The financial cage-rattlers at Vanguard have announced the launch of their first London-listed Exchange Traded Funds (ETFs), in a move that should bring significant long-term benefits to Brit-based passive investors.

The initial line-up of five funds will immediately go to the top of the ETF best buy rankings (by TER), either beating or matching their rival offerings straight off the bat.

Vanguard has confirmed the following five ETFs are ready for launch:

Reports suggest the new ETFs will go live on Wednesday, 23rd May.

The new Vanguard ETFs benefit from a number of key features, namely:

• Physical replication of indices. These are not synthetic ETFs.

• The new ETFs follow broad-based indices, so all are suitable pillars of a diversified portfolio. None of your leveraged Albanian Pilchard Farmers rubbish here.

• They’re Irish domiciled, so you skip stamp duty.

Previously, Vanguard’s UK index fund range has been restricted to a handful of platforms. And because of the different fee menus, working out your best option has been a special kind of torture.

The new Vanguard trackers should be available on pretty much every platform that deals in ETFs, so UK investors won’t be forced into the hands of a measly few providers.

Vanguard ETF or index fund?

Some may be disappointed that the new ETFs are largely clones of existing index funds, but the cheap TERs are worth the entry price alone.

Bear in mind though that in order to buy ETFs you must pay:

• Brokerage commissions – roughly £10 per trade, although you can cut this to £1.50 by using a regular investment scheme (the same price you’d pay for Vanguard index funds through Alliance Trust).

• The bid-offer spread – should be pennies, but spreads can take a while to settle down as a new product finds its level. Ideally holster your trigger finger for a few months to enable the spreads to tighten.

In my view, bearing in mind the above there’s no reason not to switch to the Vanguard ETFs in place of its index funds. If lower TERs are available, you might as well scoop them up.

If you usually buy, say, HSBC or L&G index funds to avoid brokerage commissions, the calculation is more finely balanced. Try a fund cost comparison calculator to weigh up your options.

Depending on how much you invest, it may not take very long for a cheap ETF to pay off. The Vanguard Emerging Markets ETF will edge the L&G Global Emerging Markets index fund after just four years, for example, even if you pay upfront trading costs of 1%.

The best versus the rest

As for ETFs, here’s how Vanguard compares to its rivals in a straight ETF vs ETF TER tear-up:

Note: The Source and Amundi ETFs involve synthetic replication.

Clearly, Vanguard has found plenty of room for price-cuts. It will be interesting to see how their rivals respond.

A new option for global investors?

Just to get away from TERs for a second, it’s also worth mentioning that the Vanguard FTSE All-World ETF looks to be an entirely new beast from the Vanguard stable.

The FTSE All-World index tracks 90-95% of the world’s investible equities across both developed and emerging markets. So this is pretty much a one-stop-shop ETF for anyone who wants to run a global portfolio.

Team it up with a broad-based gilt fund and you’ve got a diversified portfolio in just two steps.

Price war

When Vanguard first stormed the UK index fund market, it forced major price slashery from rivals who’d been using bloated TERs to leech investors for years.

Vanguard’s strategy from birth has been to screw down prices, and now it is one of the largest asset management firms in the world.

No doubt it will make more of its range available as ETFs, and continue to up the price pressure on its rivals. UK investors will be the ones who benefit.

Take it steady,

The Accumulator

Further reading:

1. Not saving enough for your old age? Try a dirt cheap stakeholder pension
2. Vanguard offer some of Britain’s cheapest index funds, but there’s a catch
3. Index funds are cheaper than ETFs

Some good reads from around the Web.

I have to use this week’s Saturday morning piece to point readers to an update to our post about Vanguard funds and Interactive Investor.

The plot thickened almost as soon as we posted that article. Initially prompted by Monevator readers’ comments, it was soon fueling even more confusion among others.

Vanguard funds that were seemingly available on Interactive Investor’s systems – and confirmed as such by staff – turned out to be part of a limited test program, not yet permanent additions to the iii stable. Please read the updated intro to the article for more on what this means.

It’s a pretty frustrating state of affairs.

I won’t go into the specifics of this SNAFU much further, since we’ve subsequently been in discussion with iii staff, who I’m pleased to say have responded with some clarity on becoming aware of the befuddlement their pilot program seems to have caused at least some customers.

But I would like to point out that it’s 2012, and no service provider can rest on its laurels.

The time is long gone when the typical investor checked his share prices in the FT on the train back to Basingstoke before joining his broker or financial adviser for a few G&Ts at the golf club.

Active investors are online, they are communicating with each other, and word gets around fast.

Yesterday we saw the IPO of Facebook, just one company revolutionising the world by capitalising on the power and appeal of community.

Blogs like Monevator have sizable communities, too – we’ve welcomed over one million unique visitors to this site since 2009. They have left thousands of comments, but more importantly they have spread links to our content across even larger discussion forums, such as The Motley Fool, Stockopedia and ADVFN. We, in turn, have spread links posted to discussions elsewhere.

This is the modern landscape that financial service providers will thrive or die in, and it’s best for everyone if the information that spreads is clear and accurate.

Consumers are wising up, sharing knowledge, and growing smarter. Tracker funds are now outselling actively managed ones. Banks are on the hook for billions in compensation partly as a result of grassroots campaigns that began on the Internet. It’s truly a hive of investment activity, as alluded to by the name of one new Web-based service, Investor Bee.

The direction of travel is clear. In my opinion, the future of financial advice and services is clearly online. Online is no longer a place for afterthoughts – it’s at the heart of how we’ll save, invest, and plan for our retirement.

I can only apologise to any readers who were excited by our post on Thursday and who are now disappointed, although I’m not sure what else we could have done, given we’d had confirmation from telephone staff that the funds were available to trade.

Still, we’d rather be contributing to the signal, not the noise.

From the money blogs

• The pleasure/pain principle – Investing Caffeine
• Europe’s depressing prospects – Michael Pettis
• First retire, and then get rich – Mr Money Mustache
• When and how to rebalance your portfolio – Can I retire yet?
• Why do economists say there is an annuity puzzle? – Wade Pfau
• Trading time for money – Get Rich Slowly
• Exploring alternative asset classes – The Digerati Life
• Become a safer investor: Get Married – The Psy-Fi blog
• What the Eurozone crisis means for you – Totally Money

Book of the week: Still befuddled by the potential of Facebook? Check out The Facebook Effect, the definitive book on the company’s first eight years.

Mainstream media money

• The endangered public company – The Economist
• Facebook co-founder Eduardo Saverin’s big tax bill – The Economist
• Banking: Same as it ever was – The Motley Fool
• How Facebook’s bankers kept the day one price above $38 – CNET
• Peston: How serious is Northern Rock’s £2 billion loss? – BBC
• Why can’t the taxman crack the tax codes? – FT
• Tracker sales soar despite the turmoil – FT
• Commemorative coins are mediocre investments – FT
• Preference shares boast yields of 7-10% – FT
• Smaller companies top returns over the long-term – FT
• How to avoid the annuity trap – Telegraph
• A good time to start a business? – Independent
• Retail bonds versus fixed-rate savings – The Guardian
• Greeks apologise with gift of huge horse – The Daily Mash

Like these links? Subscribe to get them every week!

Further reading:

1. Online financial advice in the future
2. Shock news: Asset allocation not as dull as it sounds
3. Crisis investing: Specific news events

Update 18 May 2012: Since this post was written, we have been informed by Interactive Investor that Vanguard funds are NO longer available on its platform. We are told that the company is piloting seven Vanguard funds to ensure its systems work, but will be removing them at the end of testing. We’re advised to inform you that “they will be not be available until further notice.”

We at Monevator are sorry for contributing to this confusion, which was prompted by the fact that readers kept telling us that the funds WERE available – reasonably enough, because they saw them there – and asked us what we thought.

Sure enough, we were informed by Interactive Investor staff that the funds were available to trade.

However, we were not told that the Vanguard funds were only available for a strictly limited period as part of a pilot scheme. 

Interactive Investor have since confirmed that any investors who have managed to buy Vanguard funds during the test period will be unaffected by the end of the pilot scheme. You will still be able to track performance and receive valuations within your Interactive Investor portfolios. However, it is unclear whether you’ll be able to add to your Vanguard holdings through the broker. 

Apparently Interactive Investor is engaged in ongoing negotiations with Vanguard about its entire range of funds, but we don’t know on what terms they will be offered, if at all. 

We’re leaving this post up as an historical artifact, and as something to point readers to when they next ask us about this subject. This is the second time we’ve been confused by iii’s systems here, so we’re backing away slowly, closing the door, and running in the opposite direction. No more updates until we get an extremely official announcement, perhaps signed in blood.

At last! Vanguard index funds are now available through a broker that doesn’t impose platform fees, annual charges, dealing costs, or any other sneaky expenses that can nobble a small investor’s returns.

The broker is Interactive Investor (iii) and this development means Britain’s cheapest trackers can now be bought for sums as low as £20, which previously would have been suicidal in the face of flat-rate fees.

Seven funds from the Vanguard index fund range are available through iii, including a few of the instant-portfolio LifeStrategy funds.

However, this is a developing situation and I recommend you ring iii to check whether the funds you require are available.

When rumours first circulated a few weeks ago that iii stocked Vanguard, I was told that only Vanguard’s FTSE UK Equity fund was available. This despite the fact that the entire Vanguard range is listed on iii’s website. That toe in the water has now become a whole leg, so the possibility remains that iii will go all in at some point in the future.

The currently available Vanguard funds are as follows:

• FTSE Developed Europe ex-U.K. Equity Index Fund

• FTSE Developed World ex-U.K. Equity Index Fund

• FTSE U.K. Equity Index Fund

• U.S. Equity Index Fund

• LifeStrategy 20 % Equity Fund

• LifeStrategy 80 % Equity Fund

• LifeStrategy 100 % Equity Fund

All funds are available in ISA accounts and are accumulation flavour.

Don’t take ‘no’ for an answer

One Monevator reader, Sam, has already reported being told a different story – that only the LifeStrategy 100% fund is available, and not in an ISA.

I have previously found with brokers that the story can change from operative to operative, depending on how au fait they are with their internal systems. So if you get a different tale, ask for a double-check and tell the rep to ignore NASDAQ listings – you are only interested in UK or Irish-domiciled OEICs.

Do let us know about your experiences in the comments section, too.

Sadly, iii’s website isn’t keeping up with events and there is currently no way to tell online which of the funds are available to buy and which are listed for information purposes only.

No doubt this situation will change in time – again many brokers often make funds available over the phone for a period before updating their website. So much for the wonderful world of instant digital gratification.

In general, if you want a fund that your broker doesn’t apparently stock, it’s always worth hounding them about it over the phone. They may well say ‘yes’.

A rare victory for the little guy

It’s taken three years for Vanguard funds to breakthrough on a no-fee platform and achieve the same no-strings-attached status as the HSBC index funds, for example.

The reason Vanguard has been resisted is that they don’t pay trail commission to platform operators (i.e. a fee deducted from the fund’s TER that makes it worth the while of your broker or fund supermarket to stock the fund).

Commission of this kind is due to be abolished by the end of the year under the FSA’s Retail Distribution Review (RDR).

The likes of Hargreaves Lansdown recoup their expenses through a platform fee, while Alliance Trust charges dealing fees for buying Vanguard funds.

Many have predicted that all low-cost online platforms will go down this route, making life extremely difficult for small investors as flat-rate fees take large bites out of modest contributions.

But iii have specifically added the following line to their charges sheet:

Charges for “non-commission paying” products – NIL.

It’s a positive sign that iii are seeking to differentiate their offering from other platforms as RDR approaches. There are no guarantees the situation won’t change, but it would surely be a PR disaster for a firm to stake out that position ahead of RDR, luring small investors in, only to move the goalposts a few months later.

So assuming the Vanguard funds aren’t being used as bait, and the website issues are sorted, this new ultra-low cost option adds up to great news for small investors.

Stop press

Before you take any big decisions, you should know that Vanguard is about to launch five physical ETFs on the London Stock Exchange. The Motley Fool has the scoop.

Apparently the FTSE 100 tracker will have a TER of 0.1%, which will make it an instant low-cost table-topper. Expect a listing in the next few weeks, and a Monevator report to boot.

Take it steady,

The Accumulator

Further reading:

1. Hargreaves Lansdown bags Vanguard funds
2. Is it worth sticking with Hargreaves Lansdown to get Vanguard funds?
3. How to lifestyle Vanguard LifeStrategy funds

One of the most fun things about managing your own investments is coming up with an asset allocation strategy to diversify your portfolio. It’s a chance to tinker like an alchemist to find that blend of asset classes that’s going to help you weather the storms ahead, and see you dancing upon the sunlit plains of financial independence some time yonder.

That’s the dream, and in the weeks ahead I’m going to write a simple guide to devising your own asset allocation.

But first we need a primer. What are the asset classes that make suitable straw for your passive investing nest?

In the rest of this post, I’ll highlight the pros and cons of the main asset classes.

This will be familiar stuff to many Monevator readers, but it’s always useful to have a frame of reference, especially as the investing world can rarely agree on a consistent definition for anything.

Cash

Filthy lucre, spondoolicks, the route of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be. The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor.

Good

• You can’t suffer a capital loss.

• It’s liquid like water. If you lose your job and need some food or rent, your cash reserves can quickly be converted to satisfy whatever need is at hand.

Bad

• Cash will be clobbered by inflation over time. £100 will only be worth £74.41 in 10 years, if the ongoing inflation rate matches the historical average of around 3%. 20 years down the same timeline and £100 will only be worth £55.37.

• Historically, cash has earned the lowest returns of the major asset classes.

Risk/Reward trade-off¹

• Risk = Low

• Reward = Low

Time horizon

Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.

More on cash

• Cash is king

Bonds

Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer does a Greece and defaults, that is).

Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation to solely to domestic government bonds.

Good

• Government bonds are much less volatile than equities.

• Historically, they’ve provided a better return than cash.

• A lack of correlation with equities makes government bonds a useful way to protect yourself against stock market crashes.

Bad

• Bond returns historically lag equities.

• They are vulnerable to inflation (unless you choose index-linked varieties) and changes in interest rates.

• Many investors struggle to understand bonds.

Risk/Reward trade-off

• Risk = Lower than equities, higher than cash

• Reward = Lower than equities, higher than cash

Time horizon
You can match your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.

Sub-classes²

• Government bonds i.e. UK gilts, US Treasuries
• Corporate bonds
• Inflation-protected bonds i.e. index-linked gilts, TIPS
• Local government bonds
• Junk bonds i.e. high-risk bonds with terrible credit ratings

More on bonds

• Gilts explained
• Corporate bonds central

Equities

Equities (commonly known as stocks or shares) are historically the riskiest and best rewarded of our main asset classes.

That relationship is writ in stone by the laws of finance. Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.

Good

• Equities have traditionally outgunned every other asset class when it comes to long-term returns. They are the most powerful asset class in your diversified portfolio.

• Equities are capable of outstripping inflation. They’ve historically delivered a return of 5% after inflation, in the UK.

• The longer you hold equities, the better your chance of achieving your financial goals.

Bad

• Severe losses can occur at any time and frequently do. You could easily lose 30% of your capital in a single year.

• Losses can be very long-lasting. Japan is the textbook example of a market that’s failed to recover its value in over 20-years.

• The highs and lows of equity ownership can feed all kinds of irrational behaviour, from panic-selling in the face of loss to piling into a bubble market. Fear and greed rule.

Risk/Reward trade-off

• Risk = Higher than bonds, property or cash

• Reward = Higher than bonds, property or cash

Time horizon
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.

Sub-classes

• Capitalisation e.g. Large cap, small cap
• Style e.g. Growth, value
• Geography e.g. Domestic, emerging markets, international
• Sector e.g. Technology, utilities, consumer staples

More on equities

• UK asset class returns

Property

As an investment asset class, property (or real estate) refers to commercial property that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house.

Exposure to commercial property is generally achieved through real-estate investment trusts (REITS) or ETFs. Sticking all your money in a ‘buy-to-let’ concentrates rather than diversifies your holdings and is taking a big punt on the everlasting strength of the UK property market.

Good

• Historically, the risk and rewards of property have been a halfway house between equities and bonds.

• It can be a useful diversifier, as global property returns have demonstrated a moderately low correlation to UK equity.

• Property is also likely to keep pace with the rate of inflation.

Bad

• Property bubbles can pop and inflict large losses on funds.

• Property is illiquid, which can lead to funds imposing exit restrictions on investors during periods of market stress. In other words, they can’t sell their buildings quickly if everyone wants their money back at the double.

• UK investors tend to have a rose-tinted view of property due to the strength of the home market over the last 20 years. However the asset class has historically lagged equities.

Risk/Reward trade-off

• Risk = Higher than bonds or cash, but lower than equities

• Reward = Higher than bonds or cash, but lower than equities

Time horizon
As per equities.

More on property

• A property primer

Commodities

Investing in commodities is the business of speculating on the price of cows, or oil or gold. You are betting that the future price of the asset will be higher than the current price.

However, there are very few opportunities for ordinary investors to bet directly on that spot market price because few of us can actually store several million barrels of oil.

With the exception of some precious metals like gold, a regular Joe’s only option is to invest in commodity funds that provide exposure to the price movements of commodity future contracts³.

Commodity future funds thus don’t make their money from the onward march of the spot price but by trading futures and earning interest on collateral.

Good

• Low correlation with equities may reduce portfolio risk.

• Gold is negatively correlated with equities.

• A good inflation hedge.

Bad

• No long-term source of reward for direct commodity exposure. Commodities don’t pay dividends and future returns should equal inflation.

• There is no clear evidence that investors can expect a long-term return from commodities futures either.

• The workings of commodity future funds are extremely complicated.

Risk/Reward trade-off

• Risk = Equivalent to Large Cap US equity.

• Reward = Inconsistent and hotly debated. Better thought of as a method to reduce the risk of equities.

Time horizon
Commodities should be thought of purely as an equity diversifier and therefore held for a similar timeframe (if at all).

Sub-classes

• Energy e.g. oil, gas, petrol, heating oil
• Agriculture e.g. wheat, corn, soybeans, cotton, sugar, coffee, cocoa
• Industrial metals e.g. aluminium, copper, nickel, lead, zinc
• Livestock e.g. live cattle, feeder cattle, lean hogs
• Precious metals e.g. silver, gold

More on commodities

• Exchange Traded Commodities (ETCs)

Alternative asset classes

Other asset classes exist, of course. You’ll no doubt have heard tales of the killings to be made in:

• Hedge funds
• Private equity
• Currencies
• Volatility e.g. the ‘Fear index’
• Collectibles e.g. art, wine, cars

A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:

• Their role in a diversified portfolio is highly questionable.

• They suffer from high costs, or illiquidity, or other barriers to entry/exit.

• A high degree of expertise is required to avoid being spanked by other players in the market.

• Their track record is murky at best.

The bottom line is that any investor can construct a highly diversified portfolio from the main asset classes: cash, bonds, equities and property, and also stirring in commodities if you’re truly convinced by its merits.

Take it steady,

The Accumulator

1. Note, this is the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently.
2. This isn’t an exhaustive list, just a quick run-down of the more common varieties.
3. An agreement to buy or sell a commodity at a particular price, at a set date in the future.

Further reading:

1. Weekend reading: A quick guide to Monevator
2. Shock news: Asset allocation not as dull as it sounds
3. US historical asset class returns

A few weeks ago, I mentioned I’d stopped putting new money into shares around Christmas, and that I’d become more defensive in the active part of my portfolio.

I was also wondering where to stash the cash I’d raised from CGT defusing and a (still) imminent windfall lump sum.

Was there a good alternative to another Pavlovian lunge for equities?

It proved a lucky time to get reflective, given the subsequent market falls. I don’t claim to be able to call the market, but I do keep an eye on it, and now two years in a row I’ve been fortunate to see shares slip just after I’ve gotten slightly less gung-ho about valuations.

It all helps, but I don’t think I’ve developed an unflappable sense of market timing – amusing though it would be to claim as much in 100-pixel high letters on Seeking Alpha.

(Here’s my market call: Sooner or later the FTSE All-Share is going to be a lot higher, and likely on a loftier P/E rating. I don’t know when, and nor does anyone else. I invest in anticipation).

Besides, I was really just tinkering at the edges.

I have been extremely long the stock market since 2009¹ because to me equities seemed cheap compared to the alternatives, which mostly look about as appealing as drowning your sorrows with a Slush Puppy on the Titanic.

I didn’t set out to become quite so overweight in equities, nor for my lob-sided bet to last so long. I had hitherto always retained a big cash cushion, at least.

Then again, I never imagined interest rates would be held at 300-year lows for three years, even as inflation topped 5%. These are unusual times, and my actions have been adaptive (and not particularly astute – I’d have made money with a lot less volatility if I’d held a sensible amount of government bonds throughout, instead of dumping them too early on fears of a bubble).

I don’t recommend this lack of diversification, although equally I don’t think it’s a terrible idea in your 20s and 30s if you can take the gyrations (and assuming you’ve an emergency fund, and that equity markets look cheapish).

In my circumstances and with my unusual temperament it suits, but even I don’t want to be like this forever.

What I currently like apart from shares

When shares seem to be leaving the bargain basement, it’s commonsense for even an ultra-aggressive investor to consider shoring up on diversification.

But how? A few readers asked me as much via email.

I couldn’t tell them and I can’t tell you what you should do to follow me for two good reasons:

1) This is an educational website, not the diary of a guru. Read and ponder but don’t copy. Most readers will be best off with at least 90% of their money invested passively, rebalancing mechanically, not speculating.

2) The stock market fell, and so I’ve reinvested most of the free cash back into equities anyway!

With the FTSE now around 5,500 and the UK market on a P/E of 10 or so, I’m not quite so concerned about lightening up any further. I never thought UK shares looked dear, and now they’re cheaper again. Europe looks a steal.

Long may it last! The last thing I want is for the stock market to go up while I’m earning money and buying shares, especially when cash and bonds are paying a pittance. I owe a Greek politician a few Euros (or some drachma, soon enough).

Nevertheless, here are some of the choices I made or considered on the road to staying close to where I started, just in case you find them interesting.

Gilts

Dismissed as too expensive. I’ve been wrong about this before. The Accumulator has made a good case for holding your nose and government bonds regardless.

Index-linked NS&I certificates

I’d love more of these tax-free beauties, but as I warned when they last showed their face, they’ve proven more fleeting than an English summer. In current conditions I would buy these whenever they’re offered.

Cash savings account

The worst of times. You can get 3.5% in an ISA, but my annual allowance always goes immediately into the stocks and shares flavour.

Outside of an ISA, you can get over 4% if you lock your money away. But it’s taxed (and harder than on dividends or capital gains) so the net rate is unattractive. For emergencies only.

Peer-to-peer revisited

I’ve been a tad more active with Zopa recently: I got money away in the prime three-year market at on average close to 7% earlier this year.

Long-time readers may remember when I was spooked by a rash of bad debts. Apparently the Zopa risk machine was on the blink for a week in 2008; that clustering didn’t escalate, after all.

Furthermore, Zopa has made itself more attractive with the introduction of a Rapid Return facility enabling lenders to potentially close out most or all their loans – an option originally only given to borrowers. It’s not perfect or free, but it’s better than nothing.

I’ve also realised that as an early adopter I’m paying a lower fee of 0.5%, versus 1% for new members. I do like a perk!

On the other hand, Zopa long ago removed the one-year terms I used to prefer (and it is fiddling again with the length of terms).

Zopa has been running for about seven years now, and I feel that (as best we can tell from the outside) it’s proven it’s not going to blow up overnight. I’ll probably put more cash into Zopa in the months ahead, and may investigate other peer-to-peer platforms.

Remember though that being a Zopa lender is not the same thing as opening a cash savings account –the loans you make to individuals are more akin to a corporate bond, and you get no compensation from the FSA if a loan goes bad.

I may be over-cautious, but for this reason I don’t think I’ll ever go crazy here (so no more than around 5% of my net worth).

Corporate bonds

I feel investment grade corporates only look at all good value currently because gilts are so expensive. As for higher-yielders, junk bonds in the US just hit an all-time low.

If junk bond buyers are right about the prospects of the companies issuing their junk bonds, then I’d rather be in the shares.

Quixotically enough, I did put an order in for a slug of the latest Tesco Personal Finance corporate bond, which is paying 5% and runs for 8.5 years. This looks attractive to me, but for a specialist view check out the write-up on the excellent Fixed Income Investor.

It’s free² to buy into these at launch, which helps. With no dealing costs or spreads I wouldn’t mind investing in a few such offerings from various top-tier companies at 5% or more and holding to maturity, to create a slightly risky mini-portfolio.

Lloyds preference shares

I sold my 2010 tranche of these non-payers; I own some beaten-up Lloyds shares, too, unfortunately, and wanted to cut exposure. I got out at just over breakeven (no thanks to the huge spread).

I would have done better to hold given that I bought back in earlier this year, and again more recently.

Lloyds’ recent results confirmed its intention to resume payment on these securities, and sure enough the LLPC shares I own just went ex-dividend.

I’m hopeful I’ve locked in a long-term yield of over 10% on purchase here, with the potential of capital gains to come, and all in an ISA. I’ve bought a meaningful amount, but I suspect I’ll wish I’d bought more.

They’re much riskier than traditional fixed interest and shouldn’t be considered an equivalent, but the potential rewards are far higher, too.

Tilt towards more defensive shares

Over the past couple of years, I’ve churned a particular portion of my active portfolio like a hedge fund manager rolling in a bathtub of his client’s money.

In this account, I’ve gradually favoured more defensive shares as the market rises – generally ones that pay a decent dividend – then switched back later into either an ETF or else risky shares on big dips.

In the turmoil of late 2011 I switched out of the likes of Unilever into riskier fair, for instance, then earlier this year I switched back.

That sounds more elegant than the reality.

I only do all this trading because I’m so overweight the stock market overall: I am prepared to pay for (the illusion of) more control. It’s not ideal on either a cost or returns basis, but because markets have gone sideways, I feel it’s paid off – not least because I’ve slept better at night.

Note though that the majority of my individual share portfolio wasn’t touched in the past year, except to defuse capital gains.

Gold / other commodities

Considered and rejected. I do retain a little physical gold with Bullion Vault, partly as an experiment, but it’s not a very meaningful amount.

I’ve actually softened my views on gold over the past few years. I do still think it’s a barbarous relic, as Keynes wrote, but I’ve decided at heart we’re all barbarians so gold will have its moments. I’ve no idea how to value it though.

This leaves me to look at charts, cross my fingers, and hope. I may start to trickle money in if it gets below $1,500. I’d only be looking to build a 1-3% position.

I’ve occasionally looked at various ways to buy into timber, which is a great long-term asset in a funk due to the US construction slump. Some trusts look very cheap in terms of the discount to their net assets, but the managers extract a pretty pound of flesh in fees.

Currently on the back burner, but timber may get some windfall cash.

‘Special situations’

These are a couple of shares that I’ve bought because I think something unusual is on offer that’s not closely correlated with the wider stock market.

US residential property

I would love to buy into the US housing market directly. I think it looks cheap, especially off the beaten track.

I’m too scared to fly to Florida to buy a couple of ‘condos’ with ‘no money down’, mainly because I’m afraid I’d get arrested for asking for that in the wrong place…

US listed REITs or housebuilders are an option, but we’re back to equity risk.

I’ve an American friend who I trust and respect, and who I’d consider buying with. But he’s a cautious fellow, and isn’t biting!

To be honest, this is flight-of-fancy stuff. I’m no natural landlord, and I still don’t own a UK home, with all the tax advantages, as I fear they’re still too expensive.

However if I were writing this blog as a native of most of America, I’d be out shopping for a house tomorrow.

1. At one point in early 2009 I was selling physical possessions to buy shares!
2. My broker gets a half percent kickback from Tesco.

Further reading:

1. Plan to invest as shares fall
2. I’ve nearly maxed out my Zopa lending
3. Zopa interest rates falling

There is nothing like investing when it comes to exposing yourself as a weak-minded gimboid.

I know all about buying stocks low and selling high. I understand the rationale behind Warren Buffet’s aphorism, “be fearful when others are greedy and greedy when others are fearful.”

Yet when my portfolio hits red, I fret. When my return numbers glow green, I can feel the pleasure centres in my brain light up like Vegas.

That uptick in fortune may cost me every time I buy more equities, but hang the expense, I want to be a part of this now! The party’s on and I need to get my snout in the trough, quick.

I know this because despite being a good passive investor who pound-cost averages and rebalances annually, I am not an entirely mechanical man. And oh, the flesh is weak.

Only flesh and blood

I have until now allowed myself a measure of freedom: a certain amount to invest every year that isn’t dictated by the calendar.

Don’t get me wrong. This isn’t a gambler’s float, used to punt on some company that’s rumoured to be on the verge of inventing cancer-curing jam.

I still invest my discretionary dollop in index trackers, but I’m free to do so whenever I wish.

And I couldn’t take the plunge last year when the market did. I wasn’t brave enough to blow my ammo when equities were relatively cheap. I held on and on until the upswing in March, and got less for my money.

Oh, of course I had my excuses. My brain was able to provide me with plenty of self-justification, reassuring me that reason was in control not instinct:

• I was worried about my job.

• My company was restructuring.

• My monthly drip-feed was already casting cash into the cavernous cakehole of the capital markets.

• I better not throw in anymore in case I’m axed – then I’ll need every penny.

But in reality the overweening fear of loss was in charge.

It turns out that I am just one of the herd, a member of the cattle class. I’m not special at all. I react and feel like everyone else making up the statistics that show that irrational behaviour costs investors.

The US Dalbar study keeps tabs on the consequences of our bad behaviour, revealing that:

The average equity investor has underperformed the S&P 500 by 4.32% for the past 20 years on an annualised basis.

That’s a shocking amount to lose because we can’t control our urges.

Gorilla warfare

It takes willpower to overcome the apeman within. And there’s evidence that willpower is in limited supply for all of us. We can’t bank on having enough in reserve when we need it.

So the fewer decisions that are left up to my meat-bag of a brain the better. Passive investing would be much easier if I could program a robot to handle it all for me and to physically prevent my continued interference. Ah, a lazy investor’s dream of the future.

Given that I don’t expect Amazon to ship me my own automatic investing droid anytime soon, I need to automate as much of the investing process as possible, because the one human behaviour that does work for me is inertia:

• I don’t stop the broker’s direct debit that comes out of my bank account.

• I don’t mess with the regular investment scheme that funnels money straight to my chosen funds.

• I don’t take money out of lock-in schemes like ISAs, pensions and fixed-term bank accounts, where a cost is imposed upon me for doing so.

Inertia is the great human pacifier. It’s a force that’s regularly more powerful than fear in my world, especially if the fear is intangible like an investing loss.

Eliminate all carbon units

But there are other weak points of human intervention that could yet scupper my plans.

I can fiddle with my asset allocation every time I choose the next fund to buy and, boy, what mischief I could get up to when it’s time to rebalance.

So far I have resisted the urge to keep thrashing my winners but it’s always taken a stiffening of resolve, and a quick prayer of deliverance to the passive investing gods.

Will I do the right thing in the future? I can’t say for sure. I’m regularly tested and I’m only a passive investor.

If you recognise these weaknesses, then it’s worth knowing that the closest current proxy for my investing robot is the Vanguard LifeStrategy fund series.

It’s an index-tracking, fund-of-funds with built-in rebalancing features – truly automatic investing. All I need do is pick the asset allocation of my choice, set-up a direct debit to keep it oiled and then let the program run.

The human being thus retires from the game (which is the point of the exercise after all) and leaves the rest to the robot. No more worries about pesky emotion.

Take it steady,

The Accumulator

Further reading:

1. Simple mind games to stop passive investors hitting self-destruct

Companies have good and bad years, which temporarily elevate or depress their earnings¹ and so skew their P/E ratios.

When added to the vagaries of forecasting, this prompts some investors, led by 1930s legends Graham and Dodd, to instead compare prices with average earnings across multiple years (taking into account inflation) to derive a cyclically-adjusted P/E ratio.

By comparing a company’s current multiple-year P/E ratio to its historical average, you can then try to decide whether the shares are cheap without being misled by short-term blips.

Ten years seems to be the most favoured timescale, though some people work with five or even three-year histories.

Newsflash: Company earnings oscillate

What a company earns in any particular year is dependent on many different factors. These range from how well it executes its business plan and the trading conditions in its sector to the performance of rivals, the mid-life crisis potential of the MD, and even dumb luck.

But nearly all companies’ earnings are also affected by the ups and downs of the business cycle.

Stock market indices are just a collection of listed companies. When you add up a weighted average of the earnings generated in a single year by all the companies in a particular index, individual factors such as management skill or new product developments just disappear into the noise.

On this aggregate view, the earnings total varies mostly with the wider economic cycle, since nearly all companies are affected by it to some extent.

Earnings are cyclical: Over a period of years, the total earnings from all companies in an index will tend to rise during economic expansion, and fall sharply in slowdowns or recessions. For successful companies, the trend will be upwards over the decades. But most will suffer setbacks en-route.

If companies are cyclical, so are stock markets

Because earnings are cyclical, we might decide to calculate a rolling P/E for the whole market based on an average of multiple years of earnings, just as Graham and Dodd did for companies.

The resultant cyclically-adjusted P/E ratio is most often calculated over ten-year periods. It’s often known as PE10 as a result, which is less of a mouthful!

PE10 is also dubbed the Shiller PE, in honour of the US academic Robert Shiller, who popularized PE10 when he used it to predict the stock market crash of 2000 on the basis of an elevated P/E ratio versus ten-year earnings.

But whatever you choose to call it and however many years you look at, the idea is the same – to try to see if a market looks good value compared to history, perhaps also by considering where you think we are in the economic cycle.

(The start of) the trouble with PE10

I want to stress immediately that in that last throwaway comment is one of the big problems with PE10: It’s rarely clear what the economy will do in the next year.

• For example, it’s often joked that economists predicted 12 of the last six recessions.

• As for growth, Western markets took far longer than expected to emerge from the global slump of 2008.

In the absence of a functioning crystal ball, we are left with forecasts, best guesses, and playing the odds if we want to try to time our entry and exit into the stock market by the PE10 measure.

Given that capitalist economies have historically tended to expand for more years than they’ve contracted, you might decide to assume any current expansion will continue into the near future.

But be under no illusions. Boom and bust will never be abolished, and some years you’ll find an apparently healthy economy collapses out of the blue, taking company earnings with it.

Sourcing PE10

I’m not going to tell you how to calculate an accurate cyclically-adjusted PE ratio.

I’ve never personally done the maths, and others have explained in great detail how they calculate PE10 if you’re keen and something of a maths masochist.

Unfortunately for lazy souls like me though, PE10 data is hard to come by for almost all markets, as far as I’m aware.

The exception is for the S&P 500 in the US, where many people track the PE10 ratio. There’s even a regularly updated graph plotting PE10 for the US index:

PE10 for the S&P 500. Yes, most of the falls look obvious in retrospect, but they're not so clear at the time. (Chart from multpl.com)

You sometimes see investment banks quoting PE10 ratios for the UK market, but I don’t know of a go-to source. Macro hedge funds and the like compute this sort of data for themselves, but they don’t make it publically available.

Richard Beddard of iii provides a somewhat jerry-rigged version of PE10 for the FTSE All-Share index. Another UK blogger used to offer self-calculated updates of a shortish-run PE10 ratio for the UK. Sadly his last post on the matter was in summer 2011.²

If you know of other sources, please do share in the comments below.

Not the droid you’re looking for

I wouldn’t get too caught up on seeking a spurious level of accuracy when looking at PE10, anyway.

A figure from a reliable-sounding authority quoted in the press is good enough for me for six months or so, assuming no major earnings shocks in the interim.

That’s because I doubt that PE10 is the fine-tuned timing tool that certain of its adherents claim it is. I therefore don’t need it to three decimal places.

Just as one year’s earnings are a unique event, so are the past ten years. A longer-term timescale is usually better in the mean-reverting world of investment, but there’s no magical reason why looking at ten-year data suddenly becomes extremely accurate for forecasting.

As I write in 2012, for instance, the ten-year history includes two big earnings collapses, one of which was the largest since the Second World War. That’s unusual, and the ten-year history might therefore be unduly depressed, in turn over-inflating the PE10 ratio. I think the next ten years could be better.

On the other hand, perhaps earnings over the past ten years were illusory, having been fueled by credit expansion in the first half of the decade that led to unsustainable consumer spending and indebtedness. If so, then to what extent we still need to work off the excess remains to be seen.

Moreover, many companies took on too much debt in the go-go years. The PE10 ratio looks at market capitalisation not enterprise value (the latter would factor company debt in the numerator, the ‘P’ part of the ratio), so it doesn’t tell you anything about changes in balance sheets.

Again, this is another hindrance to the usefulness of looking at ten-year figures.

To counter that point in turn, some of the most indebted companies went bust or were radically devalued in the slump (property companies, for instance). Perhaps ongoing earnings will be of a higher and more sustainable quality, justifying a higher PE10 ratio?

I could go on. The point is that contrary to what some imply, PE10 will not see you dive effortlessly in and out of the market like a seagull stealing chips.

Even Professor Shiller concluded his original paper with humility, warning that PE10′s apparent predictive abilities might just be a coincidence.³

More concerns about PE10

My point here isn’t to tell you the market is cheap or expensive. It’s to warn you that cyclically-adjusted PEs may be a useful tool, but I don’t think they’re the silver bullet they’re sometimes touted as.

PE10 became much more popular in the choppy post-2000 investing climate, not least in the light of Shiller’s seemingly vindicated prediction. Understandably (if optimistically) people looked for ways to better time their entry into the stock market, and to get a sense of when to take money off the table.

There has been some research suggesting a valuation-based timing strategy might improve risk-adjusted returns compared to fixed asset allocations, but the margin seems slender to me.

Other respected voices have flatly dismissed PE10. Passive investing guru Rick Ferri says times have changed:

“Shiller’s method is fine in a bear market when people feel compelled to justify low prices, and had it existed, PE10 may have worked okay prior to 1950 when dividends were high and earnings payouts were also high.

If you look at a [chart] of real earnings growth and real price growth there wasn’t much from the mid-1800s to the mid-1900s. But there was dividends.

After 1950 [...] fewer companies paid dividends (only about 30% of companies pay dividends today), and the dividend payout ratio is also low (about 35% today).

Since the 1960s people have expected earnings growth due to earnings reinvestment and stock buybacks, and they got it. So, today, PEs should go higher than the 125 year ‘average’ PE 10 when the economy begins to recover.”

Taking another tack, my blogging friend Mike at Oblivious Investor has pointed out that if PE10 worked in the past, then it probably won’t in the future. This is because such inefficiencies tend to be ironed out once they become well-known.

As for me, I think valuations do matter to future returns, and PE10 gives us another way of measuring them.

But I also think that the average person – and quite possibly everyone else, discounting for luck – is poorly placed to make a finely graduated call based on it.

In the March 2009 stock market lows, for example, what looked a high PE10 ratio compared to the bear market bottom of the 1970s was frequently given as a reason to steer clear of US equities.

The US market went on to double within less than three years!

For those who do want maths to tell them what the market will do in the future, the excellent Moneychimp offers a simple calculator that uses PE10 to estimate future returns for the US market, and also to adjust for dividends.

It’s a bit larky, which is how you should treat PE10 in my opinion.

A useful measure, in perspective

Personally I keep an eye on both simple and cyclically-adjusted P/E ratios. But I don’t take either too seriously.

Making up some numbers for a fictitious market for illustration: I wouldn’t sweat it if a market was on a PE10 of say 20 versus its historical average PE10 level of 15. But if its PE10 got towards 25 for any extended time in this illustrative instance, I’d consider that fair warning.

Your own mileage may vary. Passive investors are strongly advised to ignore the whole sideshow in favour of fixed allocations and mechanical rebalancing, except perhaps at times of seemingly extreme over-valuation – the year 2000, say, not the hindsight overvaluation of 2007.

And those don’t come along very often.

1. A quick reminder: Earnings in this context are basically the same as profits. Dividing the share price of a company by its earnings per share in a particular year gives you its P/E ratio.
2. The blogger remains a Monevator reader however and sometimes does requests, if you ask nicely.
3. He wrote that in 1996 and his prediction pretty much proved right, though, so he might be more strident now.

Further reading:

1. Valuing the market by P/E ratio

Many passive investors are in a pickle over gilts (or US Treasuries or whatever your domestic government bond might be, if you’re tuning in from outside the UK).

Mechanical asset allocation rules dictate that we must sink a proportion of our savings into government bonds, according to our individual risk tolerance. But aren’t we on a hiding to nothing, as gilt prices have soared and yields dwindled thanks to government manipulation of the market?

It certainly seems so when an investing legend like Warren Buffet comments:

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Surely the only way for gilts to go is down as interest rates rebound? Surely some kind of ‘active’ evasive manoeuvre is required?

What are gilts for?

Let’s ignore for now the fact that similar fears were widespread a year ago, only for the UK gilt sector to return 15% in 2011 and the index linked gilt sector to weigh in with a 21% rise.

Let’s even assume that this chart-topping performance makes it all the more likely that gilts must drop.

Before leaping into action we need to consider a few questions:

• How catastrophic will the ‘inevitable’ bonfire of the bonds be?

• Why do I have a gilt allocation anyway?

• What if things don’t turn out according to the forecasts?

To answer the first question, the role of government bonds for investors who are building their capital is to reduce the risk of underperformance by equities.

The more your portfolio is insulated with gilts, the less violently it should convulse as it’s held to the bare wire of the market.

Hence ‘merely human’ investors are less likely to go panic-sell crazy during market turmoil, and you’re better diversified should equities not live up to their long-term performance billing.

These important protective features of gilts remain true even in the face of the current market situation, and particularly given the economic uncertainty faced by the world.

If we should slip into a Japanese-style economic ice age, your gilt positions will provide a stable source of income and a welcome redoubt against deflation.

And if you pare back your gilt allocation to a point where your portfolio is riskier than you can truly stand, you may well do far more damage to your long-term prospects than you would in that much-feared gilt bear market, if instead equities fall, your nerve snaps, and you belatedly sell your shares at low prices.

This is because bear markets in bonds are generally pretty tame in comparison to equity nose-dives.

How bad can the losses be?

According to Vanguard, the largest annual loss that a 100% UK bond portfolio would have suffered in the last 30 years is -6.27% (in 1994).

Compare that with the -29.93% sliced off UK equities in 2008.

Better still, gilt funds¹ come with an in-built recovery mechanism. As the price declines, yields rise, so as your bonds mature they can be reinvested for a lower price into new gilts that pay higher levels of interest.

As Vanguard² points out, this mechanism eventually works in our favour:

Over the long term it’s interest income – and the reinvestment of that income – that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising rate environment of the 1970s and early 1980s.

Duration is the key characteristic on your gilt fund factsheet that shows how badly it will be affected by a rise in interest rates and long it will take to recover.

For example, if a gilt fund has an average duration of 7 years then it will lose (or gain) approximately 7% of its net asset value (NAV) for every 1% rise (or fall) in interest rates.

A duration of 7 also means that the fund will recover its original value within seven years as higher interest payments compensate for falls in price (though the recovery can be faster in practice).

What action can I take?

One thing you can do, therefore, is to make sure you only invest in gilt funds with a duration that’s no longer than your time horizon. That way you can’t suffer a capital loss on your portfolio’s gilt allocation.

And if you’re strapping in for the long term then you can take comfort from the fact that you’re likely to be able to ride out sharp rises in interest rates.

Interestingly, though a rapid rise in interest rates would seem to be a nightmare scenario for bond investors, the Vanguard study I quoted above found it actually delivered the highest expected return over 10-years (in simulations upon intermediate holdings of US Treasuries) in comparison to scenarios that are more bond-friendly in the short-term.

But if such reassurance is not enough to stay your hand, then it is possible to maintain your allocation to defensive assets while reducing your exposure to a price drop (otherwise known as maturity risk).

You can do this by increasing your allocation to shorter-dated gilt funds at the expense of longer dated funds.

This works by shifting some of your allocation from a long dated gilt fund to an intermediate fund, or from an intermediate fund to a short-term fund.

The table below shows what kind of difference that would make in terms of duration, using some example UK-listed gilt funds:

If interest rates rise by 1% then the iShares ETF’s duration reveals that it will only lose 2.57% of its value in comparison to a 9.5% loss for the Vanguard intermediate fund.

But if interest rates fail to budge, we can see from the yield-to-maturity that the short-term fund will pull in less than a third of the income of its intermediate rival.

If you’re more worried about volatility than long-term returns, a shift of this kind could make sense – particularly if you already have a high allocation to fixed-income.

Another way to trim your exposure to maturity risk would be to increase your allocation to cash.

The best instant access bank accounts yield 3% and you can get a two-year fix at 4%. That’s considerably better than the current yield on gilts, your portfolio will be less volatile, and there’s no risk of a capital loss.

As ever, the risk with cash is that it has delivered the worst historical return over the long-term and is highly susceptible to inflation.

The slippery slope

The elephant in the room for passive investors is that once you start trying to outsmart the market, how will you know when to stop?

Interest rate forecasts are a total lottery. After the credit crunch, it was widely predicted that interest rates would rise in 2010, then 2011, and now 2013. I’ve seen commentary that predicts a flatline until 2015.

Once rates do rise, when will be the right time to get back into gilts? Will you be able to do it when equities are crackling like a fried egg in Death Valley? Or will you be too busy diving in and out of gold?

If you’re a long-term investor, you shouldn’t dump your gilt funds. Historically, they’ve always been a drag on a portfolio, but they’re not there to boost returns. Gilts are there to diversify risk.

If your risk tolerance hasn’t changed, then your allocation to gilts shouldn’t change either.

Take it steady,

The Accumulator

1. I’m going to refer to gilt funds throughout the rest of this post, as I assume that most passive investors won’t want to strain themselves buying and managing their own gilt ladders.
2. The study is based on the US market, but the UK is analogous enough for our purposes.

Further reading:

1. Gilts (UK government bonds)
2. Vanguard LifeStrategy funds turn passive investing catatonic
3. Vanguard dealing fees fall, adds new funds

You’re probably familiar with the price to earnings (P/E) ratio as applied to individual shares.

Well, the same sort of metric can be used – subject to the usual laundry list of caveats – to try to decide if an entire market is cheap.

A quick refresher. To calculate a company’s P/E ratio, you simply divide its share price by its earnings per share.

Monevator PLC has a share price of £10 and earnings per share of 50p.

The P/E ratio is £10/50p = 20

As a quick and dirty rule, a high P/E ratio indicates there’s a lot of future growth expectations baked into the share price, while a low P/E may indicate the market doesn’t expect so much growth from the company in the future.

Such expectations about earnings can involve all kinds of things, from a new product launch or a shift in the perception of margins, to some big crisis like the BP oil well disaster that takes a scythe to anticipated profits. They all work back into the P/E ratio.

It’s no exact science, but by comparing a company’s P/E ratio to that of its rivals and to its own historical range, you can try to get a feel for what other investors are expecting.

And the same sort of thing can be done for markets.

To calculate the P/E ratio for a stock market or index, you divide the total market value of all of the market’s constituents by their combined earnings.

Or, rather, you have someone else do it for you!

The Bloomberg terminals used by professional City folk deliver P/E ratios for different markets at a stroke.

Commoners must trawl around more or less accessible resources. The Financial Times data section enables you to download various index and country level P/Es, for instance.

You will also find journalists, analysts, and yours truly peppering articles with index or country P/E ratios.

Learning about earnings

It’s important to establish exactly what P/E ratio is being used.

The ‘P’ part of the equation for a simple P/E ratio is always the current price.

But with companies, different earnings (the ‘E’ figure) can be plugged in to give you an insight into slightly different views about the company.

• Using historic earnings tells you how highly the company is rated on the basis of its last full financial year’s earnings. (Note: In the US where companies report quarterly, the trailing four quarters is most often used).

• Forecast earnings plugged into a P/E ratio gives an indication of how cheaply – or expensively – the market is rating next year’s earnings.

• A third variant gives you a mix of both, by adding the last reported half-year’s earnings with the earnings expected in the next two quarters .

And the same variations be used when calculating the P/E for the market.

Which P/E ratio is best? It doesn’t really work like that.

Comparing historic P/Es from different years can tell you how optimistic or pessimistic the market has been in the past – or how much it’s been surprised – but it doesn’t tell you much about the price you’re paying today.

Forecast earnings are the most important to the future value of your investment, whether you’re looking at a company or an index.

Unfortunately forecast earnings are also the most unreliable, because they haven’t happened yet! (Perfect your crystal ball and you’ll be rich in no time).

It’s therefore a good idea to look at all the different P/E ratios to get the most rounded picture you can.

If a company or market is rated at a P/E of 20 on a historical basis but only 5 on a forward basis, say, you need to understand what happened in the past or what’s expected in the future to make earnings swing about so wildly.

Uses and abuses of the P/E ratio

Let’s get back to valuing the market by P/E ratio.

By comparing its P/E with its historical range, with other markets, or with the P/E at other points in time – say in the depths of a previous recession – you can hazard an opinion as to whether it now seems to be pricing in too much optimism or pessimism, given your view of the economic situation.

Beware that such comparisons involve plenty of uncertainty and ambiguity – on top of the sheer unreliability of the macro-economic forecasting that will surely influence your view of a market’s future earnings.

Comparing the P/Es of two different markets can be misleading, for instance, because the P/E tells you nothing about the balance sheets of their respective companies.

One market’s firms may typically be more conservative and so use less debt, while another’s may be geared to the eyeballs. That’s likely to change the attractiveness of those future earnings to different investors. The cash-backed companies are on average probably safer, and so may deserve a premium rating. Or alternatively you may feel they’re too conservative, and so unlikely to grow.

Different markets are also biased towards different industries. An index dominated by resource companies will probably be more at the mercy of the economic cycle than a more diversified index, so I’d expect it to generally trade on a lower forward P/E multiple than a market stuffed with consumer staples.

There are even issues with comparing the same market across time.

You might compare an index’s P/E in what seems you like the trough of a bear market with an even lower one from a similar crash in the 1970s, only to decide it suggests that the current market has a lot further to fall.

But what those figures don’t reveal is that general interest rates were say 10% in the prior bear market whereas they might be (for example) only 2% when you make that comparison.

So you’re not really comparing similar investment environments.

Markets, moods, and P/E ratios are all cyclical

Because earnings fluctuate as economies expand and contract – and because investor enthusiasm is cyclical, too – investors may seek to smooth out a P/E ratio over a number of years.

I’ll look at this so-called cyclically adjusted P/E ratio (most commonly termed PE 10) in the next part of this series.

To conclude this post, valuing the market by its P/E ratio is a useful shortcut to getting a sense about how other investors see that market.

But it is definitely not a foolproof guide to future returns for all the reasons stated – and also because there’s “nowt so daft as folk”!

A market may seem cheap to you by its P/E ratio and yet get cheaper for years or vice-versa, purely because your fellow investors become more fearful or greedy.

Such sentiment will resolve itself eventually in all but the most apocalyptic scenarios. There’s a common sense limit to just how low a P/E multiple can get for an entire market, in most circumstances.

As always with equities though, you’d better be ready to strap in for the long-term.

Further reading:

1. Valuing the market: Are shares cheap?
2. The cyclically-adjusted P/E ratio (PE10 or Shiller PE)
3. An emerging market index fund for UK investors

Hearing that I’m one of those oddballs who is still investing in the stock market, people ask me things like “Are shares cheap?” or “Is it a good time to put money into an ISA?”¹

Invariably I waffle in reply that regularly saving into a cheap diversified portfolio over the long-term is a good practice that sidesteps such concerns.

But if the questioner is more sophisticated – or more persistent – I may venture a view that a particular market looks cheap or expensive, in my opinion.

‘Sophisticated’ here means experienced enough to have heard such views hundreds of times before – and so hopefully formed the opinion that they’re not worth very much, especially in the short-term!

(The most sophisticated investors are arguably those who ignore all this kerfuffle due to the evidence that it probably won’t give them any edge, and so invest purely passively instead).

However one fellow – a Monevator reader, to boot – surprised me the other day when he asked me what we actually mean when we say ‘shares look cheap’?

A very good question.

Over this series of posts, I’ll outline some of the ways you might hear people arguing that the stock market is at bargain levels, grossly expensive, or something in between.

I’m not going to consider the present state of the market. I want this series to be more of a reference guide than a one-off market call. You can then use the methods described in whatever market conditions you face in the future.

You can guess evaluate along with the rest of us!

Price is not the answer

Firstly, let’s look at what doesn’t work, at least for private investors like us. And that’s technical measures based on prices.

To my knowledge nobody can consistently predict and profit from short-term stock market moves. If you hear some pundit saying for example that the market has advanced “too fast” and so we “are due for a pullback next week” ignore them. They don’t know anything you don’t know. (On this evidence they may know a lot less).

I don’t personally believe that stock markets are totally efficient. There’s evidence that momentum exists in prices, for example.

But that doesn’t mean I think it’s easy to profit from short-term gyrations in the overall market. Quite the opposite!

Investing in shares is not unique in this respect.

Imagine you’re an expert in antique furniture. If I put a tatty old chest of drawers up for sale in the newspaper small ads for £20 and you realise from my description that it’s a Georgian antique, you’re well placed to make a profit.

If I auction it, however, the chances are others will spot its value, and bid against you. This activity itself can draw more expert traders to the fray. I may be ignorant about antiques, but this process means my lot should still sell for around the going rate in a public market.

Ah, but what is that going rate?

As an expert in classic furniture, you will have a view. You might exit the auction early because “prices look toppy”. Alternatively, you might laugh maniacally as you strap the drawers onto your roof racks, muttering to anyone in earshot that: “the market is temporarily depressed, but one day true value will reassert itself”.

You sound very knowing. But a year or two later, you may be saying the same thing as my drawers gather dust in the corner of your shop.

Fashions come and go. Your expertise in old furniture was enough to tell you that my chest of drawers was Georgian and you knew such items had traded at a high price in the past. But it didn’t give you any omnipotent clairvoyance about whether and when other buyers would pay what you consider a fair price for Georgian drawers in the future.

The odds may be on your side. Your knowledge of both antiques and fashion trends – and even the mood of your fellow dealers – all help.

But there’s no certainty.

Prices are adrift without an anchor

This is all very familiar to investors in shares.

In the years immediately after the dotcom bubble burst, you’d often hear pundits urge others into the market on the grounds that the FTSE 100 was 10% or 20% or 30% down from its high.

But this simple 10%-off type answer to the question “are shares cheap?” proved a poor guide to the future level of the index. Twelve years on and the FTSE 100 remains below its high of late 1999.

Some markets might never return to what you once considered a reasonable price (as I have found to my cost with London house prices). Many people are late to buy into recovering stock markets because they become anchored to a low price point, and forgo gains while waiting for a retrenchment that never comes.

They get scared because the market has risen 20%, but who is to say it was fairly priced then? Perhaps it was excessively cheap?

Going on pure prices/levels isn’t much use, then, whether you’re buying a new Art Deco sideboard or wondering whether now’s the time to put your inheritance into a UK tracker. If the FTSE 100 was once 6,500 and it’s now 5,500, it’s not at all evident from these numbers whether the old level was too high or the new level too low, let alone where prices will be in the next year.

Head too far down this road and before you know it you’re a chartist looking for triple candlesticks up your golden Uranus as you try to simplify an inconceivably complicated summation of opinions about every company in the index.

Price versus value

Don’t get me wrong – every investor looks at stock market graphs, even if they don’t admit to it. Even passive investors take solace from graphs showing the UK stock market climbing remorselessly over a hundred years or more.

I am not immune to price anchoring and other behavioural quirks, either. But personally I try to fight the daily impulse to consider shares cheap or expensive based on the absolute level of the index.

Instead, if you want to reach an opinion about whether the market looks cheap or expensive (and remember, that’s very much optional to a good investing plan) I believe you need to try to value it against something more fundamental.

And here’s a big difference between investing in antiques and buying into the stock market – one that’s often missed by newcomers to shares.

If I buy a FTSE 100 tracker, then I am buying a slice of all the future earnings of the FTSE 100, which I hope to be paid through a regular dividend and/or a rising price due to companies reinvesting their profits. Both earnings and dividends tend to rise over the long-term, not least due to inflation, so if I can wait long enough I’ll likely be rewarded.

In contrast, my Georgian chest of drawers either goes up in price, or it goes down.

Okay, technically speaking, my drawers provide a functional utility that has a value that ownership confers. You can store underpants in them, for example. More subtly, you can also show off your wealth by putting them in your living room (my drawers, not my underpants, though I can see the confusion).

If you didn’t buy my antique drawers, you might have to go to IKEA to get storage for your pants, and frame and display a bank statement to show off your wealth.

However I think it’s fair to say most of the premium in an antique over a sturdy knock-off is in the expectation of the value to be realised through a future bid².

Such an expectation isn’t groundless – real assets tend to appreciate ahead of inflation over time, which is why investing in quality furniture, houses, stamps and even art can help preserve your wealth. But the utility value you’re gaining from it is a lot more vague than the dividend yield you get on a basket of shares.

And however long you wait, I don’t think you’ll ever get what you paid for your 1970s avocado bathroom suite.

Ways to value the market

In short, we need to relate the level of the market to some other value – such as those company earnings or the dividend yield – in order to see if it’s reasonably priced or not.

I’m not the first to reach this conclusion, unsurprisingly. Over the years, many different rules-of-thumb have been devised to try to decide whether shares are cheap or expensive.

The rest of this series will highlight some of the more popular ways you may hear being used to value the market according to these so-called fundamentals.

None of these methods gives you a silver bullet solution to timing a market.

Far from it!

Hedge funds crunch tens of thousands of variables and still they run off a cliff in a year like 2008. To expect a simple ratio to give you a solution to the age-old quest for the holy grail of market timing is bonkers.

That said, I don’t personally think it’s folly for someone to decide to take an overall view on whether shares look good value, and to tweak (not wantonly trade) their allocations accordingly.

The academic evidence is that most investors would historically have done better to stick to fixed asset allocations and rebalancing as opposed to attempting market timing. But for those of us who do dabble with the dark side, these valuation methods may collectively cast a little light and help us to do better.

At the very least, after reading this series you’ll be able to decode even more City-speak when you hear it!

1. Yes, you and I know an ISA is just a wrapper, and so it can contain cash or bonds as well as shares. The general public is not so well informed!
2. Something antiques have in common with gold, incidentally.

Further reading:

1. Valuing the market by P/E ratio
2. Weekend reading: Some other fools who think the market is cheap
3. How to create your own cheap, simple and secure Guaranteed Equity Bond

Over the weekend we updated our passive investing nerve centre with some fresh links and a new introduction, which is reproduced below. We hope you like what we’ve done with the place!

Are you after an investment strategy that’s simple to understand, easy to implement, and gives you a good crack at beating the average fund manager over the long term?

Then passive investing could well be for you.

Welcome to our passive investing guide for UK investors. Our mission: to explain what you need to know about passive investing and how to do it.

Why passively invest?

With passive investing, you don’t worry about what the price of gold is doing this week. Nor do you spend days buried in company reports trying to evaluate stocks.

There’s no need to time the market, pick winning companies, or convince yourself that you have the special powers required to beat other investors – especially since the vast army of superbly equipped professionals you’re up against can’t reliably outperform, either.

As a passive investor, you refuse to play The City’s game.

Instead you use low-cost funds called index trackers to reap the market’s return and get rich slowly.

We’re fans of passive investing because:

• There’s a mountain of evidence showing passive investing is a superior strategy compared to believing the latest hot fund manager or investment scheme will smash the market.

• It can save you from costly mistakes in the pursuit of fatter returns.

• It’s as simple as investing gets. You need no more than half a dozen funds in a portfolio to spread your money across the key asset classes. You can even get by with just two funds.

Does this all sound too good to be true? Rest assured this isn’t some bizarre offshore saving scheme or whatnot.

Passive investing is increasingly the first choice of savvy investors, with net sales of tracker funds in the UK reaching a record £1.9 billion in 2011 according to figures recently cited by Which.

That brings the total held in tracker funds by UK investors to £39 billion!

The passive investing mindset

But passive investing isn’t just about the types of funds you buy. We think it’s also about how you approach the whole business of achieving your long-term financial goals.

By accepting that successful investing is a long-term pursuit, you mentally equip yourself to cope with the horrendous market crashes that will occur from time to time.

You also come to realise that a diversified portfolio is your best chance of reaching your goals.

Passive investing offers all this and it’s a strategy you can easily manage yourself for only a small investment in time. It enables you to sidestep the ruinous conflicts of interest that riddle the financial services industry, then leaves you to get on with the rest of your life.

Sure, passive investing requires some upfront research to understand. And that’s what the passive investing section of Monevator is dedicated to helping you with.

Further reading:

1. Tracking error: A hidden cost of passive investing
2. Vanguard LifeStrategy funds turn passive investing catatonic
3. Five reasons why you’ll love index investing

The last word in passive investing has to be an index tracking fund of funds. Prise the lid off one of these la-Z-Boys and you’ll find a portfolio of index trackers nestling inside like a Russian doll.

This means you can buy just one low-cost fund and – hey presto – instant diversification across all the major asset classes. Meanwhile, all those bothersome asset allocation and rebalancing decisions are automatically taken care of by someone else.

It’s a complete meal solution delivered by intravenous drip. Once you’ve set up the direct debit you barely need to remain conscious to manage it.

If that sounds like your thing, then we’ve previously recommended Vanguard’s excellent LifeStrategy fund of funds range. But since then HSBC has waded in with its rival World Index Portfolio offering.

Choices? Sounds like the kind of work a lazy investor can do without. So let Monevator do the hard yards for you…

Snooze wisely

HSBC offer three excitingly passive fund of fund varieties:

As you’d expect, the sliding scale of equity to fixed income and cash aims to hitch investors up with a fund to match their risk tolerance and growth expectations.

For example, if the violent bucking of the stockmarket makes you feel sick like a rollercoaster ride, then the Cautious fund is most likely to be your bag.

To be frank, this kind generic approach will probably fit you about as well as shoes that come in small, medium, or large, but it is standard practice.

More eye-catching are those bloated Total Expense Ratios (TER). They’re more than twice as high as Vanguard. Even the fact that there are no upfront charges or dealing fees for the World Index Portfolios doesn’t seal the deal for HSBC, unless your contributions are very small and your time horizon is very short.

The HSBC World Index literature constantly bangs on about a 0.5% Annual Management Charge. Ignore this disingenuous figure. The higher, tucked away TER number is the one that counts.

Coma coma coma chameleon

So does the HSBC fund of funds work harder for its higher TER?

Well, it certainly offers more elaborate asset allocation. Unlike Vanguard, the World Index has fingers in the property and commodity pies, not to mention foreign and high-yield bonds.

The fixed income allocation for the World Index Balanced Portfolio breaks down like this:

Personally, I prefer much more inflation protection in my fixed income allocation. The 1% in UK inflation linked bonds is a token at best.

I also expect my bonds to provide my portfolio with stability, so I’m happy to live without the risk of corporate bonds, emerging market debt, and high-yield junk – even if that means lower overall returns.

The equity, property and commodity divvy-up looks like this:

I’d think twice about bearing the extra expense of the World Index Portfolio funds just to get the sliver of property and commodities on offer here. The extra diversification isn’t going to make much difference when each asset class is worth less than 5% of the overall portfolio.

US equity holdings are also pretty low in comparison to a global total market portfolio that would devote more like 50% to the American economy. By contrast, the Emerging Market tilt is fashionably high.

Of course, I’m the kind of investor that wants control over my own asset allocation, whereas a fund of funds is designed for people who keel over at the very thought.

But I don’t think the ornamentation of the World Index Portfolios is worth the expense, unless brochure talk about “in-house quant-based optimisation processes” helps you sleep at night.

It’s also interesting to note that even HSBC confesses: “The finessing of a multi-asset allocation model is as much an art as it is a science.”

Amen.

Crude awakening

The contents of a World Index Portfolio are mostly the regular HSBC index funds and ETFs that you can buy as separates, if you’re more active than a Koala who’s given up Eucalyptus leaves for Lent.

HSBC will also use other firms’ products to cover certain asset classes – e.g. there’s a Lyxor commodities ETF in the mix.

Other noteworthy features include:

• The portfolio is rebalanced every quarter.

• Asset allocations are reviewed annually, so watch out for any changes you’re not comfortable with.

• The cruder risk tolerance choice makes the World Index funds harder to lifestyle than Vanguard’s LifeStrategy funds.

• The Balanced Portfolio fund size has nearly halved from an opening £5 million to £2.67 million in five months. Not a great sign. Vanguard’s equivalent LifeStrategy 60% Equity fund sits around £8 million.

• The funds are not UCITS products, they are Non-UCITS Retail Schemes (NURS). This enables them to invest in property and commodities and unapproved securities (up to 20% of the fund’s value) among other things.

• HSBC mentions that the fund’s can invest in private equity although it won’t dabble in hedge funds.

• Income and accumulation versions are available. Look out for the ‘retail X’ share class.

• Check out the factsheets here.

Time for bed

The big problem I have with the World Index Portfolios is the lack of a published index to benchmark them against.

The whole point of passive investing is to gain the market’s return by using low-cost index funds. If you don’t know what index your fund is meant to track, then you have no sound way of judging its performance.

For my money, HSBC’s World Index fund of funds is over-elaborate, expensive and, too opaque in comparison to its Vanguard rival. Fail.

Take it steady,

The Accumulator

Further reading:

1. 9 lazy portfolios for UK investors – 2010 remix
2. Low cost index trackers that will save you money
3. Our Slow and Steady passive portfolio