a triumph of quantity over sometimes dubious quality.



It may be hard to overcome these shortcomings, which are rooted in a tradition that has rewarded good administrators over freethinking innovators, and made it hard for individuals to exchange ideas. It has also discouraged the curiosity, critical spirit and collaborative approach that are the hallmarks of advanced manufacturing.



These problems will not retard Chinese innovation and technological competitiveness forever. But to adapt, China requires extensive political reform, more robust institutions and a tilt in the role of the state towards supporting enterprise. It will not be helped by the uncertainty over the nature of its downturn and the consequences of the leadership change.




The writer is an economist, consultant to UBS Investment Bank and author of ‘Uprising: Will Emerging Markets Shape or Shake the World Economy?’


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Copyright The Financial Times Limited 2012.



America and the Middle East

Murder in Libya

The world’s policeman must not retreat from the world’s most dangerous region; indeed America should do more

Sep 15th 2012
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FOR many Americans the killing of Christopher Stevens, their ambassador to Libya, this week crystallised everything they have come to expect from the Arab world. In a country where the West only last year helped depose a murderous tyrant, a Salafist mob attacked the American consulate in Benghazi, killing Mr Stevens and three colleagues. The trigger for this murder, the riots in neighbouring Egypt and the storming of the American embassy in Yemen? A tacky amateur video about the Prophet Muhammad that the Obama administration had already condemned. Why on earth, many Americans are asking, should the United States try to police a region, when all it gets in return is mindless abuse, blame for things it cannot control, and mob violence?



The slaying of Mr Stevens is hardly the only recent example of Arab dysfunction. Just to take the seven days prior to the killing: in Iraq scores of people were killed in bombings on one day and the vice-president was sentenced to death in absentia for alleged murder; in Yemen the defence minister survived an assassination attempt; in the Gaza Strip Israel killed six militants; in Tunisia extremist Salafists smashed up a bar that serves alcohol to the town where the Arab spring began; and most graphically of all, in Syria the death toll in the gruesome civil war continued to rise exponentially—to over 25,000.


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On the campaign trail Mitt Romney has been clobbering Barack Obama for being too keen on the Arab awakening. Many conservative Americans associate it with hostile Islamists, like the Muslim Brothers and their friends who now run Egypt and Tunisia, and see it as a threat to America’s ally, Israel. Americans of all sorts are nervous about being dragged into Syria and worried about Iran getting the bomb. They are fed up with being described as anti-Islam when their country is in fact far more welcoming to Shia Muslims than, say, Sunni Saudi Arabia is. With their troops now mercifully out of Iraq, their efforts to push the Israeli-Palestinian peace process going nowhere and shale gas reducing their dependence on Arab oil, surely it is time for them to leave the world’s least grateful people to make a mess of their lives by themselves?




This is a seductive narrative—and no doubt it will play even better on the campaign trail after Mr Stevens’s death. But it is deeply wrong in both its analysis and its conclusions. Many parts of the Arab world are in fact heading in the right direction. And in the parts that are not, notably Syria, the United States is more needed than ever.



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From one lunatic to another




Begin with the killing of Mr Stevens. Armed jihadists were involved, but other aspects seem more accidental than symptomatic. One misguided extremist in America made the video, and another lot of misguided extremists in the Arab world picked on it. Far from encouraging the violence, the Libyan government deplored Mr Stevens’s murder (though Egypt was less clear) and Libyans mourned a popular ambassador.




This underscores a much bigger point. The Arab spring, for all its messiness, is still broadly moving in the right direction. In Tunisia, Egypt and Libya tyrants have been replaced with democratic governments. These are more hostile to Israel than some of the dictators were, but just as in Turkey greater sympathy for the Palestinians reflects popular opinion (as democracies tend to). The Muslim Brothers hold unpalatable views on women, education and much else, but in government they have had to temper them because voters want jobs and bread on the table more than they want sharia law.




It will take many years, but these democracies promise eventually to embrace a style of government that is more like Turkey’s moderate, democratic Islamism than Iran’s harsh theocracy. At that point America would be spared its outsized role: Turkey and Egypt could emerge as effective regional powers and the Arabs could take moreownership” of their problems.




But until then, America will remain essential to progress. Libya’s relative success, despite the murder of the ambassador, was largely thanks to American firepower at the start of the campaign against the Qaddafi regime. It was the State Department, in effect, that told Hosni Mubarak’s people that the game was up in Egypt. America is needed to put more pressure on the Gulf monarchies it supports to loosen up their political systems.



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And in the nascent Arab democracies, it can give vital economic support. Unemployment is rising in Egypt, Tunisia and Libya, as governments struggle to replace the crony capitalism of the dictators. Small amounts of aid, especially if it is contingent on economic reform, could make a huge difference. If the Arab economies fail, the cost to the world of ever more angry young men being turfed out of work could be immense.



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From Tehran to Damascus





Helping the Arabs sort themselves out is not naive do-goodery; it is rooted in Kissingerian realpolitik. The Middle East is still the crucible of Islam: so much that affects American diplomacy around the rest of the world, from Pakistan to Indonesia, Nigeria, and even the suburbs of Paris, has its starting point here. It is the world’s energy centre: the Middle East still sets the price at America’s petrol stations (something that could be rapidly proved if Israel attacks Iran). And the region is home to many of America’s most committed enemies, including Iran.




In general, America should do more in the Middle East, not less. Two issues look especially neglected because of American domestic politics. One inevitably is the Israeli-Palestinian dispute. The Palestinians are themselves divided; but America should vigorously point out that each new (illegal) settlement that Israel builds in the West Bank makes it harder to make peace between Jews and Arabs. The conflict still enrages much of the region. Mr Romney’s electioneering on this, as on bombing Iran, has been especially crude.




The other issue is Syria. The number of dead is rising by as many as 200 a day, as fast as in the worst period in Iraq. So long as Bashar Assad remains free to kill with impunity, the slaughter will devour Syria and its people, sectarian hatred will eviscerate the country and its institutions and Syria’s poison will spread across the Middle East. Even now Jordan and Lebanon are under threat.




As our briefing this week makes clear, there is an alternative: to protect the Syrian people by enforcing a no-fly zone over their country. It is far from an easy decision, but depriving Mr Assad of his aircraft and helicopter gunships could save many thousands of lives. Bringing a swifter end to the fighting could yet give Syria a chance to emerge as a nation at peace with itself and its neighbours.




In the week of Mr Stevens’s killing, the idea of intervening in yet another Muslim country might seem far-fetched to many Americans. But if they think that today’s Libya is dangerous and violent, imagine what it would have been like were battle still raging. The humanitarian and strategic costs of standing back from Syria would be even higher.



So it is with the entire Middle East. Ultimately, anti-American violence thrives under the tyrants and the dictators. Because the Arab spring promises to put the Middle East into the hands of the people for the first time, it offers a better future. There are no guarantees, but America has everything to gain from being at the heart of this great awakening.




How long before money collapses and what will it mean for gold?

Julian Phillips argues that, while developed world economies will prevent the global monetary system from a total collapse they will, in the end, once more fully harness gold.

Author: Julian Phillips

Posted: Thursday , 13 Sep 2012
JOHANNESBURG (Gold Forecaster)







The Current Scene
 
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Since 2007 and the start of the "credit-crunch" the developed world's money system has been under stress. As a consequence, there has been an economic downturn that government and bankers have not been able to stop, convincingly, in the last five years.
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The developed world has decayed to the point that it can't handle another major crisis such as an oil price well into the $100+ area.
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Food inflation, now threatening, must not be allowed to take off because consumer/voter reaction will undermine government and money still further.
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As it is confidence in both the euro and the dollar is at a low ebb. Yes, it is still the only means of exchange and it can be forced onto citizens, but general confidence in the economy, the monetary system and a broad range of markets is suffering as never before.
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There are bright sparks of hope, such as the Dow Jones Index returning to the highs it saw in 2007; however, this is by no means in the same investment climate as before the credit-crunch. Fear and instability pervades most markets as faith declines.
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Daily we see another Eurozone crisis unfold casting doubts on the continuance of the euro and the financial credibility of its weaker members. Overall, on both sides of the Atlantic, consumer confidence continues to fall after so many efforts by central bankers to resuscitate their economies.



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Why is so large a burden being put onto the central bankers, who should only really support governments' actions? Because the U.S. government is mired in political gridlock, it cannot achieve the vigorous action needed to do all it can to restore growth and confidence, and doubts now remain as to whether it's too late for any government to do so.
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Forecasts of a dollar decline are seen daily as its debt levels mount to new, unacceptable highs. With the impendingfiscal cliff' on the horizon and promises of a heated political battle, consumers and companies expect a savage tax blow around year's end, further damaging consumer confidence. Will we see a recession in the States next year? It seems likely. Its timing could not be worse.

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In the Eurozone, we daily see discord between citizens of the financially stronger nations and the weaker ones. Government discord is constantly apparent. Growth is proving even more elusive in the world's biggest trading bloc as it stands in a mild recession already.
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Hope springs eternal, but today, realities keep hope on the run.
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Can the Money System Collapse?
 
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The thought seems unrealistic to people because it's what we use every day. But the money we use is entirely reliant on government and its central bank. If their performance does not meet the criteria required by money then confidence in that money will collapse eventually. It's clear that all currencies are not performing well at the moment as the balance sheet of most nations (except China) gets weaker and weaker. If most nations were individuals, then they would have been bankrupted by now.
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A look back in history shows that not one paper currency system has lasted throughout the centuries, with the exception of those based solely on gold and silver which remain as money assets all the way.

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Not today, you may well answer! We say oh, yes, today too. Despite all the rhetoric since 1971, gold remains in the bulk of the world's leading reserves for that rainy day when something else is needed other than the currency issued by the nation's central bank.
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How Does Money Collapse?
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Look back at Argentina in the 1990's and you see it using the U.S. dollar, but the economy of Argentina could not support the use of the dollar so it reverted to the Peso after savaging its citizen's dollar savings in exchange for that Peso. That was a ‘collapse' of their currency. If the Greeks return to the Drachma or the Spanish the Peseta, we will see a similar scene; it will be a collapse of their currency (the euro) inside their nation.
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Can the dollar collapse? Because it's a government-controlled money system, the dollar will remain the means of exchange it is, even in a collapse.
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A collapse will be expressed in several ways:
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Its exchange rate against other currencies can fall heavily. In the case of the dollar as the world's foundation, un-backed currency, this is unlikely as it supports the un-backed currencies across the world indirectly. Its trading partners will try to pull their currencies down with it so as to protect their trading with the U.S. The same applies to a greater or lesser extent with the other main trading blocs of the world such as the Eurozone and China. You will have noted the narrow trading range of the euro and the dollar between $1.21 and $1.45 over the last few years. This is because of the mutual support between the Fed and the ECB by way of currency swaps.
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It can collapse inside the country, as its buying power declines rapidly. This is monetary inflation usually caused by the over-issuance of a currency.
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Another form of collapse could include a bond market collapse where the markets push interest rates up so high as to make it impossible for governments to repay debt. This level is generally set at 7% and we have seen it in the P.I.G.S. nations of the Eurozone over the last three years. If these countries had separate currencies, they would have collapsed, but inside the euro we see that that final collapse will be expressed by exiting the Eurozone and returning to past currencies.
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In a nation where there is still a working economy, a collapse can also be expressed by the imposition of Capital and Exchange Controls, restricting the flows of money in and out of a country to protect the capital inside its borders. Its citizens usually bear the brunt.
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Can the Global Monetary System Collapse?
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We're of the opinion that even if the system is hobbling along, it will continue until global economies collapse. This was the case in Zimbabwe in the last decade. The Zimbabwe dollar continued in use because the government enforced its use inside its borders. But to all intents and purposes, it had collapsed long before then. In the case of Zimbabwe, the U.S. dollar became the currency of trade in the country and in what's left of its economy. This is still the case today.
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Before any such collapse occurs, we are certain that each individual developed world economy would cooperate with each other to take whatever measures are available to them to shore up the monetary system. These measures will prevent the system from a total collapse, keeping it staggering on all the way. We believe that they will fully harness gold then.
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The questions remaining are how and when.

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Julian Phillips is the founder of www.GoldForecaster.com and www.SilverForecaster.com