Lars Kroijer is an occasional contributor to Monevator. His book, Investing Demystified, makes the case for index fund investing. Given the woeful performance of value funds over the past decade we thought we’d resurrect this classic post to give Lars a victory lap.

Most Monevator readers will know that I think passive investing in index funds is the rational choice for nearly everyone. A global tracker fund is the only fund most people need.

That’s because I believe most people have no edge when it comes to the extremely competitive investment markets.

I don’t even think many of us can judge whether one entire country’s stock market is better value than another, let alone pick individual stocks that will outperform.

For that reason, I think the most investors are best off using world equity index tracker funds to get their entire exposure to shares.

A world index tracker enables you to let the global capital markets do the hard work of figuring out where your money will earn the best return – because that is what is reflected in the various regional weightings in a world tracker fund.

International capital has spoken. You can just enjoy the ride.

Cheap and cheerful

Investing in a world tracker is the ultimate admission that you don’t know any better than the market.

By understanding your limitations as ‘dumb’ money and just ‘dumbly’ following the market, you actually make a very smart investing decision.

However many firms and pundits have tried to take passive investing in a different direction.

Whether it goes under the name of Smart Beta, fundamental indexing, alternative weighted indexing, or anything else, fans of these methods claim they can deliver superior returns to vanilla market weighted index funds.

The alternative-weighted funds aim to exploit various return premiums that have outperformed in the past.

For instance, there is much research that suggests that value (i.e. companies with low price-to-book or price-to-earnings ratios) and smaller companies both outperform the general market over the long-term.

Various indices and products to track them have been created to reflect this line of thinking.

Let’s put aside the poor performance of some of these strategies in recent years.

Is it rational to invest in them at all?

Dumber and dumberer

In short, I don’t think my definition of a Rational Investor – that is somebody who knows they have no edge – should buy alternative weighted investments as proxies for their market exposure.

By actively deselecting a portion of the market (that is to say buying alternatively weighted index funds with lower exposure to higher growth or larger companies, as in the example above), anyone who does so is implicitly claiming that the money invested in these deselected companies is somehow less informed than they are.

That is a pretty grand statement, and inconsistent with Rational Investing.

In contrast, I think it is probably fair to assume that those investors in high growth or large companies are highly experienced and informed, have read all the relevant books on investing, and are well aware of all aspects of the historical outperformance of various sub-sectors of the markets.

They are not stupid. In fact they are as much a part of the market as the value or smaller company investors are.

Do you really think that the trillions of dollars that follows companies like Google and Apple is somehow poorly informed?

Do you think that you know more about the markets than they do to the extent that you should deselect those stocks?

Expensive to implement

In my view anyone who suggests an alternative weighting to simply tracking the overall market looks a lot more like an active than a passive investor.

Likewise, the implicit cost of the part of the portfolio that diverges from the general index can easily approach the fee level of an actively managed fund.

Suppose an alternative weighted index has an overlap of two-thirds with the wider market, but it costs 0.3% more per year to implement than the market cap weighted tracker.

In this case you are effectively paying 1% per year on the one-third part of your investment that is different from the general market.

That is a fee level akin to some active managers.

An alternative universe

I think that many of these alternative weighted indices are created to match what has had the best historical performance and thus is easiest to sell.

If stocks with high P/E and growth rates had been the best performers over the past however many decades (as indeed they were over the last ten years) then I think the most popular alternative weighted indices would all consist of that market segment. We’d be marketed to with charts outlining all the reasons why the outperformance of expensive growth companies was expected to continue.

We would then be equally guilty of fitting the product to past returns and essentially saying that we had the insight that the future would be like the past.

And I don’t believe we can rationally say that.

Do you have edge or not?

As well as the active deselection of some parts of the market that it implies, my main issue with small company investing has to do with implementation.

Actively implementing a portfolio of smaller companies is very expensive. The trades required to build up the portfolio are subject to large bid/offer spreads and price movements if you trade in any size.

But even if you could pass the hurdle of costs, you are still left with the same question – do you really know enough about the markets to claim edge to the extent that you over-weight these stocks at the expense of other stocks in the market?

What is it that you know that the wider market doesn’t?

Whether you are picking a North American Biotech index, the Belgian index, or an index of commodities stocks, you are essentially claiming edge and an advantage in the market.

That’s no different from if you were tipping Microsoft shares to outperform.

Yet many passive investors who would scorn the ability of the average person to pick stocks will happily debate the pros and cons of these alternatively weighted indices.

I think that’s inconsistent.

Place your bets

Everyone wants a get rich quick scheme, so here is one for fans of alternative weightings.

Buy a fund tracking whatever alternative index you think is sure to outperform and sell short the broader index against it with as much money as you can borrow.

Now wait for the world to prove you right.

This will guarantee you riches, and a constant stream of lackeys from the financial media turning up to write articles about your investing brilliance!

Sounds unlikely?

I agree.

Instead: stick with the broadest and cheapest market.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

What caught my eye this week.

The question of ‘enough’ is a perennial one in the circles this blog moves in.

Seriously! We can barely check into a Personal Finance and Investing Blogger Cult Meeting before a heated debate breaks out over how much is enough given sustainable withdrawal rates, official inflation versus lifestyle inflation, ‘one more year’ syndrome – or even whose round it is.

(The argument that buying a round of drinks will tack three months onto a future retirement date is an entry-level Jedi mind trick for the likes of us).

Enough already

In the latest outing for one of the most popular-but-vague words in finance, Ashby Daniels at Retirement Field Guide deployed ‘enough’ towards finding wider contentment, writing:

Enough is a term that has very little quantitative definition, but much subjective definition.

Often, we can’t tie a specific number to enough, but we know when we are there. It’s subtle and yet definitive. It just hangs there waiting to be acknowledged or ignored.

But the important point is that we know it exists. It’s just a matter of whether we want to pay attention to our inner voice or ignore it completely.

Here’s a funny example that backs up Daniels’ point.

Long-time readers will know I’ve an on-off fascination and struggle with Bitcoin, and cryptocurrency more generally.

Back in December 2017 I um-ed and ah-ed about whether Bitcoin was in a bubble – and whether it was even a real financial asset.

A lot of digital data has flowed under the bridge since then, but the future of crypto is not what I’m thinking of in this post today.

Rather, it’s about what I did next.

You see I decided I wanted to own a bitcoin.

I could always see a possible future for bitcoin, especially as a store of value, and every day it survives the case is reinforced.

And I see owning Bitcoin as like making an investment into the part-ownership of a digital payment solution of the future.

But I have absolutely no idea how to value the stake accurately – and nor does anybody else as far I can tell.1

So I decided I would own one bitcoin. There will only ever be 21 million of the made-up blighters, and 18 million of them are already out in the wild (or lost). Owning one out of 21 million seemed meaningful if the boldest predictions came true, but it wouldn’t kill me if the price crashed again.

This was a regret minimization approach to ‘enough Bitcoin’.

I’m not bitter

I built up to owning my notionally-shiny single bitcoin in fractional dribs and drabs during the second half of 2019 and early 2020, through more than half-a-dozen buys at much lower prices than today.

So of course when the Bitcoin price took off later this year, I was miffed that I hadn’t bought two, five, or even 10 or more bitcoins.

But I was more relieved that at least – at last – I owned one of them!

And when the price of the ephemeral asset fell $2,000 in 24 hours this week, I was a little surprised to lose a meaningful wodge of paper digital wealth so quickly.

However since I only owned one bitcoin, the impact of the dive was lost in the noise of my overall portfolio.

My conclusion? I have enough Bitcoin!

[continue reading…]

1. Note I’ve bolded the word ‘accurately’. I have heard all the arguments about the cost of hashing or comparisons with the total value of gold or the number of millionaires in the world, and so on. They can’t all be precisely right… [↩]

Note: Exchange rates between different currencies fluctuate all the time, and the currency pairs used below are purely illustrative from the time of writing. Today’s numbers aren’t relevant to understanding currency risk.

One area where investors and even experts get themselves into a muddle is currency risk – specifically when it comes to the currency that a fund is priced or denominated in.

Currency risk itself is pretty straightforward. It will be familiar to anyone who has ever been on holiday or who owns a property abroad.

Let’s say you’re a British resident who’s headed to the U.S. for a vacation in three months. You decide to take some dollars with you, and you opt to convert a whopping £1,000 into dollars because you’ve heard you’ll need to tip big to avoid a riot.

You’re also very old-fashioned, so you want to get this sorted out three months in advance.

Ignoring transaction costs1 and at the time of writing in 2013:

• At a rate of £1:$1.60, your £1,000 buys you $1,600 dollars

Let’s suppose that before your holiday, the pound strengthens so that £1 now buys $2. But you’ve already changed your money, at the old rubbish rate!

• At the new rate of £1:$2, your $1,600 is now worth (1,600/2) = £800

Ouch!

It could have gone the other way, too, of course.

Currency risk has upside as much as downside.

Currency risk and the underlying assets

Converting holiday money is straightforward – and exactly the same thing happens when you make overseas investments.

Let’s say that rather than going on holiday, you do what I’d do – being a tightwad – and invested £1,000 into a tracker fund that follows the US market instead.

All the stocks in the tracker fund are based in the US, listed on the US markets, and priced in dollars as you’d expect. Your US tracker fund is therefore buying a bunch of US dollar denominated assets.

At a £1:$1.60 exchange rate:

• Your £1,000 investment buys $1,600 of dollar assets2

Three months later, the exchange rate is £1:$2. If the US stock market has not changed over the period, you’d log on to your broker and see:

• Your investment is now worth $1,600/2 = £800

Of course it’s more likely the market would also have moved over three months, as well as the exchange rate. If the US market had gone up 10%, your investment would be worth £880. If it had fallen 10%, you’d be looking at a princely £720.

In fact, it’s usually stock market moves not currency moves that will dominate your returns.

(Also, currency fluctuations usually – though not always – happen more slowly than in my example, which I dialed to ‘high’ to make my point.)

Fund denominations don’t matter

Safari, so-goody, as Christopher Biggins used to say in a kid’s TV program that has me showing my age.

Where people get confused is when they buy a fund that is denominated in a currency other than that of the underlying investment.

A typical example would be a UK-traded ETF that tracks the Japanese market, but is denominated (/priced) in euros.

The mistake people make is they think they are exposed to multiple currency risks – in this case the euro as well as the Japanese yen.

This is wrong – you are only exposed to the underlying asset’s currency.

Lots of people make this slip. For example, when I wrote this article Morningstar had an article up (since removed) about fund denominations that stated:

…unless, of course, you really know what you’re doing when it comes to forex and, for example, you want to take a bet that emerging market currencies will appreciate against the euro, that the euro will appreciate against sterling, and that these events will converge in time for when you choose to sell your shares.

The implication of this quote is that a UK investor who buys an emerging market fund that’s denominated in euros faces a double-whammy of two currency risks – the pound versus the euro, as well as versus the emerging market currencies.

That’s incorrect.

As a UK investor you’re only exposed to emerging market currency risk in buying the euro-denominated fund. The exchange rate between the pound and the euro is irrelevant.

Currency risk: The science bit

I’ll show why it’s the underlying asset currency that matters in two different ways.

First I’ll use a bit of algebra, and then we’ll go through a real-life example.

Algebra first.

Let’s say you are a UK investor who has rather oddly decided to buy a euro-denominated ETF that holds only UK shares.3

The Euro-priced ETF holds UK-listed assets – BP, Tesco, Lloyds, and so on – that are denominated in sterling.

(1) The quoted price of the ETF in euros:

= Value of UK holdings * (pound/euro exchange rate)

Now let’s say you log into your UK fund platform to find out what your ETF investment is worth today in pounds – your native currency.

Clearly its £ value is equal to the value of the ETF in euros, adjusted for the euro/pound exchange rate.

(2) In other words, the value of the ETF in £:

= Price of ETF in euros * (Euro/pound exchange rate)

Now we can substitute (1) into equation (2) to give us the value in pounds as:

= Price of ETF in euros * (Euro/pound rate)

= (1) * (Euro/pound rate)

= (Value of UK holdings * (Pound/euro rate)) * (Euro/Pound rate)

= Value of UK holdings * (Exchange rates cancel out)4

= Value of UK holdings

In other words, as a UK investor who is investing pounds, this fund of UK assets is worth its value in pounds, regardless of whether it’s priced / denominated in euros, yen, or Malaysian ringgits.

What about if you were a UK investor buying a euro-priced ETF that invested in the Japanese stock market?

Here the underlying assets are Japanese, so the exchange rate that matters for a UK investor is the pound/yen exchange rate.

To see this, we can modify my equation above to take the value of the ETF in pounds to be:

= Value of Japanese holdings * (Pound/euro rate) * (Euro/Yen rate)

= Value of Japanese holdings * (Pound/Yen rate)

Again, the pricing currency (here it’s euros) is irrelevant and vanishes from the equation. The euro introduces no extra currency risk.

Note: Some funds hold a lot of cash, which may introduce an additional currency risk. If for example you own a European-based investment trust that invests in Japanese equities but that holds 10% of its assets as cash in euros, then as a UK investor you do face currency risk on those euros, as well as on the much larger exposure to the Japanese yen. Cash held by ETFs and trackers is usual trivial, however, and can be disregarded.

Currency risk in the real-world

Let’s really drive the point home with a real-world worked example.

Imagine the Japanese tracking ETF mentioned above comes in two denominations – the original euro-denominated ETF that we looked at above, and another one denominated in pounds sterling.

As a UK investor, you’d be naturally drawn to the ETF denominated in pounds. But in theory it makes no difference which one you buy5.

Let’s look at the pound denominated Japanese tracking ETF first, using real data from Google Finance for historical stock market levels and exchange rates.

It’s 6 Jan 2012 and you decide to invest £1,000 into this Japan-tracking ETF.

At the time of your investment:

The Japanese stock market is at 8,390

£1 buys 119.5 yen6

You invest £1,000, which means you invested in yen terms:

1,000*119.5 = 119,500 yen

On 4 January 2013 you decide to cash out. Over that time the Japanese stock market rose to 10,688 – a gain of 27.4%.

So your investment in local yen terms is:

= 119,500 yen plus the 27.4% gain

= 152,243 yen

We now have to convert back into pounds. Turning again to Google Finance, I see that on 4 January 2013:

£1 buys 141.6 yen

So your investment is worth in pounds:

= 152,243 / 141.6

= £1,075

Notice that although the local market went up 27.4%, you’ve only gained 7.5% in pounds. That’s because the pound strengthened against the yen, which meant your yen bought fewer pounds when converted back into sterling. This is true currency risk in action.

Hopefully that was pretty easy to follow. But what if you’d bought the euro-denominated ETF?

Trickier to work out, as we need to know a couple more exchange rates.

On 6 January 2012:

One pound bought 1.21 euros

One euro bought 98.6 yen

So – deep breath! – you again invest £1,000:

£1,000 = 1,210 euros

1,210 euros = 119,472 yen

As we saw, the Japanese market rose 27.4% over the year.

This time your investment in local terms:

= 119,472 yen plus a 27.4% gain

= 152,208 yen

Checking on Google Finance, I see on 4 January 2013:

One pound bought 1.23 euros

One euro bought 115.2 yen

So converting back:

152,208 yen = 1,321 euros

1,321 euros = £1,075

Magic! Again you have ended up with £1,075, despite the fact you invested via a euro-denominated ETF.

The exchange rate changes between the pound and the euro have disappeared from the equations. It is the exchange rate between your currency and the currency of the investment – in this case the yen – that matters, and determines your currency risk.

Why this happens: Related currency pairs are perfectly inter-connected, which is what enables the denominating currency to ‘disappear’ above. If this wasn’t the case, then you could profit when currency exchange rates got out of kilter. For example, you might be able to convert pounds into yen, and then convert those yen into euros, and then convert those euros back into your original currency, pounds, for a profit. You can’t do this because the currency markets are extremely liquid, deep, and efficient, and any miniscule opportunities like this are immediately arbitraged away.

Currency risks and rewards

Don’t be surprised if you see people saying something different to the above. They’re wrong and I’m right, as the worked example I plodded through above proves, even if you weren’t convinced by my elegant algebra.

Check the figures with Google Finance if you don’t believe me! And see this similar example that uses the Thai baht.

The takeaway should be clear:

• Currency risk is determined by the local currency of your foreign asset.

• Even if you buy a vehicle that is priced in your own currency, such as a UK investor buying a UK-listed ETF that’s denominated in pounds, if the fund invests in overseas stocks then you’re exposed to the currency risk of the underlying assets.

Despite the scary name, currency risk isn’t necessarily a bad thing, as you can win as well as lose. Also it’s another kind of diversification and so in some ways it can reduce risk.

With that said, there’s a strong argument that you’re not really being compensated with higher returns when you take on currency risk and so you should avoid it where you can.

This is a huge topic for another day. Broadly speaking, currency risk is less of a concern when investing in overseas stock markets but something you’d ideally avoid when investing in overseas government bonds. (For much more detail, see this long paper by Vanguard).

You can avoid currency risk in any asset class by using the appropriate currency-hedged ETFs. This may increase your costs, however.

You definitely need to think about your home currency when allocating for the long-term. If you’re going to be a UK pensioner, it would be madness to have all your assets in Japan. One day you’ll need to spend pounds in the shops and you don’t want to be completely at the mercy of the prevailing pound/yen exchange rate when you retire.

Most UK pensioners would have a large stock of UK government bonds, however, or perhaps an annuity or other sterling-based asset. And of course putting all your money in Japan is the antithesis of passive investing as we explain it around here, which is based on global diversification.

As a product of a well-constructed long-term portfolio, currency risk is not something to be afraid of.

1. The costs of exchanging money at airport booths and so on are massive in the real world, and you should explore all the different ways to pay abroad, such as the newer Fintech solutions – but that’s another article. [↩]
2. Again ignoring any transaction costs. [↩]
3. An ETF targeted at European investors, in other words. [↩]
4. One small caveat is there may be money changing charges made by the fund or charged by your broker when converting from one currency to another racked up along the way. But that is a separate issue. [↩]
5. As throughout this article I’m ignoring small currency related transaction costs that are a different issue [↩]
6. I am going to ignore small rounding errors throughout for clarity. [↩]