When you’re teaching somebody a new subject, simplifications can creep in. Rules of thumb at best. Outright untruths in the extreme.

For example:

• The simile “as blind as a bat” isn’t true – many bats see better than we do. (Maybe they’re also better than us at similes?)

• Christopher Columbus didn’t think the world was flat. The notion combines scientific and terrestrial exploration into a neat historical parable, but even the Ancient Greeks and Romans knew the Earth was probably a sphere. (Columbus owned books that told him so.)

• Teaching children the classical laws of motion wouldn’t be made any easier by telling them they’ll eventually learn the whole shebang is a gross simplification – that Newtonian physics is a shadow on the wall approximation of the statistical weirdness of quantum mechanics. (Yes, I know I’m oversimplifying here, too!)

• The “i before e except after c” rule often works – but not enough that foreign students can seize the weird exceptionalism of the feisty English language. (Spot the rule’s deficient idiocies there?)

So it is with investing. We say higher returns come with higher risks. That assets that go up and down a lot in price such as shares should to be held with a long-term view, and that braver investors can eventually capture higher returns this way.

But reality isn’t quite so simple. Those higher returns are only expected – not guaranteed – and not all risk is rewarded.

For starters, some risks don’t even come with the expectation of higher rewards:

…the relationship of more risk, more reward does not always hold.

In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.

Academics call these lousy bets uncompensated risk.

Read our previous article on uncompensated risk to learn if you’re gambling for nothing.

Not every stock market has read the textbooks

It’s also important to realize that even the ‘right kind of’ risk can go unrewarded.

You might expect higher returns, but higher returns are not guaranteed.

For example, we say investing in risky equities can be expected to deliver higher returns than super-safe government bonds. But there’s no guarantees, and no timescales.

Indeed there have been long periods where the return from bonds beat shares!

Over the ten years to the end of 2008, for example, the annualized returns from US and UK shares were negative. In contrast, bonds soared.

So much for risk and reward over that decade.

And in case you’re thinking you can handle a ten-year duff stretch – and you will have to over a lifetime of investing – some have had it much worse.

How would you feel if your well-founded risk-taking wasn’t rewarded for half a century?

In 2011 Deutsche Bank reported that:

…for three members of the G7 group of leading industrialised nations, Italy, Germany and Japan, returns from equities have been worse than those of government bonds since 1962.

Indeed, the Italian stock market has even managed to deliver a negative real return over the past half-century, -0.38 per cent on an annualised basis versus +2.64 per cent for bonds, “a remarkable statistic in a world where we are all used to seeing equity outperformance increase the longer you expand the time horizon”, wrote Jim Reid, strategist at Deutsche.

In Japan, government bonds have delivered a real return of 4.17 per cent a year, beating the 2.72 per cent of equities, while in Germany bonds have won by 4.28 per cent versus 3.46 per cent for equities.

Academics – and professional investors – struggle with findings like these. They go against the theory of efficient markets I discussed earlier.

For the market to get it wrong for 50-odd years might suggest:

• Those markets were unusual for some reason.

• We don’t have enough data. (A tossed coin coming up 10 times in a row doesn’t disprove probability theory. Try tossing it a million times.)

• The efficient market theory has limitations.

Personally I’d plump for a mix of all three in the case of Germany, Italy, and Japan.

But I’d also point out that all the leading efficient market academics hailed from the US, a country that has had the strongest, most consistent, and least ‘anomalous’ markets – with the best data, tracking a period including two World War victories, or three if you count the Cold War, and a transition from emerging market to sole global superpower status.

Could this very positive North American experience have biased the research or the conclusions? It seems feasible, but we’ll leave going down that rabbit hole for another day.

The important point here is expected returns are not guaranteed returns. Real-life investors in some countries never saw a sniff of them over a lifetime.

There are several important practical takeaways. For example, somebody on the point of retiring should not have all their money in equities, despite the higher expected returns.

Stock markets usually crash once or twice a decade, and that can chew up your higher returns in the short-term. That’s a big risk, especially for an imminent retiree or a newly-retired one. Statistically you might think it’s unlikely, but if it’s you, and you had no back-up plan, you’re somewhat stuffed.

This is called sequence of returns risk. It’s not a reason to have no shares or own only gold, or any of the other dramatic things people write in the comments on blogs. It’s a reason to own fewer shares, and to diversify.

Risk in real life

I was set thinking about this recently by a family friend.

Having come into some money, she bought me that quintessential millennial brunch of avocado on toast and picked my brains about what to do with it. (The money, not the toast.)

My first step when this happens is usually to send over a bunch of Monevator links, and wait to see if they get read.

If the person doesn’t do their homework (and they usually don’t) then that helps inform where I steer them next.

But in this heartening case my friend read all the suggested articles, and she was keen to let me know so.

For example she explained to me that she now understood that she should never sell, that stock markets always come back, that you have to take risks to win… right?

Er, right, I said. Sort of.

It’s complicated!

Investing is like that. You have to learn a lot to realize there’s a lot you don’t or even can’t know for sure.

One excellent if rather gnomic definition1 of risk is:

“Risk means that more things can happen than will happen.”

Whereas my friend had taken risk to basically mean “what goes down will come up.”

We can have expectations, given time, but there can be no certainty. If there was certainty, there’d be no extra risk. And if there was no extra risk then there’d be no expected higher returns – because they’d have been bid away by the market, at least in theory.

As blogger Michael Batnick says, you are owed nothing:

This is how stocks work. The stock market doesn’t owe you anything.

It doesn’t care that you’re about to retire. It doesn’t care that you’re funding your child’s education.

It doesn’t care about your wants and needs or your hopes and dreams.

Batnick stressed in that article that he still believes shares are “the best game in town” for long-term investors.

But you must have realistic expectations about your expectations.

Shit happens

To conclude, I’ve long wanted to include this graph in a post. It’s from Howard Marks’ wonderful investing book The Most Important Thing:

Source: The Most Important Thing.

What this graph shows us is that expected returns do indeed increase with risk – but there’s a range of potential outcomes along the way. Some are dire. Plenty are bad.

It is a good graph to sear into your brain.

This graph is why most people are advised to use widely diversified stock funds, not try to find the next Amazon or Facebook.

It is the reason to hold some money in cash or bonds even when savings accounts pay you nothing and bond yields are negative.

It’s why we should stay humble and diversify our portfolios across asset classes, even ten years into a bull market. (Or make that especially ten years in…)

As with many things, expect the best outcome when investing – but be prepared for the worst.

1. I first heard it from Elroy Dimson of the London Business School. [↩]

What caught my eye this week.

Are US markets enjoying a bull run of unprecedented longevity? You might think that could be answered by looking at a graph of long-term stock market gains, but the topic is surprisingly controversial.

Michael Batnick explored the debate this week, if you like that kind of thing.

Now, no offence to Michael but my favourite part of his post was this quote from Adam Smith’s classic book, Supermoney.

Here’s how he describes the late stages of a bull market:

We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air.

We know, by the rules, that at some moment, the Black Horseman will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors.

Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so that everyone keeps asking “What time is it? What time is it?”

But none of the clocks have any hands.

Wonderful. (Or, as a blogger, ‘well jel’, as the Majorcans would apparently say.)

In a variation on this end of days theme, Vanguard also wrote this week on why it is so hard to predict the next bear market.

But that article’s title misstates reality.

It’s actually very easy to predict a bear market. We’ve seen dozens of high-profile pundits make exactly that prediction over the past decade.

What’s hard is to be right!

[continue reading…]

War! What’s it good for? How about reducing fees to nothing?

Yes, fund giant Fidelity is now offering North American investors a US total market equity index tracking fund and an international equity tracker fund with fees of 0%.

While many still complain the markets are rigged and that small investors get a rotten deal, Americans who do their research can now invest for free.

So is this it? Investing nirvana?

Not quite.

Firstly these funds are for US consumers – and British investors still seem to pay higher fund fees than US investors in general. That said, even we can get cheap index trackers costing 0.1% or less a year.

Cost-wise, going from there to zero isn’t as big a leap as ditching an expensive active fund charging 1% or more. The big wins have already been achieved.

More subtly, as my co-blogger The Accumulator likes to say even cheapskate passive investors know someone has to be paid somewhere. So what’s the catch?

I see two potential wrinkles.

Firstly, the new 0% funds track Fidelity’s own in-house indices, rather than indices from one of the benchmark behemoths. This will save them paying licensing fees to the likes of MSCI or FTSE, but many investors would prefer index homogeneity across the tracker fund universe.

Second, the 0% funds will probably lend shares to short-sellers for a fee, which Fidelity will pocket. Some feel this practice sees a fund’s investors taking the risk but the manager getting the reward.

Neither wrinkle would stop me investing.

All indices are constructs and I expect a company of Fidelity’s standing has put together something reasonable. (We’ll look into this in the future).

As for the stock lending, defaults on security loans in such circumstances are rare, and should be covered by collateral. The Accumulator has previously expressed concerns though, and it’s true stock lending does add counter-party and related collateral risk to what ‘should’ be a simple fund.

You’ll pay (or not!) your money and take your choice.

Heroes and zeros

One thing not to worry about is Fidelity’s bottom line. The firm achieves roughly $18bn in annual revenues. Most of that comes from managing retirement accounts, active funds, and share trading, not from trackers.

When we last did a roundup, the cheapest world equity index fund for UK retail investors was already from Fidelity, charging just 0.13%. But apparently they offer US investors an equivalent charging just a tenth of that!

Going from such low fees to zero won’t upset Fidelity’s business model anytime soon. Rather, the zero percent funds are a loss leader, like our free current bank accounts. The firm will aim to make the money up elsewhere.

It will also cause headaches for rivals such as Vanguard and Blackrock. These index fund giants are less able to go to zero without scything their revenues.

The future of active management

Eventually I think we’ll see an index fund that charges a negative fee.

That’s right – you’ll be paid to invest!

A fund would achieve this by passing on those stock lending fees to its investors. It’ll probably be a gimmick rather than mainstream, but what a powerful signal it would send.

Sometimes I have to pinch myself. I’m not that old, yet even I can remember when the standard way to invest was to pay an advisor a trail commission of say 0.5% a year forever for putting you into an active fund that charged 2% a year. As if that wasn’t enough, you also paid 3-5% as a one-off upfront fee for the privilege.

There are protection rackets with better terms than that.

No wonder we’ve seen a huge shift to passive investing. Active investing is a zero-sum game, so pound for pound, by charging higher fees the average active fund can only lose by comparison. Simple mathematics guarantees that while there may be a few market beaters, the majority will under-perform – just as the evidence confirms.

For the average edge-less investor (that is, nearly everyone) index funds offer the cheapest, simplest, and most likely path to investing wealth.

Of course, as more people understand this, the financial services industry tries to obfuscate the truth to protect its cash cows.

We’ve all read the articles that misunderstand how passive investing works and blame it on every market evil under the sun – from flash crashes to low returns to high volatility to job losses to, well, giving a toehold for Marxism on Wall Street.

More constructively, some have advanced theories as to how active funds can turn back the indexing hoards.

But these generally fail a quick inspection:

• Some say active funds must work harder to earn their higher fees. But active investing is a zero sum game. Tens of thousands of smart people are already busting their guts. Everyone works harder, pays more, and on a market wide level the under-performance will persist.

• Active investing should be the preserve of specialist hedge funds, say others. They overlook the fact that hedge funds as a group have delivered worse returns than a cheap 60/40 passive portfolio for more than a decade. And with over $3 trillion under management they’re no longer niche.

• Just wait for a crash! Then active funds will prove themselves over dumb index funds that will follow the market down! This overlooks the fact that active funds are the market. (Did someone say zero sum game?) Falling markets are caused by active funds selling shares, or at least being prepared to pay less for them. Where active funds do better in falling markets it’s typically because they always hold a wodge of cash ready for client withdrawals, not because of skill. Cash keeps its value. You can mimic this brilliant strategy by keeping some money in a High Street savings account, and save on the fund fees.

• A few optimistic people say the industry as a whole should pay for the price discovery service that active managers perform, which index trackers exploit for free. As long as active managers are the ones driving around in sports cars there’s zero chance of that happening.

• Some say active investing needs to be reinvented through simple Factor Investing / Smart Beta / Return Premium funds. These enable investors to buy into something supposedly more concrete than ‘magical’ manager skill. A retort is that factors may not persist – our own contributor Lars Kroijer is one skeptic.

That last is already happening, anyway, through the proliferation of factor-based ETFs. Their undeniable advantage versus traditional active funds (though not the cheapest market-weighted trackers) is they’re less expensive to run.

Computers don’t demand sports cars!

Active funds must cut costs to compete with zero

I believe that cost cutting is the only way that active funds can compete long-term.

The reason active funds do so poorly as a category is that in a zero-sum game, their high fees gnaw away at their returns.

Before costs are taken into account, there is a share of money in active funds that does beat the market – which is balanced by an equal weight that loses.

The net result is the market return (which is captured most cheaply and consistently by passive funds).

If active fund managers leveraged technology to cut costs across their businesses, they might be able to reduce their total expense ratios to best-in-breed pricing of say 0.3% or less.

That would still be two to three times as expensive as a decent equivalent index fund (let alone a free one) but at least it’d be competitive.

Many people seem to believe they deserve to beat the market. And they like humans managing their money more than machines. Passive investing feels wrong. That’s why the active industry persists.

If active funds were much cheaper, these notions wouldn’t be so consequential, and the case for choosing a tracker over a ‘fun’ flutter on a flavour-of-the-month manager would be weakened.

I don’t say that it would be logical for the average investor to then choose active – they’d still on average lose to the market. But it’d be much less potentially damaging.

Slashing costs – that’s the only proper way for active to compete long-term.

Actively foolish

The industry though continues to prefer an alternative route of spreading fear and confusion to try to salt the earth for passive funds.

Just last week saw another doozy in the Financial Times.

The article – Passive Investing Is Story Up Trouble1took a machine gun to modern markets. Albeit a machine gun filled loaded ping pong balls.

The result was a lot of random seeming attacks bouncing everywhere and missing their target.

The piece attacks robot traders for their supposedly indiscriminate – or at least business-agnostic buying – before strangely conflating their activities with passive investing.

Investors in index funds and ETFs are also lamentably clueless, the author implies, pushing up the most popular stocks with their relentless buying.

Never mind that many a robot’s algorithmic strategy is focused on company fundamentals, via the factor investing I mentioned above.

And never mind that – for the gazillionth time – money that flows into the big market-cap weighted funds does not in itself distort prices. That’s not how it works!

Market cap weighted index funds follow the prices set by active investors.2

Anyway, even the allegedly witless robot traders who follow price signals are not just waving their steely fingers in their air. Prices contain information, whether it’s a shortage of cocoa that pushes up the price of chocolate bars or a surplus of some high-flying tech stock that people want to dump after a terrible trading update. A robot trader’s algorithm is not ‘think of a number between one and a hundred and pay it’.

But perhaps the biggest laugh is the implication that passive investing and automated trading has brought imminent ruin to a previously calm money-making oasis.

Stock markets boomed and blew up for a hundred years fine without index funds or robot traders. Flash crashes are dramatic and unsettling, but they last a couple of hours – manias and funks driven by human emotions can persist for decades.

If the big gains we’ve seen for US tech giants like Apple, Alphabet, and Amazon are priming the stock markets for an imminent rout (and I don’t think they are, incidentally) then it will be because active investors set too high a price for those shares – not because passive money dispassionately followed it.

And when the dust settles after the next crash – and there will be a next crash – we’ll see how well these active gurus sidestepped the alleged silliness they see today.

Perhaps a bevvy of skeptical active funds will smash the market and vindicate their high fees?

I wouldn’t hold your breath.

1. [Search result] [↩]
2. The one quirk is when a company enters or leaves an index that is being tracked, there can be a price impact from passive fund trading and those who anticipate it. But that is a one-time event, is rarely what’s being attacked, and the overall affect is relatively small. [↩]