What caught my eye this week.

A UK budget visualization website did the rounds among certain of my excitable friends this week (I know, with friends like these…) and I promised to flag the tool up here.

I’ve no idea how accurate the data is, which is sourced to 2016 according to the slug. (The ‘total UK budget’ in the tool corresponds to ‘total government spending’ in the 2016 Wikipedia entry for the UK budget.)

Anyway, what they most liked was seeing the representation of our EU expenditure in blue.

No, not the large block of dark blue in the centre – the tiny light blue sliver next to the ‘D’ in ‘Departmental expenditures’:

Click to enlarge (but you’ll still have to squint to see the EU contribution)

That blue trace is the strand that the Conservatives, the Brexit Party, Johnson, Farage, and the rest have whipped this country into a fearful fury over. That is the torrent of money that can save our NHS and Make Britain Great Again. That is apparently worth spending three years fighting about and taking our democracy to the brink over.

In some quarters, that expenditure – much of which comes back to us one way or another – is the reason for all our ills. Apparently.

Of course in more sensible Leave voter living rooms it’s the laws and regulations that matter – not that as far as I’ve heard anyone can ever name more than a few edge cases they object to, and not that we won’t strive to meet EU regulations to trade with them in the future – but still… even for such voters is the juice worth the squeeze, as US rapper Lizzo sang earlier this year?

Most of us long ago made up our minds about that.

[continue reading…]

Way back in the mists of time spring we solicited questions from you for Lars Kroijer, our favourite hedge fund manager turned promoter of passive investing.

You replied with dozens of queries. Almost hundreds. Enough to make us pause and consider how we should go forward.

With the markets riding high, you asked, was it better to wait for a fall before investing? Active managers might lag the market overall but why not invest in those who are winning? And should you hedge your currency exposure?

The questions piled up in comments and over email.

Hence we’ve decided to try something a different – a tie-up between Monevator and Lars’ popular YouTube channel.

Every month we’ll pick three or four of the questions and answer them individually, in video form, as below. If this works then it will hopefully become a regular series. We’ve already got enough questions to last until 2023 or so, and I’m sure more will come in over time.

So let’s get started!

Please note that 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, please pop over to the Monevator site to read this: Q&A with Lars Kroijer.

Why not wait for the market to drop before investing?

Congratulations to Monevator reader Steve L. who pops the champagne bottle on our series with a question about market timing:

Lars replies:

The question for this video pertains to a reader who has been wanting to invest in equity markets but has been waiting for a dip to get in at a more favourable price. That dip has failed to materialize and he’s wondering what he should do now.

Yhe first thing I would say is nobody knows what’s going to happen in the market in the future, whether it’s going to be dipping in the near-term or in the long-term.

If you had that knowledge, it would be incredibly valuable, and I suggest you go get rich on the base of it!

What we do know is that the equity markets historically have gone up about four or five percent above inflation per year. This is based on hundreds of years of data and it’s perhaps not unreasonable to guess that markets in the future over the long-term are going to go up by roughly what they had done in the past, given a similar kind of risk profile.

Of course, markets are going to be extremely volatile in the short-term. Nobody knows what’s going to happen and that’s important.

Now, just the fact that in the past you’ve been unlucky and failed to invest right before markets went up does not mean that you should not invest now.

I’d say my view would be there’s no time like the present to get invested in the equity markets, assuming you have the kind of risk profile that allows you to make those kinds of investments. And if you do so of course there’s a risk that you invest right before a market crash and you can be unlucky in doing so.

If you want to avoid this risk, you can spread out your investment over in blocks of three or four. So, say you have $100 to invest you can do that in four blocks of $25 instead of one block of $100.

That does however increase transaction costs and potentially increase tax and other admin costs to you as well.

So, that’s my advice. Get invested and if you can’t afford the near-term risk spread it out over several [time periods].

The pros and cons of currency hedging

The next question is from Richard J., who is concerned about the exposure that his passive funds have to foreign currencies:

Lars replies:

Richard asked whether you should really be hedging currency investments in global equity trackers. This applies to other non-domestic investments too, I assume.

Just to explain what I think he means: If you take an example of someone who invest a £100 into a global tracker – it doesn’t quite work this way but it’s a way to think about it – the provider will take the £100, FX’s the money into various currencies and buys the underlying stocks for those currencies.

So, for example they would take your £100, they FX it into dollars and among other stocks buy Facebook shares.

This would create a dollar-sterling exposure and the question is should you be hedging this exposure?

So, on balance I don’t think you should.

Now, there are a couple of reasons for this.

One is it’s actually really hard to know exactly what your FX exposure is. The reason for this is that the companies that you’re buying shares in themselves have a lot of FX exposure they might be hedging.

You can take Facebook as an example. They have operations all over the world, including in the UK, and it can be hard to know exactly what you should be hedging. Furthermore, I think something like 50% of the earnings of [a market] like the S&P 500 are actually made outside of the US and in a wide array of currencies and so that slightly mitigates the issue and could actually mean that your currency hedging is done wrong.

The second reason you shouldn’t be currency hedging is that it can really be quite expensive and as I alluded to, quite imprecise, not only for the reasons I mentioned but also even if you did get the exposure right you should really constantly be trading around this, as shares and the various currencies move up and down. This would lead to very significant transaction and admin costs which would impair your returns in any currency.

The third argument why I don’t think you should be hedging your FX exposure is that FX exposure can actually be a diversifier.

So, if you think of your £100… You’re buying not only exposure to companies in many, many countries but you’re also buying exposure to many currencies, so if there is a shock in your local currency – in this case sterling – the fact that you hadn’t hedged the currency actually means that you’d be better off. Shocks in currency markets tend to move against your local currency and are really a ‘shock up’. So actually, this is not only cheaper and less cumbersome et cetera, but it’s actually probably a good thing to not be currency hedging.

The argument for currency hedging is that you should be investing your money in the currency where you eventually need the money and I think there’s some truth to that.

But […] there’s the admin, transaction costs, that natural diversifier… and at heart that it’s hard to know what actually what the right exposure is.

If despite these facts you still want to currency hedge, I would question whether you really should be investing in as risky an asset as equity markets can be.

Why not invest with a winning fund manager?

Finally for this month, why not run your money with a star fund manager like Nick Train or Terry Smith, asks reader Paul K.?

Lars replies:

The question in this video comes from a reader who although he is a fan of passive investments asked why should we not just invest our money with a star active fund manager? He says Fundsmith or Lindsell Train but there are many.

So, first of all he’s saying he’s a fan of passive which I take to mean that he doesn’t think we should go and invest and try to pick Facebook versus Google versus Apple and a thousand of other stocks but instead invest in markets as a whole and sort of take a passive approach.

But the question is then why not get someone to make our investments for us? Someone who’s presumably done very well in the past.

The answer to the question really has a bit to do with statistics.

If you look at it over a ten-year horizon, only ten to 15% of active fund managers outperform the index of the markets that they operate in.

So, if you think of the S&P 500 or someone that is operating in those markets, only 10 to 15% of them will actually do better than that index over the decade.

Now that’s not necessarily because they’re bad managers. It’s just that because on top of the fees that they’re charging you they incur other costs, like bid-offer spreads, sometimes auditing, trading costs and so forth. It all adds up over time.

[The reason] we often think that the active managers do better than they actually do is because of a huge selection bias.

So, if you go ten year back in time and look at the top hundred managers then only, statistically, ten or 20% of those are still around and because [the industry] focuses on those we tend to forget all the ones that didn’t do well and think therefore that everyone did well. So that’s a typical selection bias.

I’m not saying that the ability to pick individual stocks or indeed [successful] active managers doesn’t exist.

I’m just saying it’s a very tall order to claim that you have [that edge], and particularly the ability to pick the ten to 15% top managers ahead of time is a very, very tough tall order to claim.

Until next time

We know it’s been a bit of a wait to get started with these questions. But hopefully the news that reader favourite Lars will be a regular feature on the site for a while makes up for it.

Let’s hear what you think about Lars’ replies – and any other feedback please – in the comments below.

This post is one of a series looking at returns in the decade after the financial crisis.

I was finishing my basic education in passive investing as the Global Financial Crisis (GFC) shook capitalism. It didn’t feel like the best time to put my financial house in order but – on the off chance that the sky wasn’t falling in – I was learning as much as I could as fast as I could.

Then as now there was no shortage of pundits, authors, superstars, and salesmen laying out their ideas. The market stalls were festooned with promises:

• All-weather diversification!
• Superior risk-adjusted returns!
• Negative correlations!
• Cheap fundamentals!
• Megatrends!

My head span as I inhaled the aromas of green energy, soft commodities, precious metals, small caps, and high yields.

Which of these spices would add zing to my mix?

Only a few index trackers had a long-term history when I emerged from my bolthole in 2009. There was no way to verify their behaviour1 over the all-important ‘long term’.

But now you can.

Tracking the trackers

The Cambrian explosion of index trackers is more than a decade old. We can now see how closely the longer-toothed ones have matched up to the theory and promise.

The charts that tell our story come from Trustnet.

Trustnet provides annualised and cumulative return data for periods of up to 10 years. The results below are quoted in nominal £ returns, with dividends reinvested from 14th September 2009 to 13th September 2019.

Subtract 3% average inflation to convert the nominal returns into real returns.

The case for global diversification

If I’d been an investing clairvoyant 10 years ago then my name would have been Jack Bogle. Like the father of the index fund, I’d have put everything into a US stock market tracker and subsequently reaped the rewards of one of the great bull markets.

That skyrocketing green line on the graph above is Vanguard’s US Equity Index fund. It returned an astonishing 16.3% annualised. Any US assets you owned in 2009 have soared by a cumulative 350% (see the 10y column in the table).

Perhaps they’re pumped by quantitative easing and corporate tax cuts. Maybe the social dividend has been inequality and the rise of populism. Whatever the case, as investors in the US market we should acknowledge we’ve lived through extraordinary times.

Back in 2009, as a UK investor without the witch-sight, I diversified across every major geographic region on the good ship Earth. And nobody should be sorry if they did that because the iShares MSCI World ETF2 brought in a still exceptional 12.1% annualised and 214% cumulative return. (See the brown E line on the graph).

That’s a 9% annualised real return versus the historic average of around 5%.

Ch-ching!

Note that hard as it will be for newer passive investors to fathom, there weren’t any vanilla all-world trackers available in 2009. The MSCI World bought you exposure to developed world stock markets only.

Most of those other markets chased the US like perfectly nippy sprinters trailing Usain Bolt:

• The supposedly moribund Japan returned 8.5% annualised.
• The iShares UK Equity Index Fund – tracking the FTSE All-Share – delivered 8.3%.
• Europe also scored 8.3% as it dodged the gloomy prophecies of a Euro area implosion.3

The big story in 2009 was the ascent of the emerging markets and I agonized over whether and how to reflect this in my portfolio.  The West was doomed to low growth and the future belonged to the BRICS4 said the talking heads, plus any other developing nation that clustered under memorable acronyms like MINT.

Put yourself into the position of a pundit in 2009. The emerging markets had notched 18.7% annualised between 1988 and 2006 and their acronym-powered growth seemed unstoppable.

But then the brakes went on. These next-big-things posted a relatively poor decade and trailed the developed world, as you can see from the yellow B line on the graph. The emerging markets could only muster 6.6% annualised (3.6% real return after inflation). All-mighty China forked over a measly 5% annualised return (2% real).

Frontier markets (see pink line G) were another smart money bet in 2009. They were the new emerging markets, it was said. Highly volatile yes, but a diversification play because their economies were less integrated into the global mainstream.

Thankfully wiser voices preached caution. More than a decade ago the sage Bill Bernstein explained that economic performance and stock market success don’t always go hand-in-hand:

During the twentieth century, England went from being the world’s number one economic and military power to an overgrown outdoor theme park, and yet it still sported some of the world’s highest equity returns between 1900 and 2000.

On the other hand, during the past quarter century Malaysia, Korea, Thailand and, of course, China have simultaneously had some of the world’s highest economic growth rates and lowest stock returns.

In even simpler terms, just as growth stocks have lower returns than value stocks, so do growth nations have lower returns than value nations – and they similarly get overbought by the rubes.

This is why hot tips are so often a reverse signal for contrarians. When a story is obvious it often collapses under the weight of expectation.

Ten years later and the frontier markets have returned 6.6% annualised – the same as emerging markets.

The graph also shows that the world’s equity markets have been highly correlated, too. They’ve zigzagged together, although the emerging and frontier markets have been sickeningly volatile.

Many shall fall that are now held in honour5

The global portfolio did not score you the best result over the last decade, and it never will.

But the most powerful geopolitical narrative 10 years ago would have sent you in precisely the wrong direction.

The equivalent story in 2019 is to go all-in on the US. It’s the global hyperpower with an incredibly flexible economy blah blah blah, all-conquering tech industry yadda yadda. But don’t commit the cardinal sin of projecting the 10 years forever forward. Ben Carlson has shown how the pendulum has swung back and forth.

The US lagged the rest of the developed world in the 1980s and 2000s while surging head in the 1990s and 2010s. Trends mean revert and commentators have been calling the US market frothy since 2011.

This short piece by Jonathan Clements gives you a 20 year perspective. It is an even starker warning against recency bias.

Looking back 10 years doesn’t tell us what will happen in the next decade, but it can help us remember that basing our decisions on predictions and compelling stories is a mug’s game.

I’ve been called worse things than that, but sooner or later the commentators are liable to be right.

Take it steady,

The Accumulator

Public service announcement: October is going to be sentimental around here, as we continue to gaze back 10 years and see how several other passive-friendly strategies have fared. Subscribe to get all misty eyed with us.

1. Never mind the fact we all know that past performance is no indicator of future results. [↩]
2. The iShares MSCI World ETF is currently more than three-fifths invested in US companies, anyway. [↩]
3. I kept Europe off the graph for simplicity’s sake. [↩]
4. Brazil, Russia, India, China, and South Africa. [↩]
5. Horace. [↩]