Lars Kroijer on…avoiding Covid-19 losers, ultra-low interest rates, and dividend cuts

Passive investing champion Lars Kroijer is back with another trio of answers to your investing questions. Once again this is a collaboration between Monevator and Lars’ popular YouTube channel.

This time we sent Lars some queries we’ve received in the Covid-19 era. As before, his answers are in both video and edited transcript form below.

Note: embedded videos are not always displayed by email browsers. If you’re a subscriber over email and you can’t see the three videos below, head to the Monevator website to view this Q&A with Lars Kroijer.

Should we try to avoid the obvious losers from Covid-19?

Our first question comes from Rachel, who asks whether the pandemic is a reason to avoid certain sectors that are going to be ‘obvious losers’ – or to hire a manager to do so?

Index trackers might be best for normal times, agrees Rachel, but these are not normal times?

Lars replies:

As I’m answering this question in June 2020, virus cases might be down but there is still a lot going on – lockdowns, severe travel restrictions, and rumors of remedies and treatments.

However there is not yet a vaccine and in fact, there is a threat of a second wave of infections.

The future is still highly uncertain. Economies face huge declines and certain sectors like travel and hospitality are facing massive impacts in the future.

So, the first questions really is, would you be able to pick a stock market sector to be an obvious underperformer? And my argument is you cannot. Shares in a lot of these sectors have fared incredibly poorly – but that is not something you know will happen from this point on.

Let us say you have one sector that has already gone from a hundred in value to twenty in value. Will that decline happen again? Not from hundred – but from twenty?

That is actually an incredibly bold statement, to say that you know this sector better than the trillions and trillions of dollars already invested and the very, very well-informed investors all over the world.

So no, I do not think you can pick these sectors to yourself. I recommend you stick with the broadest, cheapest, index tracking fund you can get your hands on.

What if you find a smart investment manager to avoid the bad sectors? Someone with access to all the right information, people, and so forth?

Well, in normal times, one or two active managers out of ten perform ahead of the relevant index over ten year periods, after all the fees and expenses they incur on top of what they charge you. You can argue that these are not normal times, but is it really likely that the 10-20% outperformers will become more than 50%? I do not think so.

Can you then pick one of the few investment managers who will outperform the market? Again, that is very unlikely. Past performance is not of an indication of future performance, so you can’t just pick the ones that have done well in the past, unfortunately!

So again, I think save yourself of all the fees and expenses and buy the broadest, cheapest, global index tracker.

Of course what is going to happen is once this plague is over, one way or another, some investment managers will have done very well. You should expect to see big billboards, and books written about them saying how they knew this or that what happen. But that is the winner’s argument. We are not going to see billboards, talk shows, and so forth highlighting all those that have not done well.

I appreciate the desire to do something in these turbulent times. You probably have a lot of other stuff going on economically. I’d strongly encourage you to look more closely at your personal financial circumstances.

We also know that equity markets are probably a lot more risky than they were before the coronavirus. This is a far more volatile market. If you want to reconsider your asset allocations, there are other videos in this series that address this issue.

What do low or negative rates imply for 60/40 portfolios?

The question in this video comes from Dave, who asks: if central bank interest rates go negative, what implications does that have for the 60/40 portfolio?

Lars replies:

First of all, the 60/40 portfolio refers to the idea of having 60% of your money in equities and 40% in bonds. The idea is this is a reasonable level of risk for a lot of investors. You have the upside in equities but you also have the 40% bond allocation to temper the risk.

My view is it’s great to keep things simple but risk is really quite an individual thing. It depends on the stage of your life, your non-investment assets and the correlation of these, and also just how you feel about risk, your job, and so forth.

So, the 60/40 might suit you – but do not assume it is for everyone. If you are interested, there are product providers like Vanguard and others with funds where you automatically get this – or a similar fixed – allocation.

Back to the question, and the answer, unfortunately, is not really clear. If you assume that the risk of the government is fixed, which is a big assumption, and that the equity risk premium does not change as a result of interest rate changes, then it is clear your expected investment return will be lower as a result of lower interest rates.

What does that mean in practical terms? It means you will expect to have lower investment income in the future if you keep the 60/40 investment portfolio. For those looking to retire, this means you will either have to save more, consume less, or work longer, which is obviously not great.

Of course you can exchange or expand your portfolio composition from 60/40 to invest more in equities. But all else equal, this will be a higher-risk portfolio. So you have got to make sure that you have the risk tolerance to do that.

In reality, it is not that simple. Central banks set their interest rates in response to the status and the prospects for the economy. It is a great tool to get the economy going. Their decisions on interest rates filter through to bond yields for investors, and obviously with lower interest rates there is an incentive to borrow more money and invest in the economy.

But can you assume that government risk is a constant? You cannot really assume that. You also cannot assume that the equity risk premium is a constant. It is also not really knowable.

The equity risk premium is generally deemed to be 4-5% above inflation. But it really changes dramatically with the changing of the risk of the equity markets. And it is also perhaps not a terrible assumption to say that in a lower interest rate environment where governments are actively trying to boost the economy that the equity risk premium may go up.

I should mention we are discussing here real interest rates, so that’s after-inflation. So if you have high inflation country, even with a 10% nominal interest rate and 9.5% inflation, that still means the real interest rate is only 0.5%. So there is no free lunch there.

But going back to the 60/40 portfolio, this video is shot in the middle of the pandemic and one thing is very clear – the risk and the equity market’s expected future volatility has varied dramatically and shot up massively.

So if you have kept a 60/40 portfolio, well the overall risk of that portfolio has changed a lot. In a sense it is quite an active choice to simply say you want to keep 60/40. So, just be sure you can stomach that higher risk.

Of course with higher volatility, it is not unreasonable to expect higher future returns. But that’s at the cost of the higher risk.

I would also say that the answer to this question would be clearer if you had a 100% bond portfolio. In that case, it is pretty clear there is no potential compensating factor from equities and you will simply earn less and have lower real returns for your portfolio, and you would have to adjust for or simply live with that fact.

In summary, I’m sorry the answer is not clear but I still hope my commentary was somewhat useful!

Do widespread dividend cuts mean equities are less attractive?

Finally, a question from Sandeep who asks whether the widespread dividend cuts we’ve seen affects my view on the attractiveness of equities as an asset class?

Lars replies:

This video is shot amid the Corona pandemic and a lot of companies have cut dividends because of the highly uncertain economic future.

But this does not really change my view of the attractiveness of equities as an asset class.

I’m not aware of any studies that suggest that a lower dividend yield will automatically lead to lower overall returns for equities going forward. And even if that were the case in the past, it is not clear that it would be the case in the future.

Now, ‘overall returns’ means both dividends and the capital gains from owning these stocks. And obviously, changes in the dividend are often seen as a sign from management as to how things really are. An unexpected lowering of a dividend will very often lead to a massive price drop. It is essentially management saying we do not have the cash to pay the dividends that we thought we did. That signal is very bad.

But it is also a very good assumption to say that market prices adjust quickly to these new circumstances. Therefore it is a very bold statement to say that you can outperform the market after dividend cut announcements by assuming it says something about the prospects for the wider markets.

Now, just talking briefly about dividend cuts in the Corona pandemic and what happened when the virus spread globally, quickly. What we saw was the market reacted much faster than companies around the world were announcing dividend cuts. So, those dividend cut announcements did not lead perhaps to the same magnitude of price movements you’d expect, because the market was already expecting these dividend cuts.

Of course, they were still surprises, both positive and negative, from the signal and effect of the changes to the dividends but nothing [to exploit as an edge] – certainly not for regular retail investors.

More broadly speaking, I would say some people like receiving dividends and others do not. For me that often has a lot to do with tax. Your specific tax situation, the jurisdiction you are in, and whether you want dividend or capital gains

Let us say you had a €100 stock that is paying €2 in dividends – after the dividend date, that stock should go €98. If you have a parallel situation where the stock did not pay dividends, you’d stay at €100. What is better for you depends on your tax situation, so that is worth keeping in mind.

Until next time

Please do feel free to add to or follow-up Lars’ answers in the comments below.

Watch more videos in this series. You can also check out Lars’ previous Monevator pieces and his book, Investing Demystified.