Lars Kroijer on…hedge fund mimicking ETFs, checking your portfolio, and minimal risk assets

When we asked you for questions to put to passive investing guru Lars Kroijer, we were inundated. So we’re doing something a bit different – a collaboration between Monevator and Lars’ popular YouTube channel.

Every month Lars will pick a few of your questions and then answer them individually, in video and transcript form, as below. We’ve already got enough questions to last us a year or two, so sit back and enjoy!

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 I invest in passive products that mimic hedge funds?

First up this time, Tony asks about ETFs that seek to mimic hedge fund exposure. Do they make sense for a passive investor?

Lars replies:

In short, I don’t think you should invest in these sorts of products. There are a couple of reasons.

First of all, it’s incredibly hard to mimic hedge fund exposure. There are perhaps 10,000 hedge funds in existence. They are doing all sorts of things. But it’s really really hard to get access to a lot of them – they’re closed for new investments. Besides, it would be impossible to create investments in the proportions or the sizes of these hedge funds.

So the exposure you’ll end up having is probably quite far from the actual hedge funds’ exposure.

I think what a lot of these ETF providers try to do is not to replicate an investment in hedge funds, but to say synthetically what does hedge fund exposure look like? So they would say that hedge fund exposure is like having point two of S&P, point one of oil, point two of gold, and so on. But like this you’re creating a lot of tracking error versus the actual hedge fund industry.

To me, a passive investor is someone who doesn’t think that through active security selection they can outperform the market. I think there are a lot of benefits from coming to that realization. But a hedge fund is almost opposite of that. And by picking the people that we think can outperform the market – the hedge fund managers – we are indirectly being the pickers ourselves, too, by picking the funds.

So I think investing in hedge funds is almost the opposite of what a passive investor should do. Generally, the huge fees and expenses associated with the funds put you so far behind that unless you have some special angle, it’s worth staying away from them.

There’s probably been some value created in hedge funds over the last couple decades, but there’s also been tons and tons of fees. There’s also selection bias – we tend to hear from only the successful funds, much like in the mutual fund industry, and we don’t hear about the huge failures because they tend to die and disappear. That’s another reason I think just to stay away from this type of investment.

I would say that if you’re really interested in hedge funds (and if you’re able to invest in them, because they often have minimum investment sizes) I would do the work and find a few funds that perhaps offer unique investment opportunities, and invest in those.

That can be an incredibly exciting thing to do and but it’s also something that’s hard for regular investors. In any case, I think it is slightly outside the scope of this question.

Checking up on your portfolio

Rick asks how often he should monitor the funds in his portfolio:

Lars replies:

First of all, there’s no firm rule for this whatsoever.

Just to take a step back, one of the major benefits of a passive portfolio – on top of probably making you wealthier in the long run – is that you spend very little time on it.

You don’t have to spend a ton of time reading the Financial Times, the Wall Street Journal, or research reports. You don’t have to understand whether Facebook is a better investment than Apple. No, you just buy the broadest cheapest index tracker and let the market do all that for you. That saves you a ton of time.

Incidentally, let’s say you invest in a market that’s up 10% – say Europe. [With a tracker] you make that investment with zero time spent and almost no cost.

Let’s say instead you’re up 12% [from investing actively] in the market. That’s only 2% that you spent all that time to achieve – because 10% you got via the market!

I’d even question whether you can reliably make 2%. But even if you did, it’s only the 2% extra you spent all that time achieving.

Coming back to the question, I would say definitely have a look at your portfolio when there’s money flowing in and out. Also have a look when something in your personal circumstances has changed that could impact your risk profile.

This could be a personal thing such as – to start with the positive – a bonus at work. Or it could be you lost your job. Perhaps you got a windfall through an inheritance, which is often obviously not entirely a good thing. Or perhaps there’s an external issue, such as an economic crisis where you live.

I would definitely have a look in those circumstances – and perhaps it’s not a bad idea to get help from a local financial adviser.

But in general, I’d say have a look at it every three to four months just to make sure things are not totally out of whack and then have a more thorough review once a year, perhaps again with a financial adviser. In general, when you hear lots of financial drama in the news that could impact both the markets and currencies again, check out how that impacts your portfolio.

And of course as Rick suggests, once in a while you should think about whether there are better products out there? Has your tax situation changed?

And again, that could be worth talking to an adviser about.

What is the point of owning the minimum risk asset?

Finally for this session, Paul asks why do we need to have a minimal risk asset – that is, the lowest-risk asset we can get our hands on – in our portfolios?

Lars replies:

The short answer is you don’t always need this asset, but you’re very likely to.

Just taking a step back, it’s my view that most people are very unlikely to be able to outperform the financial markets. As a result, they should put together a very robust two product portfolio.

Firstly, they should invest in the global equity markets, through an index tracker typically.

Second, they invest in the lowest risk asset they can possibly get their hands on. For most people, this is typically government bonds that are highly rated in your local currency, with a maturity that suits your investment horizons.

You combine these two to match your investment risk profile, and you’re done! Investing can be more complex than that, but in my view, it doesn’t really have to be for most people.

So why do you need this minimum risk asset? Well, if your risk profile is such that the risk of the global equity market suits you, then you don’t need it. For most people though, that’s just too risky. So they temper the risk of the global equity markets by also investing in a very low-risk asset and then combining the two so that they optimize for their own risk.

Let’s say you want a 50/50 allocation – you’d need to put 50% of your portfolio in the minimal risk asset.

In some people’s cases, they want all their assets to have no risk at all! In that case they’d invest only in the minimal risk asset.

Until next time

Right, we’re out for this month. 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.