John Clifton Bogle, who died recently at the age of 89, may not have been a household name in Britain, or even in his native country, the United States. But he was a true legend in the world of investing.
Better known as Jack, Bogle founded the investment company Vanguard in 1975. That same year he also introduced the first index fund for ordinary investors. They called it “Bogle’s folly” at the time, and commentators doubted it would ever take off.
But Bogle stuck to his guns, and index funds eventually changed the face of investing. As for Vanguard, it’s now one of the largest investment companies in the world, with $5 trillion under management.
Jack Bogle could have been one of the wealthiest people on the planet. But he chose a mutual ownership structure for Vanguard, which instead of enriching shareholders, drove down costs for investors.
Millions of people are considerably better off today than they would have been without him. Bloomberg estimates that, over the last 45 years, Bogle has saved Vanguard investors $175 billion in fees. Add to that the money he saved for customers of other firms that lowered their fees to compete with Vanguard, and the total must run into trillions.
To quote the financial blogger Morgan Housel, Bogle is the biggest undercover philanthropist of all time.
But perhaps Jack Bogle’s biggest legacy is his intellectual honesty. He told investors the truth — that low-cost index funds are the best way for most of us to invest.
In The Little Book of Common Sense Investing, he wrote: “Simply buy the entire stock market. Then get out of the casino and stay out. “This investment philosophy,” he went on, “is not only simple and elegant. The arithmetic on which it is based is irrefutable.”
Bogle is perhaps best known as an advocate of low-cost passive investing. “The iron rule of the financial markets,” he once said, “is reversion to the mean.” Simply by the law of averages, there will always be active fund managers who have outperformed the market in the short term. But, over the long term, only a tiny fraction of them are able to beat it after you factor in the costs of using them.
Yet Bogle also liked to remind people that fees and charges aren’t the only reason why investors fail to achieve their goals. They are often undone, he warned, by their emotions and by acting on impulse. Investors, he said, need to put their emotions to one side, have rational expectations for future returns, and avoid changing their strategy in response to market noise.
Jack Bogle’s honesty and professional integrity didn’t exactly endear him to Wall Street. In one of his later books, Enough, he wrote: “On balance, the financial system subtracts value from society.”
But, towards the end of his life he repeatedly expressed a hope that things will change, and that the financial industry will one day become a profession.
“No matter what career you choose,” he urged readers of Enough, “do your best to hold high its traditional professional values, in which serving the client is always the highest priority.”
Bogle then quoted the English Quaker William Penn, founder of Pennsylvania, the state he loved and lived in: “We pass through this world but once, so do now any good you can do, and show now any kindness you can show, for we shall not pass this way again.”
Jack Bogle may have gone, but his legacy lives on. He truly was the man who changed investing for good.
In this report, we look at the recent risk-return performance for a broad range of asset class exposures for GBP-based investors, as represented by our selected indices for each exposure.
The objective of the report is to show the historic 1 year and 3 years risk-return characteristics of the investment opportunity set available to multi-asset investors when constructing portfolios.
Get the full report here
The absence of a clearly defined plan for Brexit is creating damaging uncertainty for businesses and the markets.
Leaving the EU, but remaining in the EEA through EFTA would address the concerns of the majority of Referendum voters, whilst also requiring a spirit of compromise from both sides.
Joining EFTA would immediately provide the UK with continued free trade within the EU/EEA, a more valuable set of external Free Trade Agreements, and the added flexibility to negotiate its own free trade deals bilaterally.
Setting a timetable for re-joining EFTA provides a straightforward solution that will give the necessary confidence and direction to businesses and the markets whilst respecting the outcome of the EU Referendum.
This paper, drafted for but not published by the Centre for Policy Studies in July 2016, sets out the rationale for Britain in EFTA or "BREFTA" and calls for greater engagement with the "C10": the largest ten Commonwealth economies.
The broker and fund platform Hargreaves Lansdown has just brought out a list of recommended funds called the Wealth 50, which has received plenty of attention in the financial media.
HL used to have a larger list, the Wealth 150, but the list been gradually shrinking. The number of funds has been whittled down further and there are now 60 of them.
The company says that the funds have been selected after quantitative and qualitative analysis by its in-house research team. It has also negotiated lower charges for its clients. Wealth 50 clients will save, on average, 30% on ongoing charges, with the cheapest actively managed fund carrying an annual charge of 0.22%.
We lead such busy lives that when we’re offered a short cut, something that saves us time and effort, we generally like to take it, and that’s precisely why companies such as Hargreaves Lansdown produce these sorts of lists.
But are recommended fund lists, or buy lists as they’re sometimes known, really of any benefit to investors? Research by the Financial Conduct Authority, showed they can be very misleading. In its interim report on its study into competition in the asset management industry, the FCA reported that most funds on these lists fail to beat the market and that firms that publish them are often biased towards their “own brand” funds.
We shouldn’t be surprised. Academic research has consistently shown that, in the long term, only a tiny fraction of funds outperform the market on a cost- and risk-adjusted basis. Dr David Blake form Cass Business Buisness School puts the figure at around 1%. What’s more, he says, future outperformers are impossible to identify in advance.
The difficulty of identifying future star managers ex ante was highlighted in a paper published last summer, Investment Consultants’ Claims About Their Own Performance: What Lies Beneath?. It was authored by Tim Jenkinson and Howard Jones from the University of Oxford’s Saïd Business School, Jose Vicente Martinez of the University of Connecticut and Gordon Cookson from the FCA.
The researchers looked at the performance of funds recommended by investment consultants between 2006 and 2015. Once fees were factored in, they discovered, the funds that consultants didn’t recommend subsequently delivered better performance than those they did recommend.
We simply don’t know how long the 60 funds on the Wealth 50 will remain on the list for, let alone what sort of returns the funds will deliver in the future. No one can systematically pick winning funds in advance, and that includes Hargreaves Lansdown.
The bottom line is that recommended fund lists are not meant for your benefit at all. They’re essential a marketing gimmick which helps brokers and platforms to generate revenue.
HL is a very successful business, which has profited from a trend towards individual investors taking more control of their retirement savings. Since 2015 it has grown its active client base by 50% and its assets under management by 70%.
But its offering isn’t cheap. On top of annual fund charges and the on-going transaction costs that funds incur, HL clients also pay a platform charge of 0.45%. That may not sound like much, but the compounding effect of paying that charge year after year has a significant impact on long-term returns.
Don’t be tempted, then, to choose from this or any other recommended fund list. They really are best ignored.
The phenomenal rise in ETF adoption looks extraordinary. But viewed in the context of any technology upgrade – from tape to CD, from CD to MP3 – there’s nothing outstanding about it. It’s just common sense.
ETFs are just a more flexible and lower cost way of getting exposure to an asset class relative to traditional mutual funds.
Whilst some vested interests in the active world murmur about “How might ETFs cope in market distress?” The answer is, repeatedly (including in recent market turmoil), “Just fine, thank you”.
Born out of crisis
Indeed, the massive switch from Mutual Funds to ETFs is in part a direct result of the Global Financial Crisis.
In the GFC, some investors were caught out by 1) not knowing exactly what was in their fund and 2) not being able to sell funds they no longer wanted to manage their risk exposure because they were “gated”. We’ve seen similar gatings of property funds after the Brexit vote, and of bond funds in face of interest rate rises.
The two greatest benefits of ETFs are, in my view, their transparency (knowing exactly what’s inside the fund on a daily basis, and how it’s likely to behave) and their liquidity (there’s a secondary market in ETFs via the exchange, which means you can buy or sell an ETF without necessarily triggering a creation/redemption process within the fund).
Transparency enables a more precise way of accessing specific asset class exposures. Liquidity is not just about intra-day trading, it’s more about the simple fact that if you don’t want to hold a fund anymore, rather than relying on the goodwill of the manager to accept your redemption order, you can simply sell it on via the exchange. This simple difference is a key advantage of ETFs.
Take the high yield bond market. So in a rising rate environment, if investors wish to sell high yield bonds, with mutual funds the manager has to sell the underlying investments (putting further pressure on price and liquidity), with ETFs, the manager can simply sell the ETF to another participant willing to come in at a level that is a bargain for both. The underlying investments need not necessarily be sold. Liquidity is only ultimately as good as the underlying asset class. But in every bond market jitter (including last week’s) bond ETFs have continued to function, and enabled liquidity.
I prefer to turn the question on its head: what product do you know of (aside from a mutual fund) that you can only sell back to its vendor? I’m struggling for examples: just a quick look on eBay is enough to show that there’s a secondary market in pretty much everything, be it vintage newspapers, matchbox cars or antique furniture. A quick look on the London Stock Exchange, shows there’s a market for pretty much every type of fund: global equity, UK value, UK gilts of different maturity buckets, corporate bonds of different investment grades, gold, commodities, property: you name it, you’ll find it.
It’s asset allocation that counts
Furthermore, I’ve never bought the argument that “ETFs only work in a bull market”. Sure equity ETFs do well in a bull market, but there are ETFs for each asset class that could be in favour at different stages of the cycle. ETFs are a portfolio construction tool to reflect a desired asset allocation. If you only want high quality, dividend paying equities, there are dual-screened income/quality ETFs. If you don’t want equity exposure, there are bond ETFs. If you don’t want long-duration bonds, there are short-duration bond ETFs. If you want a cash proxy with a bit more yield, there are Ultrashort Duration Bond ETFs. So ETFs don’t perform better or worse at different times in the cycle. Managers can perform better or worse by getting their asset allocation right. ETFs are just a straightforward way of managing a multi-asset portfolio.
From closet index to true index
ETFs are by definition the commoditisation of mutual fund industry (standardised formats that can be bought and sold at a published price). The plethora of index rules are the systemisation of investment process: whether you’re philosophy is traditional (cap-weighted), momentum, value, small cap, income, or quality there are now indices for most investment styles for most asset classes in most regions. The investor’s toolkit has got smarter, cheaper and more flexible. What’s not to like? Given the large number of closet index funds out there, we can expect a continued switch from closet index to true index to drive ETF adoption yet higher. In the meantime, if anyone knows of an eBay for old mutual fund holdings – please let me know.
Global stocks have been on something of a rollercoaster ride just lately, with markets trading at, or near, a two-year low. Doubtless many investors, especially those who are close to retirement, are feeling fearful.
Fear is a hugely powerful emotion. It makes us do irrational things, and the sad fact is that, in the context of investing, there’s no shortage of people who want to take advantage.
The Californian financial adviser and blogger Robert Seawright wrote an excellent article on this subject the other day. “When the markets are roiling,” he wrote, “fear is pitched all day, every day, and human nature buys it. And pays a premium. A very big premium.”
“Fear makes money,” says Daniel Gardner in his book The Science of Fear. “The countless companies and consultants in the business of protecting the fearful from whatever they may fear know it only too well. The more fear, the better the sales.”
So, what’s the answer, apart from steering well clear of salespeople?
First things first: don’t feed the fear. When behavioural finance expert Greg Davies was invited on to Bloomberg to talk about the market rout in 2008, he was asked, live on air, what should investors if they’re really worried. “They should stop watching Bloomberg for a start,” he replied. Apparently, they tend not to invite him now.
But, more importantly, investors who are anxious need to do some reading and arm themselves with an understanding of the bigger picture.
To do it properly, it’s going to take you a little while. If you don’t have time, you could just watch a short video just released by Dimensional Fund Advisors, on how markets reward investors who stay disciplined at times such as these. The video is presented by DFA’s Vice-President and Head of Advisor Communication, Jake DeKinder.
In the video, Jake says this:
"Recent events have increased the feeling of uncertainty and may have led some to question whether to not to make changes to their investment approach.
"It’s important to remember that while these events might seem frightening in the moment, they are not necessarily unique or unusual.
“Throughout history capital markets have rewarded investors who are able to stay disciplined. After many major events, financial markets have recovered and delivered positive returns.”
So what sort of events is Jake referring to? Well, here’s a series of graphs showing how a balanced portfolio comprising 60% equities and 40% bonds fared in the one, three and five years following the last six major market downturns:
What these graphs show very clearly is that those who stayed invested while so many others didn’t were amply rewarded on each occasion.
Here’s Jake DeKinder again:
"Over the long term, investors who have been able to remain patient and tune out the short-term noise surrounding these events have been rewarded for doing so.
“In the face of uncertainty, it’s important to remember this historical perspective, and focus on the things we can control, rather than the things we can’t.”
If you’re in any doubt about what, if anything you should be doing, you should seek the help of a financial adviser.
Otherwise, take Jake DeKinder’s advice: tune out the noise, think long term and disregard anything that’s out of your control. And most of all, fear not. Christmas is costly enough without baling out of the stock market.
Here’s the Dimensional video:
Dimensional Fund Advisors: Markets reward discipline
It’s almost that time of year when thoughts turn to resolutions for the 12 months ahead. Financial resolutions are always among the most common and, according to a poll by YouGov, the most popular resolutions in the UK this time last year included reading new books and learning a new skill.
For 2019, how about aiming to improve your knowledge of investing and personal finance through reading? No, we’re not talking about articles and blog posts, which only give you a tiny snapshot, but actual books which will leave you feeling that you’ve genuinely broadened your understanding.
If that appeals, here are seven books we would recommend.
THE BIGGER PICTURE
The Geometry of Wealth: How to Shape a Life of Money and Meaning by Brian Portnoy
Most people embark on an investment strategy without having a plan, and it’s not a good idea. True wealth, explains Brian Portnoy, is “funded contentment”. So, first of all, you need to work out what contentment looks like for you. What do you want from life? How much money do you need to enable you to lead that life? And when are you going to need it? Tackling these big questions and tending to everyday financial decisions, says Portnoy, are complementary, not separate, tasks. His book will help you to find the answers.
The Financial Wellbeing Book by Chris Budd
Personal wellbeing has almost become a new religion, but there are very few books that specifically tackle the financial aspect of it. In this book, former financial planner Chris Budd picks up on many of the issues discussed in The Geometry of Wealth. The starting point, he says is to “know thyself”. He then goes on to explain the secret to feeling in control of your finances, being able to cope with a financial shock and ensuring you always have options — and the peace of mind that goes with each of those.
The Little Book of Common Sense Investing by Jack Bogle
Jack Bogle is the founder of Vanguard Asset Management, and the world’s most prominent advocate of low-cost index funds. This short, best-selling classic explains, in simple terms, how to guarantee your fair share of stock market returns by simply tracking global markets at minimal cost. The tenth anniversary edition has been updated and revised and is personally endorsed by none other than Warren Buffett.
How to Invest with Exchange-Traded Funds (ETFs): A practical guide for the modern investor by Henry Cobbe & Shweta Agarwal
OK, we’re not entirely impartial — Henry Cobbe is, of course, Elston Consulting’s Head of Research. But this book will particularly suit those who are looking to manage their own investments. It explains how to diversified and manage a low-cost, diversified and robust portfolio constructed entirely with ETFs.
The Four Pillars of Investing by William Bernstein
Learn about investing in just three books? Are we serious? Yes, we are. To quote William Bernstein in The Four Pillars of investing, “the body of knowledge that the individual investor, or even the professional, needs to master is pitifully small.” Bernstein’s book is a superbly written, down-to-earth and easy-to-read explanation of how to design an effective investment strategy and how to construct and manage an investment portfolio that reflects your personal capacity for risk.
The Ascent of Money: A Financial History of the World by Niall Ferguson
Uh? Why do you need to know about history to be financially savvy? Well, it’s true that history doesn’t repeat itself exactly, but having a very long-term perspective helps you to understand how financial markets work. “Sooner or later, says Niall Ferguson, “every bubble bursts (and) greed turns to fear.” But the good news is that capitalism has proved remarkably resilient over the centuries and, for patient investors, equities have delivered strong returns compared to cash and bonds.
Thinking Fast and Slow by Daniel Kahneman
What? How does a knowledge of psychology make you more financially literate? The answer is that, as the legendary investor Benjamin Graham once said, “the investor's chief problem – and even his worst enemy – is likely to be himself.” As Nobel laureate Daniel Kahneman explains, our minds are tripped up by error and prejudice, and investors are a classic example. His book includes a wealth of wisdom, as well as practical techniques for improving the decision-making process.
Book lists are, of course, subjective. Books that we find helpful might not do the trick for you. Let us know how you get on with these, and if you have any suggestions for books we should add to future lists, we would love to hear from you.
All sorts of possible cures have been suggested for the ills of active fund management. Cutting fees is surely the most obvious solution if the industry wants to stem the flow of assets out of actively managed funds. Simply trading less frequently would probably make a difference too.
One of the arguments we frequently hear is that the answer lies in higher conviction, or “real” active management.
It’s certainly true that the widespread practice of closet index tracking — charging active fees for effectively hugging the benchmark — is a big problem for the industry. As well as being fundamentally dishonest, it almost guarantees that, after costs, the investor will underperform a comparable index fund.
“Real” active managers, on the other hand, genuinely try to beat the market by investing in a smaller number of stocks which they believe will outperform.
Over the long term, only a tiny proportion of active managers outperform the market on a cost- and risk-adjusted basis — David Blake from Cass Business School puts the figure at around 1%. One thing those very few winners have in common, the evidence shows, is that they tend to be high-conviction managers with relatively concentrated portfolios. Understandably, then, the high-conviction approach is being heralded by some as the answer to the overwhelming failure of active managers to outperform.
But is it? For a start, a manager can can have high conviction and yet be completely wrong. Deviating from the index doesn’t mean you’ll see better returns than the market; it means you can expect different returns, which could either be better or worse.
New research by Tim Edwards and Craig Lazzara at S&P Dow Jones Indices suggests that far from solving active management’s problems, moving towards portfolios with fewer holdings may well exacerbate them. In a paper entitled Fooled by Conviction, Edwards and Lazzara suggest four likely consequences of active portfolios becoming substantially more concentrated, none of which makes comfortable reading for active investors.
Likely Consequence No. 1: Volatility will probably increase
Portfolios with a large number of holdings are less volatile than those with small number of holdings. So, for instance, if a manager reduces the number of stocks they hold from 100 to 20, the portfolio’s volatility will almost certainly increase.
Likely Consequence No. 2: Manager skill will be harder to identify
It’s already extremely hard to distinguish luck from skill in active management. Think of each stock pick as an opportunity for a manager to demonstrate their skill. The fewer stocks they pick, the bigger the impact that luck is likely to have on the outcome.
Likely Consequence No. 3: Trading costs will rise
There are two reasons, Edwards and Lazzara argue, why costs would probably rise with greater concentration. First, fund turnover would increase. Secondly, transaction costs per trade would also rise, because trading a higher percentage of the outstanding float in a security typically incurs a greater percentage cost.
Likely Consequence No. 4: The probability of underperformance will increase
Stock returns, in technical parlance, are naturally skewed to the right; in other words, the average stock tends to outperform the median. After all, a stock can only go down by 100%, but it can appreciate by more than that. Logically, then, portfolios containing fewer stocks will tend to underperform those with more stocks, because larger portfolios are more likely to include some of the relatively small number of stocks that elevate the average return.
So, what can we conclude from the Edwards and Lazzara paper? As the authors note, skilful managers sometimes underperform, and those who lack skill will sometimes outperform.
“The challenge for an asset owner,” they conclude, “is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his clients. The challenge for a manager without genuine skill is to obscure his inadequacy. Concentrated portfolios will make the first two tasks harder and the third easier.”
Remember, S&P Dow Jones Indices is not a disinterested party in the debate about the rival merits of active and passive investing. It makes its money from licensing its indices for fund managers to use, and therefore has a vested interest in promoting passive strategies.
That said, this latest paper is a valuable contribution to the discussion and one which gives advocates of higher concentration in particular plenty to think about.
What, one wonders, would Alfred Cowles III have made of the current “debate” about active and passive investing?
Cowles was born in 1891, the son of one of the founders of the Chicago Tribune. He became a successful businessman, but his true passions were economics and statistics. One question in particular exercised his mind — can the professionals predict the stock market? — and in 1927 he set out to find the answer.
Over a period of four-and-a-half years, Cowles collected information on the equity investments made by the big financial institutions of the day as well as on the recommendations of market forecasters in the media. There were no index funds at the time, but he compared the performance of both the professionals and the forecasters with the returns delivered by the Dow Jones Industrial Average.
His findings were published in 1933 in the journal Econometrica, in a paper entitled Can Stock Market Forecasters Forecast? The financial institutions, he found, produced returns that were 1.20% a year worse than the DJIA; the media forecasters trailed the index by a massive 4% a year.
“A review of these tests,” he concluded, “indicates that the most successful records are little, if any, better than what might be expected to result from pure chance.”
11 years later, in 1944, Cowles published a larger study, based on nearly 7,000 market forecasts over a period of more than 15 years years. In it he concluded once again that there was no evidence to support the ability of professional forecasters to predict future market movements.
What is so extraordinary about Alfred Cowles’ work, and the techniques he used, is how ahead of his time he was. Cowles was the first person to measure the performance of market forecasters empirically.
Even among students of academic finance, the common perception is that it wasn’t until the mid-1970s that the value of active money management was seriously called into question, most famously by Paul Samuelson and Charles Ellis. In fact it was Cowles, more than 30 years previously, who first provided data to show that it was, to use Ellis’ phrase, a loser’s game.
So why wasn’t Cowles’ research more widely known about? Why did it take until 1975 for the first retail index fund to be launched? And why is active management still the dominant mode of investing even now, in 2018?
There are probably many reasons. The power of the industry lobby and the large advertising budgets at the disposal of the major fund houses have undoubtedly played a part, as has the growth of the financial media.
But it was Alfred Cowles himself who put his finger on arguably the biggest factor behind the enduring appeal of active management. Late in life, Cowles was interviewed about his research into market forecasters. In Peter Bernstein’s 1992 book, Capital Ideas: The Improbable Origins of Wall Street, he is quoted as saying this:
“Even if I did my negative surveys every five years, or others continued them when I’m gone, it wouldn’t matter. People are still going to subscribe to these services. They want to believe that somebody really knows. A world in which nobody really knows can be frightening.”
Cowles’ prediction has proved to be spot on. Both active management and market forecasting are far bigger industries than they were when he died in 1984. Investors, it seems, still want to believe that the market can be beaten, despite all the evidence that no more fund managers succeed in doing it than is consistent with random chance.
Think of investing, and most people think of the financial market. They think of share prices going up and down, bull runs and bear markets, spectacular successes and the occasional market crash.
The media is partly responsible. Journalists are constantly looking for stories. They have a vested interest in making investing seem exciting. That’s why they love the drama of the stock market.
Every day, newspapers publish the prices of hundreds of securities, and there are regular updates on radio and television on the latest news from the trading floor. The impression given is that investors need to keep up with the markets, and what the experts are saying about them, constantly.
The truth, however, is rather more prosaic. Successful investing is essentially very dull. It’s about filtering out the noise and focusing on a few fundamentals — ensuring you’re taking an appropriate amount of risk, keeping your costs low and diversifying broadly. Apart from rebalancing your portfolio every year or so, there really isn’t anything else to do.
In The Little Book of Common Sense Investing Jack Bogle wrote that “the stock market is a giant distraction from the business of investing”. In the long run, he explained, “investing is not about markets at all (but) about enjoying the returns earned by businesses.”
This is an altogether better way to think about investing. At a basic level, it’s about sharing in the profits of capitalism. Companies distribute those profits in the form of dividends, generally paying higher dividends when they’re doing well, and lower dividends when they’re not. The price of shares in a particular firm tends to go up when the market expects its profits to rise, and down when profits are expected to fall.
That’s why the stock market constantly fluctuates, and why, in the short term, it can be extremely volatile.
Sensible investors, however, take a long-term view. No, they’re not blind to risks such as global warming, terrorism and the threat of nuclear war. But they believe that, in general, capitalism is a system that works and that fairly rewards those who invest in in. They believe in the resilience of human enterprise and that, whatever happens in the next 30, 40 or 50 years, there will still be a demand for goods and services, and that companies will continue to make profits.
You should see investing, then, as claiming your rightful share to the proceeds of global capitalism. Remember, though, that there are all sorts of third parties — fund managers, brokers, investment platforms and so on — who would like to grab part of your share for themselves.
Warren Buffett told a story in his 2006 letter to Berkshire Hathaway shareholders, which every investor should read. It concerns the Gotrocks family, which owns all of corporate America, and receives the full value of the profits earned by those companies. Then a group of people, which Buffett calls the Helpers, offer to assist some family members to outsmart the others, "for a fee, of course". So, while the total profit earned by the Gotrocks family doesn't change, they don't get it all, having to pay some to the Helpers.
The profit of the companies owned by the Gotrocks family doesn't increase, but with more and more Helpers, charging more and more fees, the Gotrocks actually end up worse off.
Buffett’s right. There are too many Helpers in the investing industry. By removing multiple layers of “help”, which you can do by simply using low-cost index funds, you’ll end up keeping a much larger share of your investment returns for yourself.
So, go ahead. Claim your share of the proceeds of capitalism for yourself. It’s there for the taking — if only you can keep a long-term focus and resist the temptation to get caught up in all that market excitement.
One of the many reasons for indexing is that it eliminates, at a stroke, one of the biggest risks that active investors face, namely manager risk.
We’ve explained many times how the odds of beating the market through active fund selection are heavily stacked against you. Speaking in the online documentary Investing: The Evidence, Dr David Blake from the Pensions Institute says this: “The evidence shows, both for the UK and the US, that around 1% (of funds) outperform in the long term on a risk- and cost-adjusted basis. 99% of fund managers deliver negative value-added once you take into account the fees that they charge.”
All right, let’s say you’re feeling lucky, or else you don’t believe Dr Blake when he says that picking “star” managers ex ante is “impossible”. Let’s just imagine, for a moment, that you do possess a skill that has eluded every investor, professional or otherwise, to date — namely the ability to identify in advance, accurately and consistently, that tiny proportion of future outperformers. Even then you would still be relying on factors that are totally beyond your control.
Let’s take, for example, the bond fund manager Ian Spreadbury, who has just announced his retirement after more than 40 years in the City of London.
(Incidentally, the case for active management in fixed income is even flimsier than it is for equities. Because bond returns are generally modest, the costs involved in using an active manager almost always cancel out any outperformance they’re able to deliver. But we’ll leave that to one side.)
The biggest problem active investors face is distinguishing luck from skill. In a paper released in 2002, the afore-mentioned David Blake and his colleague Allan Timmermann demonstrated that it takes 22 years of performance data for a test of a fund manager’s skill to have 90% power.
Ian Spreadbury began his working life as an actuary. It wasn’t until 1985, nine years after graduating, that he moved into fund management with Legal and General. By Blake and Timmermann’s calculations, it wouldn’t have been until 2007 that you could say, with 90% confidence, that Spreadbury was genuinely skilled, as opposed to just plain lucky.
By that time, Spreadbury had spent 12 years with his next employer, Fidelity. So, how has Spreadbury’s flagship Fidelity MoneyBuilder Income fund performed since 2007? Answer: it has consistently underperformed the benchmark index. In other words, you would have been better off investing in a low-cost passive fund instead.
What’s interesting is that throughout that whole period, Fidelity MoneyBuilder Income has been highly rated by the ratings agencies. Brokers like Hargreaves Lansdown have also touted the fund in the media, predicting that Spreadbury would soon return to his winning ways. As things turned out, it didn’t happen — and nor will it happen now that Spreadbury has decided to call time on his career.
We don’t mean to single out Spreadbury for criticism. He has, in fact, performed less badly, on average, since 2007, than his peers. But we do mean to call out those who advocate switching in and out of different active funds as a sensible investment strategy.
Spreadbury is just another example of a fund manager who produced a few years of outperformance and earned considerable publicity for it and yet wasn’t able to sustain it. Once again, investors who poured into his fund on the back of all the fuss that was made have ended up disappointed.
Manager risk is a very real risk. Even if a manager is skilled, and that’s a huge assumption to make, there are so many unknowns. Here are just a few of them:
Will they be able to replicate their past success in the future?
Will they struggle, as many do, as the size of the increases?
Will they charge higher fees when they outperform?
Will you have the discipline to stick by them during inevitable periods of prolonged underperformance?
Will they move to a different fund? And in that case, should you follow them?
Will they succumb to a serious illness or critical injury?
Will they really want to carry on working into their 60s, by which time they’ll be financially very well off?
As an active investor, you leave everything to chance, and to succeed at it, you need everything to go your way. As an indexer, you pay a tiny fraction of the cost and yet you’re guaranteed to receive, near enough, the full market return, for as long as you need to.
Active management is a loser’s game, but one which the industry spends hundreds of millions of pounds every year persuading you to play.
Don’t do it! It’s a game that only they can win.
Many of the decisions that investors typically make are way beyond their circle of competence. That’s the view of GREG DAVIES, Head of Behavioural Finance at Oxford Risk.
In this interview, Gregg addresses two of the most prevalent behavioural biases investors are prone to — overoptimism and overconfidence — and argues that investors need to be much more realistic about which decisions they are sufficiently competent to make.
Greg’s specialist expertise is in improving financial decisions through behavioural science. As well as holding a PhD in Behavioural Decision Theory from the University of Cambridge, he’s an Associate Fellow at Oxford’s Saïd Business School and a lecturer at Imperial College London.
Greg Davies, in your view, how much of a problem do overoptimism and overconfidence pose to investors?
A lot of investors could be characterised as passive-aggressive. They’re passive in the sense that they leave far too much of their wealth doing nothing for far too long, and with the wealth that they do put into the market, they are aggressively trying to do something to it at any given moment. When you’re trying to do something to your investments, then overconfidence and overoptimism becomes a problem.
We all start to believe our own stories. For example, I read something in the newspaper, it resonates with me, I ascribe to it immediate and great confidence, and so I act on it. If we’re overconfident, we’re acting on stories that we shouldn’t be acting on, where we simply aren’t justified in having that level of confidence to do anything.
You mentioned newspapers there. To what extent are these behaviours encouraged by what we read in the media?
We ascribe information to things that we want to believe, so things that resonate with us we will start to believe more and more in. People will pick up and listen to all manner of things, including horoscopes at the extreme. No one ever acts, by the way, on numbers; no one buys return trade-offs. What we buy are stories, and stories come with a degree of comfort attached to them. If I have a story that is intelligible to me, if I understand it, if it just seems intuitively right, then it creeps past my guard, and the minute it is past my guard, it becomes something that I’m comfortable believing and something that I want to believe and so I become overconfident in it.
How then should investors view fund or share tips or other recommendations they read about in the money pages or on the internet?
If you were to look at all the possible decisions in front of you, some of them will be things where you genuinely have the knowledge to tell whether it’s a good or a bad decision. Warren Buffett talks about things being within your circle of competence. But some of the decisions in front of you will not fall in your circle of competence. They will be on the fringes of your competence. You might think you know something about them.
The more decisions you make, the larger the proportion of decisions that aren’t going to be in your core sphere of competence. They’re basically decisions in which you’re just going to be rolling the dice. If we’re trying to make good decisions in investing, after fees and after all the noise in the markets, we shouldn’t be rolling the dice on marginal things. We should be acting only where we really have confidence and competence.
A simple solution, surely, is for investors to make fewer decisions and just do less?
Depending on who you talk to, people will have a different answer to the question, How much should you trade to do well in the markets? There are people at one end of the spectrum who will say their favourite holding period is for ever, and here are some people who think you have to trade a lot. Wherever you are on that spectrum the right answer is less than you think it is. However much you are inclined to do, a sensible investor always does less than that.
The problem is though that it can be very tempting to try to time the market. It’s sometimes very hard to do nothing.
When markets are going up and down, it normally feels uncomfortable for us to do nothing, not to react when it seems intuitively right to do so — for example, when the market is falling and you want to get out. It’s actually very difficult for us not to act on those sorts of things. The fact is though that this is the area where overconfidence manifests itself most extremely — our tendency to think we know where things are going next. In any short or medium time frame, the simple answer is that we do not know.
The simple answer is, don’t do it. Focus on time in the market rather than timing the market. But it’s one of those things that’s simple but not easy. It’s simple to say it, but when it comes to that moment, it’s normally very emotionally uncomfortable for us not to act on what we feel to be strong information, so we jump in.
There’s an example from animal behaviour, isn’t there, that you like to use to illustrate the value of staying in the market. Talk us through that.
Yes, it’s from a study involving pigeons. You put the pigeons in a cage and they learn to peck a red light or a green light. When they peck the red light, it delivers food with a probability of 40%, and when they peck the green light, it delivers food with a probability of 60%. So these pigeons start to do things we see humans do. It's what’s called probability matching. They actually peck the green light more, because they get the food more frequently. They peck the green light 60% of the time and the red light 40% of the time.
That seems all very smart and clever until you realise you that the optimal strategy is to peck the green light all of the time. Now, interestingly, that 60:40 gap is about the same as you would expect to see major equity indices posting on a monthly basis. About 60% of months the index goes up and about 40% of months it goes down. If we could predict which months it’s going to go up or down, it would be rational to switch between being in the market and out of the market. The fact that we can’t means that we should just keep pecking the green light, because that is the most rational thing to do, unless you have a crystal ball.
We certainly live in interesting times. At the time of writing, nobody knows what’s happening with Brexit. Will a deal be reached to prevent a disorderly exit? Either way, what will be the impact on the UK and European economies? And how will markets respond?
In the circumstances, it’s understandable that many investors are considering reducing their exposure to equities until things become clearer. Investing is a hugely personal matter, and nobody should take more risk than they’re comfortable taking.
However, going to cash is not a decision that should be taken lightly, without serious thought or without seeking the opinion of a competent financial adviser. Regardless of Brexit, there’s a very strong case for keeping your portfolio exactly as it is.
So, if you’re thinking of sitting in cash while events unfold in Brussels, here are ten things need you need to bear in mind.
1. Timing the market is notoriously difficult. The evidence shows that it’s almost impossible to do it accurately with any long-term consistency, and the professionals are little better at it than the rest if us. And remember, you have to be right twice; you might get out at the “right” time and then spoilt it all by mis-timing your re-entry.
2. All known information is already incorporated into market prices. Current valuations reflect everything we know about Brexit and the likelihood of all the different outcomes. Do you honestly know something about Brexit that the rest of the market doesn’t?
3. It’s new information that causes prices to rise or fall, and that by its nature, is unknowable. True, government ministers and officials involved in the negotiations may be privy to vital information, but they’re bound by insider trading regulations so can’t act on it anyway.
4. New information is incorporated into prices within seconds, even milliseconds. If there is a significant development over the coming months, it will be absorbed so quickly by the markets that by the time you get to act on it, prices will either have risen or fallen already.
5. Correctly predicting the outcome of the Brexit negotiations won’t, in itself, be of help — unless of course you bet on it. To profit on the financial markets, what you need to do is predict how those markets will respond to the outcome you’re expecting, which is extremely hard to do.
6. Markets often react to big political events in unexpected ways. When an event is widely considered to be negative, markets often wobble initially but then recover and resume the course that they were already on. That’s exactly what happened after the Brexit referendum in 2016 and Donald Trump’s election later that year.
7. Investors typically allow their own political views to influence their investment decisions. Because most of us are prone to confirmation bias and to negativity bias to some extent, our expectations of what will happen if things either go our way or don’t go our way tend to be exaggerated.
8. The idea that there will soon be clarity over Brexit and markets will “return to normal” is unrealistic. It may well be that a deal is reached soon that takes Britain out of the European Union. But, as everyone knows by now, the divorce will be hugely complicated, and it may take many years, decades even, before the lasting effects of Brexit are clear.
9. Important though it is, Brexit isn’t the only show in town. There’s uncertainty everywhere you look, whether it’s the future of President Trump, the prospect of a global trade war or rising tensions between Russia and the West. And those are just the obvious risks. Regardless of whether the UK strikes a win-win deal with the EU that pleases everyone, or there’s a painful, disorderly exit, markets could still fall or rise sharply for a completely different reason.
10. There will always be reasons to bail out of equities. Throughout the long bull run that began in 2009, there’ve been scores of plausible arguments for getting out while the going’s good. If you had heeded any of them, you would have missed out on gains. Will it be Brexit that finally brings the bull market crashing to a halt? The bottom line is that nobody knows.
Again, you have to do what you think is right, and only time will tell what the “right” decision proves to be.
Whatever you do, though, beware of acting on emotions. Assuming that you and your adviser are comfortable with the risk you’re taking, and that your portfolio is thoroughly diversified and has relatively recently been rebalanced, the rational response is to sit tight and watch the political drama unfold.
BMO has lowered the cost of its bond ETF range by -43% from 30bp to 17bp as it passes through the economies of scale to end investors.
BMO’s bond ETFs offer access to the global corporate bond market, whilst giving investors the choice to select their preferred exposure, as defined by maturity.
iShares offers the most popular London-listed global corporate bond ETF (CRPS). This tracks the Bloomberg Barclays Global Aggregate Corporate Bond Index at 0.20% TER. Its GBP-hedged version (CRHG) understandably costs slightly more at 0.25% TER for the convenience of in-built currency hedging.
Like iShares, BMO also offers a GBP-hedged range, but has a more nuanced approach by offering investors a choice of three different ETFs each with a different maturity range: 1 to 3 years (ZC1G), 3 to 7 years (ZC3G) and 7 to 10 years (ZC7G). This compares to the average maturity of the main index of approximately 9 years.
The ability to access this exposure by maturity is particularly useful for UK institutional and pension scheme investors who are looking to construct liability-relative portfolios where both duration and currency controls are important to avoid asset-liability mismatches.
The BMO range has gathered some £117m AUM since launch in November 2015 (inflows of £3m per month on average). This compares to iShares' CRPS size of £824m since launch in September 2012 (inflows of £12m per month on average).
As the advantages of bond investing with ETFs become more apparent (secondary liquidity, transparent exposure, daily disclosure of underlying), we expect increasing price competition and greater nuance within the most popular strategies.
ZC1G BMO Barclays 1-3 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC3G BMO Barclays 3-7 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC7G BMO Barclays 7-10 Year Global Corporate Bond (GBP Hedged) 0.17% TER
CRPS iShares Global Corporate Bond (Unhedged) 0.20% TER
CRHG iShares Global Corporate Bond (GBP Hedged ) 0.25% TER
(All ETFs mentioned are UCITS ETFs listed on the London Stock Exchange)
Vanguard Asset Management is one of the companies that’s helping to change the face of investing. Based in the US, it came to the UK in 2009, and last year it launched a direct-to-retail operation, allowing investors with as little as £100 to invest each month to access a range of low-cost funds.
In this interview, Vanguard’s Head of UK Retail Sales NEIL COWELL explains why the company places so much emphasis on the importance of controlling costs, and discusses whether or not investors should use a financial adviser.
Neil Cowell, as a company, Vanguard is always emphasising the importance of fees and charges. Why is controlling costs such a key component of successful investing?
That’s right, we talk a lot about cost at Vanguard, and the importance of cost in investor returns. I think in the world of investing it can be said that you get what you don’t pay for. And costs do create an inevitable gap between market performance and investor return. The evidence is very clear when you look at the data. There’s data from Morningstar, for example, that clearly show that low-cost funds outperform their high-cost counterparts, and that alone gives a real indicator of why we attach such importance to it. In fact, Morningstar actually uses cost as a major predictor of a fund’s future performance, so every which way you look at it, costs are extremely important to investor outcome.
It’s not an easy message to get across to investors though, is it? In almost every other area of our retail lives, the more you pay the more you get.
That’s absolutely right. It’s counterintuitive. Clients definitely associate higher cost with higher quality and, as I said at the start, in the world of investing you get what you don’t pay for. When people see a fund priced at 1% per annum and another fund alongside it priced at 50 or 60 basis points, it doesn’t seem a lot in terms of a differential. But when that is actually compounded over time, it plays a terrific part in the overall return and takes quite a significant chunk from the final value.
How important is it, would you say, for people to have a financial adviser?
We’re very clear at Vanguard that clients are better served by working with an adviser. We spend a lot of time promoting the value of advice. We have a framework here that we call Adviser’s Alpha, which talks specifically around the value that an advised relationship will deliver over and above what a client left to their own devices may achieve. For a great investing outcome clients are well served by working with an adviser. We don’t say that clients who have the time, willingness and ability to self-serve can’t achieve a great outcome too, because that’s certainly possible. We just say it’s hard, and our message around the value of advice and what that adds is really very clear.
From your point of view, then, what are the major ways in which a good adviser adds value?
I think that there are two major parts. The first part is around the investment expertise itself, so the importance of getting the asset allocation right, the importance of rebalancing, the importance of ensuring that cost plays a part in portfolio construction. That does add value — there is no doubt about that. We rarely see portfolios that are constructed by clients themselves with a balance of equities and bonds, for example. They tend to resemble a collection of funds rather than a specific asset allocation. So there’s a real value add in the investment expertise element.
But I think, going back to the Adviser’s Alpha framework, where an adviser can really add value is in their role as a behavioural coach or an emotional circuit breaker. We see time and time again that when clients are left to their own devices they can start to make some very costly mistakes.
What are the most common mistakes you see people making when they try to manage on their own?
We see for example investors typically chasing yesterday’s winners. They invest in what appear to be yesterday’s winning funds, expecting those funds to repeat the performance and to prevail for the next three, five, seven or nine years. There is a clear pattern. People also try to time markets, which is not an advisable thing to do. Typically we see investors get there too late, by which I mean there’s a big difference between the fund return and the actual return the investor experiences. So those are two examples, chasing yesterday’s winners and getting there too late, of behaviours that really do erode value.
Another problem, of course, is that, in the words of your founder Jack Bogle, investors don’t “stay the course”. They bail out when markets tumble. And again, unadvised clients are more likely to capitulate.
That’s right. At Vanguard we have what we call our investing principles. We believe that for a great investing outcome, investors should have a clear, articulated and definable goal. They need to understand why they’re investing in the first place. Alongside that we think it’s important to have an asset allocation that’s appropriate to their individual risk profile, and also to choose the component parts of that asset allocation at the lowest cost possible. But then comes the critical element. Having constructed the plan, having put the time and effort into getting that all right, you need to tune out the noise and keep your discipline. Markets will inevitably experience degrees of volatility. There is an inherent behavioural bias in all of us which is loss aversion, and it’s inevitable that clients will at least consider bailing out. That’s when the adviser really adds value. Jack Bogle also coined the phrase, “Don’t just do something, sit there”. In other words, expect the volatility, be confident in the plan, and ride it out, for great investing outcomes.
What would you say to investors who think they can trust their ability to manage their own emotions and don’t need an adviser to do it for them?
If that is the case, then maybe they are on of those investors who has the time, willingness and ability to self-serve. I think they’re rare, because most of us are subject to some of these behavioural biases. Carl Richards, who writes for the New York Times about behavioural biases, tells the story of when he was an adviser, the CEO of a Fortune 500 company came to him and asked him to run his personal affairs. He said to him, “Why are you asking me to do this? You know far more about investing than I do.” And the CEO said, “The reason I am asking you is because you’re not me.” It was the peace around that separation, that emotional circuit breaker, that he so valued.
Where do you see the financial advice profession going in the future?
I think at Vanguard we’re very clear that the need for advice is growing. We’ve seen data from the US and UK that shows the need is now greater than it’s ever been, and it's also very interesting that people are more prepared now than ever before, according to the data, to pay for advice. I suppose we shouldn’t be surprised about that given the dynamics. People are living longer, life is typically more complex, and people are now contemplating for the first time running their own retirement pots rather than being able to rely on an employment discretionary benefit scheme or final salary scheme. There are so many reasons why people see advice as more important now, and it’s encouraging to see that coming through in the data.
Do you think some UK advice firms might feel a little threatened by Vanguard’s direct-to-retail offering?
That’s a good question. I don’t think it was a particular secret that Vanguard would at some point introduce a direct offering. The reaction from our adviser community has been very positive. A lot of them are interested in the extent to which there may be access for advisers at some point. We’re nowhere near that, and it may never happen, but nonetheless the interest is there. So I don’t think there has been a bad reaction to it.
I’ve been very encouraged over the last two or three years to see advice firms getting better and better at articulating their overall proposition. And I think that’s the key. Advisers these days are building more and more of their value proposition around their role as that financial coach, that behavioural coach, and no direct offering in the world can be a substitute for that.
A big problem for many investors is their overconfidence. They have unrealistic expectations about their own abilities at picking stocks and timing the market, and about the results they’re likely to achieve.
Bent Flyvbjerg is a professor at the Saïd Business School University of Oxford. An economic geographer, he’s an expert on behavioural economics and so-called optimism bias. His particular specialism is the planning fallacy — the tendency to underestimate the length of time and the expense involved in completing major tasks. But he also has a strong interest in how overconfidence impacts on investors.
Although Professor Flyvbjerg admits to making small, and very occasional investments in individual stocks, he mainly uses index funds, and recommends that most investors do the same. He says it’s a lesson that he’s learned from being too optimistic about his own investments in the past.
Thank you for your time, Professor Flybjerg. What exactly is optimism bias?
Optimism bias is a propensity that humans have to look at the future through rose-tinted glasses, so to look at it in a more positive light than is actually warranted by what happens when the future gets here. That’s it in a nutshell.
Why, then, are humans prone to optimism bias?
There are a lot of theories about that, but the constant is that this is probably something evolutionary, that we need optimism to do what we do in life and to get up in the morning, to get married, to have children and go to work. This is something we assume that has been with humans for a very long time, that this is something we need to survive. It’s Darwinistic in that sense.
It’s often very useful to be optimistic. You wouldn’t want a team of pessimists if you wanted to accomplish something. But optimism may also trip us up, so we might actually miscalculate risks regarding things that are very important. So you don’t want to get on a plane, for instance, when the pilot says he’s optimistic about the fuel situation. That’s not the kind of optimism that you want. But you do want to get on a plane where the flight attendant says that he’s going to give you a great trip, and they’re going to serve you great food and drinks and so on.
How rife is optimism in the financial industry, in your view?
It’s not just what I think. We know from solid research that it is very rife, it’s widespread, and it’s one of the things that you really need to guard yourself against as an investor — both your own optimism, and other people being optimistic with your money. That can lose you a lot of money.
Give me a specific example, then, of how optimism bias can trip investors up, as you put it.
Everybody hopes to have a windfall in the financial markets, and especially inexperienced beginners, who will think they’re going to be better than the average investor. People go into casinos and have this optimism where they’re going to beat the odds of the casino. The hardest thing to learn is not to be too optimistic. It’s really difficult. It takes a lot of time, and a lot of experience, and there are very few investors out there who have this cool realism that will make you successful as an investor.
But it’s very tempting, isn’t it, not to act when we keep hearing in the media plausible arguments for buying this or that?
Yes, it’s difficult not to get caught up in that, but it’s well documented that you shouldn’t listen to that kind of stuff. Day-to-day news on financial affairs is mostly noise. You need to look at much longer trends to get anything like useful information. You can always build a story around some random variation that sounds meaningful, and then you act on the basis of that and find that it’s not meaningful at all.
It’s sometimes assumed that financial professionals are above these sorts of biases. What do you say to that?
It’s not true. With professionals, there’s actually an additional bias — in addition to optimism bias — because they have a deliberate interest in making people believe they can do better. It’s what we call a strategic bias. Professional investment managers will try to make their clients believe that they’re better than the markets, and again it’s been shown that on average you’re better off without a professional investor than with one.
You said it’s very difficult to combat optimism bias. But how can you make a start?
The first thing to do is to realise that you have optimism bias. And of course, if you’re biased, you need to be de-biased. Experiments have been made on people who make decisions about things. One group is not told what the usual outcomes are, and the other group is told. So the second group will get a realistic image. They will think about that when they make their decision and will not be as biased as the first group. So just telling people what the empirical data are will make them less biased.
But the real secret to getting bias out is not to make subjective decisions. You basically want to make decisions that are more or less automatic. So instead of trying to time the market you would say like, if you are investing, that I’m going to invest every three months on a specific date; I’m going to invest whatever I have at that moment. You’ll do better than if you try to save up your funds and figure out where the market is going and try to time the market.
Optimism bias has to have an opportunity to kick in, right, and it’s only when we make subjective decisions that it kicks in. So the more you can eliminate those and go on autopilot, so to speak, the better off you will be in making investment decisions.
But again, its hard to temper your optimism when you read about professional investors who’ve made successful call, isn’t it?
There are so many things happening in the financial markets that there will always be stories like that, and that’s exactly what you have to disregard. Only if you see something that you really believe in and you were dead certain that it’s going to outperform the market would you be justified in doing something apart from just investing in something like the S&P 500.
How has your research impacted on your own investment decisions?
I actually try to use these ideas about optimism bias in my own investments. So I’m very conservative in that sense. (If you’re going to speculate) you should only put a little money on it — very small investments on things that have an enormous upside. By making a small investment you create a small downside. So you play on the large upside with a small downside, and the rest of your investments you just keep in the index.
You invest in index funds yourself. Why did you decide to go down that route?
Like many investors, I took a lot of time to learn this, and it cost me a lot of money. I did it because I saw that it was bulls**t (to suggest) that professional investment managers are performing better than the index. At the same time as I was developing my own experience as an investor this type of research became very well known in the early 2000s. Daniel Kahneman won the Nobel Prize in Economics for his research on optimism bias and the planning fallacy. That just showed me that you’re just giving money to other people instead of actually investing it and making money for yourself.
It’s no secret that active fund managers are losing business to index funds, but they aren’t going down with a fight.
The big fund houses have always had large marketing budgets, and they’re drawing especially heavily on them now.
As the US blogger Dan Solin wrote recently, the rational choice for investors is simply to “buy a globally diversified portfolio of low management fee index funds”. The problem is, “there’s a huge industry spending hundreds of millions of dollars annually to persuade you not to. They’ll say almost anything to persuade you to hand over your hard-earned money to them.”
But are the marketers getting desperate? Are they trying too hard to stem the flow of money out of active funds and into passive ones? There are signs that they might be.
A good example is a new campaign by Allianz Global Investors, the asset management branch of the German insurance company Allianz SE. Alliance GI executives have been touring the company’s 14 offices around the world, handing out brand new pairs of training shoes to its staff.
It might sound like a joke but it isn’t. Apparently it's designed to emphasise AGI’s belief in active fund management.
Bloomberg quotes Andreas Utermann, AGI’s chief executive officer, as saying: “Sneakers are just part of this brand relaunch. It’s not just the investment process that’s active, it’s the whole ethos of the firm and the way that we give advice.”
It is, of course, a huge gimmick. It plays on the conjunction fallacy — the common assumption that doing something is better than doing nothing, and that hard work and effort inevitably lead to better outcomes.
In fact, it’s the activity that’s the problem.
As the former fund house executive Lord Myners recently admitted, most funds perform better when the managers aren’t working at all (i.e. when they’re on holiday). Why? Because of the constant buying and selling that active managers feel they have be doing to justify their fees and bonuses and to keep their jobs. Every trade they make adds to the cost of using them, and as studies have repeatedly shown, cost is the single most effective predictor of future fund performance.
As well as redoubling its marketing efforts, Allianz GI is also revisiting its fee structures in an attempt to woo new customers. It recently cut the management fee on some of its funds in return for a performance fee it only charges if the fund beats its benchmark.
“You only pay if we perform,” says Utermann. “Why wouldn’t that be a good deal?”
Unfortunately, though, funds with performance fees are not the no-brainer the fund industry likes you to think they are. OK, you don’t get charged if the fund trails the index, but nor do you get reimbursed the money that you would have made if you’d invested in a low-cost index fund.
After costs, active funds underperform the index most years, often by large margins, and the performance of AGI funds over the years has been little or no better than those of its peers.
Over time, the cumulative effect of that underperformance will leave a big hole in your returns. Add to that the compounded management fee (even if it is reduced), and having to pay additional performance fees when the fund does beat the market, and it all makes a for a very bad deal for consumers.
Like the training-shoe stunt, performance fees are just a gimmick.
Compared to the US, the indexing revolution in the UK is only just beginning, and we can expect to see active managers become increasingly desperate to cling on to their market share. However tempting their offerings sound, you’re almost certainly better off steering clear.
An Englishman’s home is his castle, the saying goes. But in truth, the Scots, Welsh and Irish are just as keen on owning their own home. And for many Brits, one home is not enough; the level of buy-to-let and second home ownership is higher in the UK than almost anywhere else in the world.
Of course, people don’t just buy houses, flats and apartments to make money out of them. Homes bring enjoyment and utility to their owners that transcend financial considerations. But research has shown that most home buyers do see their purchase as a financial investment. Indeed, many now view property as a better and less risky investment than equities. What, then, does the evidence say about that?
Each year, Professors Elroy Dimson, Paul Marsh and Mike Staunton of London Business School produce a publication for Credit Suisse called the Global Investment Returns Yearbook. In it they show how the different asset classes have performed over the very long term — specifically since 1900.
There are several complications when assessing residential property as a financial investment. Most owner-occupiers, for instance, will need to take out a mortgage, and regardless of the size of the property, there are on-going maintenance costs involved in home ownership too. For landlords, those expenses are offset to some degree or other by rental outcome.
But, in real terms, how much have house prices grown since 1900? You might be surprised at how low the average price rise, after inflation, actually is.
Dimson, Marsh and Staunton analysed the data for 11 different countries and calculated the UK figure to be 1.8%. In Australia, where prices have grown fastest since the start of the twentieth century, the figure is 2.2%. The average annual price rise across all 11 counties is 1.3%, and in the United States it’s as low as 0.3%.
How then, does that compare with returns from other asset classes? Well, equities have actually produced much higher returns houses. Since 1900, the 2018 Yearbook states, UK equities have returned an average of 5.5% (and the average return since 1968 is higher still, at 6.4%). Bonds have returned 1.8% over the last 118 years — in other words, the same as the growth in UK house prices — while government bonds, or gilts, returned an average of 1% a year. Again, all of these returns have been adjusted for inflation.
Now let’s look at risk. “Housing has been less risky than equities,” the 2018 Yearbook states, “but the expression "safe as houses" is misleading.” As an example, Dimson, Marsh and Staunton cite the US, where “house prices fell by more than 36% in real terms from their late-2005 peak until their low in 2012”.
The biggest numerical fall in UK house prices in recent history was between 1989 and 1993, when they dropped 20% across the country and by more than 30% in London. After the global financial crisis of 2007-08 they fell 13%.
Of course, both equities have had a very good run. The bull market in global stocks is now more than nine years old. Despite that fall in prices immediately after the financial crash, UK houses have risen steadily in value since the mid-1990s and, according to the Office for National Statistics, houses now cost almost eight times average earnings.
Nobody knows where the price of stocks or houses are heading next. As ever, the most sensible approach is to stay diversified and not to be over-exposed to either.
If you own your own home, you are already heavily exposed to residential property. If you’re thinking of either trading up to a bigger house or investing in a second property, you need to think carefully whether the benefits outweigh the additional costs and risk involved.
Whatever you do, though, don’t invest in property expecting to make a big financial gain, even over the long term. To quote Dimson, Marsh and Staunton: “Residential property should not be purchased with an exaggerated expectation of a large risk premium. It is equity assets that provide an expected reward for risk.”
Most of us realise that worrying is irrational and counter-productive. Yet we can’t seem to stop ourselves, and research consistently shows that we worry about money and financial issues more than just about anything else.
CARL RICHARDS is a financial adviser, writer and podcaster who specialises in behavioural finance. Carl is from Utah but is currently living in New Zealand. He says there are two simple questions we should ask ourselves whenever we find ourselves fretting about something:
If the answer to either question is No, we should be tough with ourselves and stop worrying about it.
In this interview, Carl talks about our tendency to worry about the wrong things and the danger of perfectionism. He also discusses the importance of changing our attitude towards risk and volatility.
Carl, you’re renowned for your sketches for the New York Times, which illustrate simple, but important, concepts that people need to understand when thinking about money. Perhaps your best-known sketch is about the need to focus on things that matter and that we have control over — and stop worrying about everything else. How did that sketch come about?
That’s one of my favourite images and it seems to be one of the most popular. The story behind it was that my son, who was ten at the time, was playing lacrosse. My Mom came to watch. It was a beautiful, sunny fall day, with a crisp blue sky. It was a great day for a father to be watching one of their kids do something cool, and it should haver been an amazing day for my Mom.
But I could see as she walked to the game, like a hundred metres away, that something was wrong. She sat down and I said, “Mum what’s wrong?” She said, “Oh, nothing,” and I said, “No really, what’s wrong?” She said, “The dollar. I’m just so worried about the dollar. It could collapse.”
OK, my Mom, as far as I’m concerned, controls the universe, but she has no control over what happens to the dollar. So we started talking about that intersection of these two circles — things that matter and things that you can control. Because if it doesn’t matter, why are you worried about it? And if you can’t control it, why are you worried about it, other than to plan around it? If we can think about the intersection of things that both matter and that we can control, that’s really where we should focus, because that’s what will make a difference.
In your experience as an adviser, how much time and effort do people spend worrying about things that either don’t matter, or that they can’t do anything about?
I think the majority of an investor’s time, like the majority of a human’s time, is spent worrying about things that either don’t matter or that we have very little control over. The good news with investing, and with wealth management more broadly, is that if you were to make list of all the things that actually mattered, most of them are things we have control over — for example, asset allocation and our behaviour.
There is one noticeable thing that matters a lot but that we do not have control over, and that’s our return, in other words, the markets. We spend 80% of our time talking and worrying about the one thing that we can’t control. I’m just suggesting that we should maybe flip that a little bit. It doesn’t mean we should totally ignore the markets. I’m just saying, why don’t we spend a little bit more time on the things we do have control over that also matter?
It’s very difficult not to worry, though, when there’s extreme market volatility and stock prices are falling fast. That’s when having a financial adviser you can talk to really helps, isn’t it?
Yes, I think it is really important for the adviser to talk to the client about the nature of the financial markets, and to make sure the client understands the words you’re using. Often the industry, and even really good financial advisers, will use words like risk and volatility and assume that everybody will know what they mean. But most people don’t know what they mean. I know I wouldn’t if I weren’t in this industry.
As a client, the one thing I think you should feel absolutely sure you can you say to your adviser is, “Hold on. Back up and explain that.” Any good adviser will appreciate it, and if they don’t appreciate it, find a different one. It makes a lot of sense just to stop, if you don’t understand something, particularly around risk, which is incredibly important. Just pause and say, “Can you explain that to me? I want to make sure we are on the same page.”
How, then, should investors think about volatility? It’s certainly scary, but it’s not the same as risk, is it?
You should view volatility as risky in the short term, but not risky in the long term. Volatility is just, underneath, a measurement of standard deviation, which means, how much something wiggles. Stocks wiggle more than bonds, bonds wiggle more than cash. Short-term volatility is a measure of how much something wiggles in the short term. You just have to decide how to deal with that.
If you’re going to have a portfolio that is designed to meet your goals, it requires you to take a certain level of risk. The level of risk determines how much it’s going to wiggle in the short term, and you just have to decide how you’re going to handle that. There’s a whole bunch of tricks and techniques you can do to help you ignore it, but if you’re not paying attention to it in the first place you don’t have to deal with it, so that may be a hint.
Very often our attitude to risk is governed by our past experiences — particularly recent experiences. How conscious are you of that as a financial planner?
I feels to me like one of the big mistakes we make as humans is what the academics would call recency bias. We look at the recent past and we project that indefinitely into the future, particularly if the recent past has been something really negative. But even if our recent experience has been really good, we can make some major mistakes that way too. You think, for example, “I’ve had a bonus every year in January for the last three years and we’re thinking about buying a new house. Maybe we could buy a more expensive house because that bonus is around the corner.” And then you don’t get the bonus, and it wreaks havoc.
I think we’re really good at doing this. It happens all the time, and it’s something we need to check.
But what can you do actually do about it? It’s not easy, is it?
No, it’s not easy. The only solution I know to that problem is just to extend your view of recent past. Right now, in the Twitter age, the recent past is often, like, three minutes! It really helps if we can extend our view of the recent past and consider, “Oh remember, just five years ago that happened.”
Another way to deal with this problem is to record how we feel about events, particularly when we’re really scared and nervous and we want to sell, and we get walked in off that ledge by a financial adviser. At that moment it can be really useful to record how we’re feeling, to remind ourselves in the future what it’s like.
I think the ability to forget negative experiences in the recent past to discount negative experiences in the recent past has kept us alive as a species. No one would run a second marathon, and I’ve been told by my wife that nobody would have a second child if they could remember the pain of having the first one. We discount that really quickly. So just reminding ourselves of the pain, writing a note to ourselves, can be incredibly valuable.
You’ve written several times about the dangers of perfectionism, and why our desire to have everything “just so” can hold us back in our financial lives. Why do you think it’s such a problem?
There is a really unhealthy focus on the perfect — finding the perfect investment, building the perfect portfolio. Perfect really is the enemy of the good, especially as we don’t know what perfect is beforehand, and we’re guessing anyway.
I think the investment process only matters to the degree that it’s going to influence our behaviour. Your portfolio may not be the most efficient thing on the planet, but if it will helps to solve your behaviour, then it’s good enough. It’s like what Jack Bogle says about index funds — there may be investment solutions that are better than this, but the ones that are worse are infinite.
Of course, the other problem with focusing on the finer detail is that you neglect the bigger picture.
Right. I can’t tell you how many times people will send me questions like, “What is the ultimate emerging market small-cap fund?” It might represent 3% of their portfolio and they want to spend lots of time on it. In the meantime, perhaps they haven’t got their money invested, or they didn’t fund your retirement account this year.
Remember the old story of the doctor having a patient continually arguing over which medicine to take for high blood pressure. The doctor finally said, “Wait, you still smoke!” I think arguing about asset allocation and focusing on the specific investments underneath, trying to get everything perfect, really misses the point.
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