What caught my eye this week.
I think sequence of return risk is perhaps the least discussed Most Important Thing about investing.
That’s probably because it doesn’t impact professionals so much.
Big institutions such as pension funds and endowments typically have an infinite time horizon. There’s no cliff edge for them where they move from saving to spending – which is the cut-off point where sequence of returns risk can do the most damage.
Individual fund managers? Well, they do face a related career risk. The best thing for a poor-to-average fund manager is to achieve your great returns early on, in order to attract a lot of assets. You can then revert to the mean with your mediocre-to-bad years later, when you’re earning a fat fee on all those billions.
Of course this is the opposite of what would be best for the average investor in that fund, but that’s a topic for another day.
Anyway Ben Carlson of the Wealth of Common Sense blog published an excellent deep dive into sequence of return risk this week, noting:
The sequence of returns in the markets is something we have no control over.
Some investors are blessed with weak returns in the accumulation phase and strong returns when they have more money, while others are cursed with brutal bear markets at the outset of retirement or markets that go nowhere when they have a bigger balance.
Luck plays a larger role in investment success than most realize since we each only have one lifecycle in which things play out.
Oh yes, that’s yet another reason why we don’t hear much about sequence of returns risk – there are no perfect ways to counter it. Even the good and sensible ones are likely to sap your returns. (Like diversification, however, they can still be perfectly sensible things to do).
See Ben’s full article for some ideas on managing sequence of returns risk.
And have a great Bank Holiday!
From Monevator
I know, another week with no new content. I’m disappointed, you’re disappointed. Let’s get through the summer and see how we feel then? In the meantime…
From the archive-ator: Lump sum investing versus drip-feeding – Monevator
News
Note: Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber.1
Retire today and you’re 46% worse off than 10 years ago – Telegraph
UK growing at half the rate of Eurozone [Will they let us back in?] – Independent
The latest ups and downs of the UK housing market – Guardian
Millions of taxpayers sent warnings about offshore accounts [Search result] – FT
People start hating their jobs when they hit 35 – Bloomberg
Products and services
Atom Bank has four new Best Buy savings deals [Move quick, won’t last] – ThisIsMoney
NS&I is scrapping Children’s Bonds – Telegraph
Which? finds people trust banks more than pension products [Search result] – FT
How to claim mis-sold PPI for free – Guardian
Pension firm introduces equity release to the buy-to-let sector – Telegraph
Ford offers a £5,000 diesel scrappage scheme amid Government inertia – ThisIsMoney
The postcode lottery of pet insurance [Search result] – FT
Where to get more foreign currency for your Brexit-battered pounds – Telegraph
How to finance a home extension – Guardian
Comment and opinion
Your financial life is complicated, your portfolio shouldn’t be – Morningstar
In reality it’s hard to buy when there’s blood on the streets – Of Dollars and Data
A look at UK Robo Advisors – DIY Investor
Has Neil Woodford lost it? – The Evidence-based Investor
Probably: The cult of the portfolio manager is over – Morningstar
Stop frugality leading to lifestyle deflation – Financial Samurai
Change the portfolio, or change the investor? – Daniel Egan
The investing opportunities presented by climate change [PDF] – GMO
An interesting article for stock pickers on improving their process – SumZero
Beware: Portfolios built with ETFs do worse on average [PDF, research] – Alpha Architect
Beware the ‘billionaire bears’ – The Macro Tourist
Behavioural bond bucketing [Note: US ‘CDs’ are *a bit* like UK bank savings bonds] – Abnormal Returns
It’s not you, it’s me [Long article on mental biases and other failings] – Above the Market
39 lessons from three favourite investing books – UK Value Investor
Why retire at 43 then go back to work at 45? – The Matrix Experiment
Holiday in Siberia – SexHealthMoneyDeath
Off our beat
More evidence that being middle-aged is the worst – Quartz
Silent threats in the night: A forgotten memory until Charlottesville – Financial Samurai
Weird! Someone praising the London Underground – Business Insider
And finally…
“Governments and peoples do not always take rational decisions. Sometimes they take mad decisions, or one set of people get control who compel all others to obey and aid them in folly.”
– Winston Churchill, The Grand Alliance Vol. 3
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- Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [↩]
“Risk really matters when you no longer have human capital and are planning to live off your investment earnings for the remainder of your days.” Spot on. Life is going to be rather different for the DC and the DB pension generations. Life is also going to be different for those working for the government and those working in the market sector of the economy. I wonder whether the attempts to stir up hatred between the generations is a conscious attempt to distract attention from the latter divide in society.
I had a letter from Lloyds and the Halifax asking me to declare where I was based for tax purposes. I was very puzzled and after checking if it was a scam, sent them back. While I have money squirreled away in non-UK shares, it is all invested in ISAs with UK based firms so why they should think I’m not based in the UK is weird. Having enough money to contemplate hiding some of it away in tax havens would be a nice problem to have!!!
@Sara – I’ve also had this from HL, states it’s a new requirement from 1 Jan 2018 and they are just getting ahead of the game. I’m sure some expert will know more about this.
@ Sara
There are a lot of requests going out from fund platforms to confirm your nationality and National Insurance number, which is to do with compliance with MIFID (the Markets in Financial Instruments Directive). There are also of course a huge number of scam requests inviting you to send your bank details to some chap in a faraway place.
The Carlson article is very welcome. I almost never cease to be dismayed by the lack of attention paid in industry articles to the fact that we are all (perhaps apart from K.Richards Esq.,) mortal – and that how long you have left may make the happy statements eg about “what counts is time in the market, not timing the market” fatally misleading as a basis for individuals’ investment decisions. I have a bad feeling that this insouciance is linked to sales strategies; it seems odd to me how many articles on fund platforms somehow manage to end saying what a good idea it is to invest in fund y when it has spent time in the article pointing out that fund y’s sector is looking dodgy. I view Tom Stevenson at Fidelity as a usually honourable exception to being a salesman in disguise.
HL Wealth 150
If it isn’t already being discussed on another thread that I’ve missed, is this a good place for me to raise the topic of HL’s newly released figures showing long term performance of their Wealth 150 picks? http://www.hl.co.uk/funds/wealth150
On the face of it, the figures suggest that HL has, over the 14 year life of the W150, successfully picked funds that were more likely than not to outperform their respective indexes, after HL’s costs. They haven’t succeeded in all sectors (eg, not US, which is why they have conceded that passive is better for the US and no longer have any US equity funds in the W150), but they have outperformed in most sectors.
It seems to follow that buying HL’s picks (and selling them when HL demoted them from the W150) would have resulted in a better 14 yr return than a portfolio of passives with the same sectoral mix.
Now, I’m a big believer in passive investment, but I’m a bigger believer in being open to new evidence, so I want to play devil’s advocate. On the face of it, doesn’t HL’s data undermine a key part of the rationale for passive investing (at least for equity markets other than the US)? It is clearly a mathematical fact that most funds underperform their indexes, especially after costs. But some fans of active investment say this doesn’t matter, because only dumb investors buy those funds. There are some fund managers that do outperform, so a smart investor can beat the index by picking the outperforming fund managers. Passive proponents respond that there is no way to know in advance which ones they are, because there is little evidence that outperformance endures.
So, if HL’s data shows that they managed, on average, to pick outperformers, does this suggest that it would be better to follow their W150 buy and sell recommendations for active funds?
Or have they rigged their analysis in some way that I’m missing? They seem to have eliminated survivorship bias, because they only include returns for the periods the funds were on the W150. And it can’t be hindsight, because W150 picks are published and I’m assuming they are being honest about when they promoted and demoted funds. Perhaps their picks provided the outperformance by picking portfolios that were riskier than the index? A riskier portfolio means higher returns in the good times and bigger losses in the bad times, but as we are measuring over 14 years, this seems to suggest that HL picked funds that avoided the big losses, or they spotted that big losses were likely and took the risky funds off the W150 before their risky strategies led to big losses. So I don’t really see a problem with this.
Ben’s article mentions volatilty. While this is bad in the accumulation stage at least pound cost averaging allows the investor to recover some ground by buying in the dips.
However, in the draw down stage volatililty is a killer because the opposite is happening, and beautifully labelled by Con Keating as “pound cost ravaging” . If you draw down capital at a low point you never get the chance to recoup any of the losses. Its gone, spent, end of.
So, if you hit retirement as a bear market starts it is very tough if you are relying on capital. Those lucky enough to have a large enough pot to live off the dividends will be less affected.
It of course helps that good dividend payers tend to be less volatile.
@ivanopinion
I don’t know about HL specifically, but the for example the FCA concludes in its Asset Management Market Study that best buy lists “do not allow investors to identify products that on average, after charges, outperformed the stated benchmark.” Without any knowledge of specifics, it is of course possible that HL are the exception to the rule or just very lucky, but as you hint there are other reasons than survivorship bias why comparisons could be skewed.
“I think sequence of return risk is perhaps the least discussed Most Important Thing about investing.” Whereas I think it’s the decline in mental competence and agility as one gets older and its consequences for investment decision-making. In an age of DC pensions, and annuities that appear to be lousy value, this is a big deal.
@ivanopinion. ‘Company selling actively managed funds produces data showing that its picks outperform’. Hmm, seen this before? I haven’t looked at the article, but foremost in my mind is – who benefits from this message? Would HL publish data showing underperformance? They know their target audience likes to think of themselves as rational and informed, so their advertising (that’s what it is) will be presented to flatter the reader’s intelligence. My starting point for taking evidence seriously is that it is independently produced, transparent and replicable. In my own field, (indepedendent) research shows that industry produced data/research is biased and incomplete. Finance is no different.
@dearieme – I agree, but you reinforce a possibly problematic assumption by dismissing annuities. Are they poor value, or are they just expensive? Isn’t the high cost of annuities right now another type of sequence of returns risk? (As in, you are affected by the relative cost of annuities at the point in your life when you need them, which you can’t really influence?)
Living off financial assets is always going to be subject to risk, and personally I think the value of a lower risk income floor for essentials (annuity, state pension, cash or near cash etc) is too readily dismissed.
Robin Powell has a few thoughts on the HL list:
http://www.evidenceinvestor.co.uk/industry-research-nothing-like-real-thing/
I haven’t the time or the inclination to dig into the list right now. But as I’ve said many times, I fully believe it’s possible to beat the market, even after fund management costs, and that some funds do. However all the evidence is that it’s a very small fraction who do so over longer time periods.
The issue for me has never been “can a fund manager beat the market?” — if anything that question is playing by the rules set by the financial services industry, because sheer chance would produce some who can, and if they can put them up as the answer “yes” then they’ve answered your question affirmatively… but it was the wrong question.
Better questions are “Am I likely to find the few active funds who beat the market?” (Answer: probably not, over 30 years) and “Given that the odds of doing so are very low and there’s a simple, cheap, market-tracking alternative, do I even need to try?” (Answer: No, the market return via index funds is all most people trying to save for retirement or similar need to do the job, without the risks for the potential rewards of the active pursuit).
Could HL have selected on average market beating funds via its list for multiple decades? Yes, there’s nothing in my understanding of the world to say that’s impossible.
They could have. Perhaps their numbers show they have, or perhaps they’re tilted by survivorship bias or similar.
Either way, they are most likely affected by for want of a better term “style bias”. Without studying the list, I’d wager they have always been tilted towards UK equity income type funds, which have had a superb run over the past 20 years or so, not least by sidestepping the tech boom due to their dividend focus. Perhaps they’ve also benefited from currency risk more recently, it depends how they benchmark.
But anyway even if they have done it in the past, the next question you have to ask yourself is “Can they do it in the future, for my 30 year time horizon?” What is your reasoning to think they can? If you have some, fair enough. If not — or if you think they’ll only manage another ten years say, then why are you getting involved? How long will it take you to decide the list isn’t doing the job?
One or two years means nothing in investing; things bounce up and down all the time. Think five or 10 years — even the latter is probably only just getting into a sensible timeframe to judge over. Yet 10 years is a big chunk of the typical savers’ life. Why mess around?
I say all this as an active stock picker. If my co-blogger @TA was here he’d probably be more scathing. But the net takeaway is the same. Most people just don’t need to take a chance on higher cost active funds that have the strong likelihood of underperforming the market.
Where we differ is @TA tends to write in quite apocalyptic language about the dangers, whereas I don’t think it’ll be a catastrophe if you go active… I just think you’ll probably end up poorer. Maybe your pot will be two or three (or ten) Porsches smaller over a 30-40 year investing life, in Lars Kroijer terminology.
Then again, if backing your favourite fund managers is what gets your blood up and keeps you investing, maybe you’ll save more than you would have in “boring” index funds anyway? Again, I’m an active stock picker. I understand we all have different motivations and curiosities.
But for most people, who don’t want to become investing trainspotters, nerds, or groupies, again, why bother? Why take the risk?
If active funds didn’t already exist, would you really invent them — with all their costs and risks of doing worse? Or would you say “no, we’ve got that covered” and spend your time inventing something else? 🙂
I share everybody’s scepticism about HL’s figures. I am inclined to believe that they must have biased the analysis in some way. But I’d prefer to understand in what way the analysis is flawed, rather than simply assume it must be.
They do explain their methodology and it does seem to be a cut above most of the self-serving, simplistic analyses one usually sees from HL and the like. They seem to have eliminated most of the obvious ways of fixing the result.
They include all funds that have ever been on the W150 (for the period that they were on it), so on the face of it survivorship bias is eliminated.
I don’t think it can be “style bias”, because they have done their analysis on a sector by sector basis. They aren’t saying that the W150 has, overall, beaten a specific global index; they are analysing whether the W150 funds in each sector have beaten the index for that sector. So, they are saying that their picks in, for instance, the UK All Companies sector have beaten the index for that sector.
As I said, it might be a more subtle type of style bias, picking funds that are riskier than the index for that sector. But if so, the extra risk seems to have paid off, over a 14 year period.
“But anyway even if they have done it in the past, the next question you have to ask yourself is “Can they do it in the future, for my 30 year time horizon?” What is your reasoning to think they can?” If they have successfully done so over the last 14 years, isn’t that a reason to think there’s a good chance that they can in the future? Yes, even a 14 year record isn’t guaranteed to continue, but 14 years is a pretty long time to put down to a random lucky streak. That’s why I want to understand whether they really have managed to do this.
“Most people just don’t need to take a chance on higher cost active funds that have the strong likelihood of underperforming the market.” But that’s just it: if in fact the evidence says that following HL’s picks means there’s a strong likelihood of outperforming the market, despite higher costs, why wouldn’t you follow their picks? (You don’t even need to do so through HL.) You can never get certainty: you have to decide what is most likely to perform best. Up to now, the evidence has convinced me that no-one can, with reasonable consistency, spot which funds will outperform (and when they will cease to do so), and I’ll be amazed if HL really can do this. But I’m not comfortable just telling myself that they can’t, as an article of faith.
Is there any identifiable, large (in capital) set of investors who routinely lag the indices? If so, it’s possible that there’s a set that beats them. How about the insurers and pension funds. Do they reliably underperform?
@dearieme
Yes. Retail funds, in the aggregate, routinely lag the indexes. I think all but the biggest active investment zealots would concede that.
Retail funds are a reasonable chunk of the market: enough to create the mathematical possibility that some funds could outperform.
I don’t know about insurers, pension funds, hedge funds, family offices and sovereign wealth funds.
Thank you for the mention guys! I always appreciate it. Maybe you’d like to guest post on FS one day at talk about my favorite subject: property and what’s going on in London and the wins/losses and emotional turbulence that goes along with it?
I decided to finally sell my most valuable property to simply life. I can’t take being a landlord anymore.
Best,
Sam
I’ve taken a quick look at the HL site and Robin Powell’s response – which I agree with.
As to the rats we are all smelling, there are a number of issues on the HL analysis:
1. The biggest is the comparison of apples and pears. The HL funds are total returns, no initial charges, distributions reinvested. Compared with an index, which HL say in the notes is calculated using the average prices (so no dividend reinvestment).
2. The scales of the graphs changes each time.
3. The source of the data is ‘Internal’
4. The paragraph on the property explains there are no tracker funds available to track the IPD index, but then says of the selections were included they outperformed the tracker funds by 12.52%.
5. Loyalty bonuses from July 2006 have been added back to fund returns.
At least HL have included the graphs that show where they underperformed, and importantly these were the global sector, North America and Absolute Returns, which I would imagine are the more popular ones.
The most glaring misfit for me was the graphs that show the performance of the sector average to beat the performance of the average tracker – maybe they are comparing accumulation funds with income trackers. But then again that wouldn’t explain the Technology graph that shows the average tracker outperformed the index by over 20% – that’s some tracking error!
@Passive Pete
If you are right that they are calculating index returns using average prices, without div reinvestment, then I think you have identified the key distortion we all expected was there.
However, this would be such a crass ‘fix’, I find it hard to believe HL would do this, because they would know they would be very unlikely to get away with it. With the FCA review ongoing, it would be incredibly foolish for them to try something so egregious.
But are you sure? I can’t see where they explain how they calculate the index returns. Can you point me to it?
I think initial charges have always been rare at HL, which is one of the reasons they used to be a very good deal. So I’d expect that even if they had included initial charges it would only change a few funds returns.
I think it is fair enough to add back the loyalty bonuses, as they are also including the gross fund charges, which for most of the period included around 0.5% to pay trail commission. Of course, if the W150 funds had been bought though other platforms, many investors would probably have got bigger rebates (pre RDR) and paid lower platform fees, so in one sense HL are actually understating the fund performance.
No I’m not sure how HL have calculated the index return, like you I found very little information on their website. The pop up screen on ‘How have we calculated these figures’ gives the details on how their fund performance figures are calculated in the drop down section ‘Where are the figures from?’ However the ‘Method’ and ‘What is an index’ drop down paragraphs say very little on the method for calculating the performance of the index, tracker return or peer group return. Therefore it’s just my understanding of what they say and don’t say – they haven’t said they reinvested distributions for the index, so I think the index comparison is simply against the index.
I’m fairly relaxed about this type of marketing, as Robin Powell says, ‘I don’t actually blame the marketing people at firms like HL; they’re only doing their job.’
I also use HL for a portion of my portfolio and have always found them very good – bit I minimise fees by investing in ETF’s and individual shares, so I’m not trying to bash HL.
The way I look at it, if they don’t specify otherwise, the reader is entitled to infer that if they are using total return for one side of the comparison, they are also doing so for the other. It would be the ONLY reasonable basis. So if they are excluding dividends from index returns I’d say that is downright fraudulent and the FCA should be punishing them with a MASSIVE fine.
HL have a long term record of peddling half-truths and bulls**t, but I can’t believe they would do something so blatantly wrong.
Unlike you and Robin, I’m not relaxed about this particular marketing. If they are claiming their analysis proves they can, more often than not, spot funds that will outperform (and when they will cease to do so), then they had better be doing so on the basis of a valid analysis. This isn’t some cleverly ambiguous puffery; it is a clear claim that they have objectively proved that most of their picks have outperformed.
There is one part of the HL webpage that I think we might all agree on which says (in bold), ‘ Remember, past performance isn’t a reliable indicator of future returns.’ which begs the question – why give us all these graphs on past performance?
Yes, although how else are you going to pick, if not by past performance? We buy equities because they have delivered good returns in the past, but we can’t be sure this will continue. I would say that long term performance is a more reliable guide to the future than short term.