What caught my eye this week.

Behold! Interest rates have risen from the dead! Excuse the fervent tone, but the Bank of England has not lifted rates for as long as Monevator has been in existence. That’s no mean feat given that my first articles were written in September 2007.

(Curious? The first article on this site explains how to calculate dividend yields. Heady days).

So will rates now steadily rise towards the dizzy heights of 5% or more of yore?

I doubt it. I wouldn’t hold your breath on them being above 1% in a year’s time, personally.

Who knows though? Neither the Bank nor the market expects more than a couple of hikes over the next two years, as the BBC reports, but such forecasts are far from infallible:

Mr Carney told the BBC that the Bank expected the UK economy to grow at about 1.7% for the next few years, which he said would require “about two more interest rate increases over the next three years” […]

The financial markets are indicating two more interest rate increases over the next three years, taking the official rate to 1%.

I had a discussion with a reader in the comments to last week’s Weekend Reading. The reader wondered ahead of the hike whether using an active bond fund might make sense?

His reasoning was that bond market moves were more predictable than the gyrations of equities, and hence the case for passive investing was weaker.

I begged to differ.

It still regularly surprises me how people who have sensibly decided they have no edge in the stock market appear to think they can saunter up to the multi-trillion pound bond market and know better than it – which is really what deciding you can select a market-beating bond fund manager amounts to.

I don’t mean to pick on this thoughtful reader in particular. There have been literally hundreds of people commenting on Monevator articles for the best part of a decade making calls on the bond market. Maybe two or three said they thought government bonds – which have mostly risen throughout – looked like a good buy. Most of the rest proclaimed they were getting out of bond funds, or at most suffering them through gritted teeth, before an imminent crash.

I’d guess at least half these people were self-declared passive investors.

The reader wrote:

If the BoE raises rates next week, the affect on bonds is entirely predicatable. I would have thought just buying a bond fund that re-rates downwards is not a great idea.

At least a bond manager should have been able to foresee and mitigate the affect of a rate hike (not entirely, but just so that the damage is less than in a simple tracker)?

Views appreciated.

But as I replied, things are not so clear cut:

The short answer is that the affect of a rate rise is NOT entirely predictable.

First-level thinking that says ‘rates have gone up so bond fund will go down’ will get a person nowhere in active investing. You need to be thinking second or third level (and be lucky!) and for years on end to beat the market as an active investor.

To give just a couple of counter examples, if rates rise but the BOE attaches commentary that’s more bearish than expected about the prospect of further rises, UK bonds and bond funds could easily rally.

If the rate rise spooks the stock market or drives the pound higher and there’s a mini equity crash, again bonds could rally.

Perhaps most obviously of all, since the BOE has been hinting at a rate rise for months, it could all be baked into the price by now and the actual rise be a non-event

These are just three of many dozens of possible scenarios.

Equally, rates could certainly rise and bond funds could fall — it’s totally possible. But in active investing (and I speak as one) you have to get these calls right again and again — so that you’re mostly right more than you’re wrong, and with the right-sized positions. Not once or twice to talk about at dinner parties. 🙂

Secondly, there’s the risk/reward of predicting and positioning for a rate rise, as an active bond fund manager. Pundits and commentators to this blog have been saying rates will rise and bonds crash for nearly a decade. Even I threw the towel in — after years of warning readers not to be so sure — and asked if a bond crash might finally be upon us back in June 2015.

Luckily, humility won the day and I concluded it looked that way but I wasn’t sure, and that pure passive investors should probably do nothing to change their strategy, or alternatively only tweak it.

As things turned out yields fell even further (i.e. Bond prices rose and there was no crash). The US 10-year yield has only this month finally gotten back to where it was that summer of 2015 — having nearly halved along the way! The UK 10-year gilt yield is still below where it was then, even after months of talk about an imminent Bank Rate rise.

Also — the US Federal Reserve raised rates for the first time in December 2015 and a second time in December 2016. Did bond funds fall as was “entirely predictable”? 🙂

No, yields rose (i.e. bond prices fell!) after the first rate rise. They then rallied with the Trump election, before sliding again after the second rate rise in December 2016.

See: https://www.bloomberg.com/quote/USGG10YR:IND

But let’s leave aside the fact that bonds did the opposite of what they would supposedly obviously do. At some point I am sure rates will rise and yields will indeed rise too (i.e. bond prices and bond funds will fall for a while).

The point is an active bond fund manager has to get these bets right with the right amount of money at the right times to outperform. If a bond manager had decided it was ‘obvious’ yields would rise after those rate cuts I mentioned above, positioned accordingly, and were wrong, then they were now down say 20% over a few months versus the benchmark. They now have to make that back by being right later, and more again to start to outperform.

This stuff is hard. 🙂

Active bond managers are about as expensive as active fund managers, and in corporate bond investing at least they take as much research oomph behind them too. Yet expected bond returns are lower than equities, and right now they are very low. This means the higher fees for active bond management eat up even more of your return.

Oh, and none of this is to even get into the mathematics of reinvestment — rising yields are bad for bond funds in the short term, but in the long-term they can boost returns (due to reinvesting higher yields) which means someone who only looks at their portfolio every five years say might not even notice there’d been much of a correction unless it was truly catastrophic.

So there we have it — bond price moves are not entirely predictable, the consensus about the direction of even central bank rates has been wrong for a decade, passive investors reinvesting their bond income might even welcome rate rises over the medium to long term, and in the meantime with active bond funds yielding maybe 3-4%, TERs of say 1+% are monstrously expensive.

I don’t see going active with bonds is an obvious decision. 🙂

Incidentally I’ve noticed that for some reason, even people who accept the logic of passive investing in shares seem to think bonds are no-brainers. They are not!

The bond market is an even bigger, deeper, harder, and even more competitive market. Perhaps only currencies are bigger/harder (bordering on random in my view over anything other than the multi-decade view, and perhaps even then.)

Oh, and as a coda, UK government bond yields fell and prices rose in the immediate wake of the Bank of England rate rise. Things clearly aren’t quite so predictable…

I didn’t know that would happen. And again I want to stress I have no problem (just far too little time) with readers finding their own way and asking questions. After 15 years as an investing obsessive, I’m still learning new things every day. If anything I’m less confident about what I do know than a decade ago.

I need to be uncertain, because for my sins I’m an active investor. My returns live and die by my speculations. My uncertainty has been hard won. Spend a few years honestly tracking your returns and you’ll discover nothing is “entirely predictable” in investing.

Happily, most readers are, like my co-blogger, passive investors. And if you’re going to be a passive investor, then be a passive investor. Whether in bonds or equities or anything else.

Embrace it! In most cases it will be better for your returns than being almost passive. And you will certainly have a lot more free time and less hassle in your life.

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What caught my eye this week.

Every few days a comment is left by a new visitor to this website – or I’ll get an email via the contact form – telling us we’re mistaken to champion passive funds as the best choice for most investors.

The reason given is invariably the past performance of manager X or of fund Y. (We’re also invariably informed the commentator has been investing in it for Z years and has done very well, thank you very much.)

Depending on how eloquent the comment is, I may publish it . Sometimes I’ll reply to it, and explain the shortcomings. Often I delete the glib ones.

Now before someone screams “censorship!” imagine how you’d feel replying to the same erroneous line of reasoning for ten years, from people who don’t know half as much as they think they do but are twice as confident about it as you are – and also remember that publishing their comment unchallenged could mean another reader sees it and embarks on a money-wasting strategy, despite the best intentions of your own website.

See? Delete!

It’s just not worth looking for winners

The evidence shows most active funds underperform. Anecdotal asides that this or that fund has done better from a fly-by-night commentator simply highlight the exceptions.

Of course, some active funds do outperform. Some will be lucky, but as an active stock picker myself, I happen to believe that genuine investing skill exists, too. It’s just that very few funds demonstrate it – making it very unlikely you’ll be invested in one that beats the market, let alone the half a dozen you’ll need for a well-diversified portfolio – and that active funds cost more – meaning that searching for the needles in the haystack will reduce your returns.

Low returns in turn mean you’ll have less money to spend when you retire. Which means you’ll be able to buy fewer things you need, or that your money will run out sooner. The decision to try to beat the market against all odds has big consequences.

Unless you’re an investing nut, why bother? Go passive.

Stars in their eyes

The allure of buying better funds persists though, and it’s not hard to see why.

Mostly in life we hire experts and pay more for the better ones. Investing is weird in that doing the complete opposite is a better decision. But people understandably struggle with the concept. It feels wrong. They look for other approaches, but they’d do better to spend more time getting their head around the merits of cheap index funds.

This week for example the Wall Street Journal made a big splash in the financial gossip-o-sphere pointing to the allegedly poor predictive value of Morningstar’s five-star rating system.

Unfortunately the article is behind a paywall, but the introduction sums up the accusation:

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer – it doesn’t.

For its part Morningstar disagrees with the Wall Street Journal‘s claim. The company wrote a detailed rebuttal, concluding that:

The Journal’s story notwithstanding, the star rating has been a useful starting point for research that tilts the odds of success in investors’ favor.

The forward-looking Analyst Rating, while newer, has also exhibited predictive power.

Used together, or separately, we think these ratings can improve outcomes and help investors achieve their goals, which is entirely in keeping with our mission as a firm.

I don’t know whether Morningstar’s rating system on average directs investors to the better-performing funds of the future. (Anyone can point to the winners with hindsight.) We’ve noted before that rating systems and best buy lists are pretty useless for passive investors anyway. And while I am an active investor, I buy companies, not open-ended active funds, for myriad reasons.

However I’m inclined to agree with Barry Ritholz who writes over at Bloomberg that:

It should come as no surprise that misunderstanding what fund ratings mean is a very typical error made by, well, just about everyone.

It isn’t a forecast of future returns, nor could it be. If it could successfully do that, Morningstar would have long ago set up a hedge fund to profit from its newly discovered abilities to identify winning investments.

As Ritholz also points out, Morningstar itself has regularly pointed to low expense ratios as “the strongest predictor of performance.”

And in case you haven’t been paying attention, it is passive funds that have the lowest expense ratios. So this finding is code for ‘passive funds beat active funds.’ Again.

You’ll find a list of the cheapest passive funds for UK investors on this very website.

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Some years ago, my wife, Kate, and I were at dinner with a group of my work colleagues and our company’s CEO.

Our boss tried an experiment with the table. He drew two hypothetical stock charts on a napkin and asked us what we saw. A Rorschach test for stock nerds, you might say.

My fellow analysts and I, eager to impress our boss, searched for clever technical explanations.

“Oh, I see a ‘cup and handle’ pattern,” we might have said – or some such nonsense. We all missed the point of the exercise.

Kate, who teaches science, took a different approach. She looked at a horizontal zig-zagging chart and said, “That looks like a predator/prey diagram.”

On the second chart, Kate took a second to consider it, and said, “That looks like…faith.”

The graph looked something like this:

The table was impressed by both answers, but particularly by the second one.

The more I’ve thought about Kate’s observation, the more I believe she captured – unintentionally yet brilliantly – the essence of patient investing.

Faith?

With hindsight, it’s easy to determine which markets, companies, funds, and ETFs were great and worth holding onto through turbulence.

Historical returns, however, don’t capture the emotional roller coasters along the way.

Consider this. Had you bought shares of Wal-Mart on the 1st of September 1987 and held through the 1st of September 2017, you’d be up over 2,330% (including dividends, not reinvested). That’s an 11.22% compounded annual growth rate.

Those data points alone make it sound like it was nothing but rainbows and kittens for Wal-Mart investors over 30 years.

On the contrary!

During that period, there were 16 calendar months where the stock dropped by more than 10% and 97 weeks with 5%-plus losses. And this doesn’t include extended periods of market under-performance.

Equally important, during that three-decade period, Wal-Mart posted 26 calendar months of 10%-plus gains and 121 weeks of 5%-plus gains. A lot is made of investors selling after price drops, but my guess is most of us – certainly myself – have sold at least one good performer in order to ‘take a profit’, only to watch the stock multiply after that.

There were plenty of opportunities along the way for Wal-Mart investors to sell on panic or euphoria. It’s precisely these moments of emotional trading decisions that can derail a well-constructed investment strategy.

What it takes to stay invested

Though the impact of investment fees have on performance have been in the spotlight (and justifiably so), our poor behaviors can play an even greater role in under-performance.

This isn’t to say that a stock price plunge or a huge run-up in a stock or fund shouldn’t make us reevaluate our position. That absolutely should happen. Burying your head in the sand is not a realistic solution.

Skepticism is a healthy trait for investors. As the saying goes, the opposite of faith isn’t doubt, but certainty. Without some modicum of faith, emotion can run wild after reading a positive or negative news story, or after a substantial gain or loss in your stock or portfolio.

So, in what might we place our faith to stick with an investment – in good and bad times?

Your investment philosophy: Being comfortable in your investment approach, setting out an appropriate financial plan, and properly allocating your portfolio to various asset classes can help you weather market turbulence. Presumably you’ve created your plan with adverse market scenarios in mind. Put some faith in that strategy.

A company: If you’re a stockpicker, you might ask whether you believe a particular company you own is doing something special. Do they continue to execute on their business plan? If so, then to the extent possible diminish the stock market’s influence on your opinion of the company. Don’t check stock prices every day. Turn off real-time quotes on your broker’s homepage. Imagine you invested in a privately-run business where there was no daily price telling you its value. What would you use to measure a private company’s progress? You’d look at business fundamentals – dividends and book value per share growth, returns on equity, and so on. Use those factors to measure confidence in the company, not the stock price.

Optimism: Having invested through the financial crisis, I recall the allure of pessimistic arguments and admittedly I fell victim to some of it. A costly mistake. Bearish opinion always sounds much more refined and intelligent than the optimist saying things will turn around – even if the optimist don’t know quite how. But looking at a long-term chart of the US and UK stock markets, the pessimists haven’t seemed very smart for very long.

Historical evidence: While past performance is no guarantee of future results, there is compelling research that shows the benefits of being a patient investor. In 2013, for example, Morgan Housel dug through Robert Shiller’s U.S. market data going back to 1871. He found that your odds of generating positive after-inflation returns were as good as a coin flip in a one-year period. But over greater than 20-year periods, you would have always come out ahead in real terms. It’s not guaranteed these returns will repeat themselves, but it’s as compelling evidence as I’ve found for being a patient investor.

Source: Morgan Housel using data from Robert Shiller. 1-day returns since 1930, via S&P Capital IQ.

I’m not endorsing blind faith, but rather a healthy faith – a faith that comes with a dose of skepticism and introspection.

Being ‘actively patient’ is not simple. It’s hard to stay calm during both bull and bear markets.

With time and experience though, we can learn to filter financial results and market news to investigate the facts and discard the noise.

Bottom line

Faith seems too simple and perhaps a little naive when there are so many complicated explanations for investment performance. But the ability to keep your cool and stay focused whether times are good or bad is rare in investing.

The market is full of driven and intelligent people trying to outguess each other in the short run. Don’t play that game. Placing faith in the evidence, whether in your passive or active investing strategy, in a business or group of businesses, or in optimism alone can differentiate you from the crowd and help you achieve your long-term goals.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.