Index trackers are the investment vehicle of choice for passive investors. Why? Because index trackers provide a low cost way to build a diversified portfolio that will outperform the average active investor.

Index trackers come highly recommended by some of the biggest names in investing.

Yale’s famed endowment fund manager, David Swenson, neatly summed up the advantages of trackers:

“With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low cost.”

Safety in numbers

Like other funds, tracker funds enable lots of investors to club together to increase their buying power.

They collectively buy shares or other assets across many more companies than any individual could

For example, index trackers make it possible to invest in all the world’s stock markets via just one global tracker fund.

Trackers are therefore a good way for everyday investors to get into the stock market without exposing themselves to the dangers of individual stock-picking.

Risks and costs are reduced thanks to the scale and diversity of the fund.

And while you’ll never beat the market’s performance with a tracker, you won’t lag it by much, either.

Indexes in (just a little) detail

Most funds have an aim. The aim of a tracker fund is to reproduce the returns of a specific market index.

An index is a basket of securities (such as shares or bonds) that is used to represent a particular segment of the market.

Famous indices that you’ll know from the Ten O’ Clock News include the:

• FTSE 100
• Dow Jones Industrial Average
• Nikkei 225

An index is a bit like the financial equivalent of a poll. The body behind some particular index regularly surveys a sample of the market to get a snapshot of the bigger picture.

There are many weird and wonderful indices out there, from the All-Peru index to the Volatility Arbitrage index.

But virtually all of us only need to concern ourselves with the biggest ones around.

You need to know:

• The market you want to track (e.g. UK domestic equity).

• Which indices track that market, and how the indices differ.

You can then make an informed choice about which tracker to go for.

For example, UK equity is covered by a number of indices, the two most popular being the FTSE 100 and the FTSE All-Share.

• The FTSE 100 tracks the 100 largest listed UK firms, and covers roughly 81% of the market1.

• The FTSE All-Share covers 98% of the market; it bundles together the FTSE 100, FTSE 250 and FTSE Small Cap indices.

So if you want the most diversified index, you’d pick the All-Share.

If you only cared about Britain’s biggest companies, you’d pick the FTSE 100.

You can find out which index a tracker mimics by reading its fund factsheet.

For more about the indices, visit major providers like FTSE and MSCI.

Gain with less pain

A tracker’s job is to deliver the return of its index.

It usually does this by holding stocks (or other assets) in proportion to their presence in the index.

Some trackers will hold the lot, some only a sample, and yet others will replicate index returns using complicated swap deals2.

The key point is that trackers don’t try to pick the winners. They don’t market time. They just plod along tracking the index, handing over the returns due from the performance of its component securities.

By its very nature, a tracker will never hit three cherries on the fruit machine. It will never turn in a stellar index-trouncing result.

Its task is just to replicate the index.

In fact, a tracker will usually undershoot its benchmark due to fund costs.

But a tracker’s limited ambition makes it cheap to run – and it’s because they are cheap that most index trackers outperform more expensive active funds over the long term.

Types of trackers

There are two main types of tracker funds:

• Index funds – Index funds are the simplest tracker type available, and the most suitable for small investors contributing monthly sums. The majority of these are now structured as Open Ended Investment Companies (OEIC), while a few are unit trusts. The US equivalent is called a mutual fund.

• Exchange Traded Funds (ETFs) – These are basically index funds wrapped up in a share that’s quoted on the stock market, which you buy and sell like any other share. Buying ETFs therefore incurs trading costs that ramp up the expenses for small investors. There is though a far greater choice of ETFs than index funds – an ETF may be the only way you can get exposure to some markets.

There is a third type known as an investment trust tracker. These are few and far between and are generally pricier than index funds or ETFs, so aren’t worth worrying about3.

You can read more about the different types of tracker.

Take it steady,

The Accumulator

1. In terms of the total market capitalisation [↩]
2. These differences in methodology are one reason for differing ‘tracking error’, which is the percentage amount by which a tracker fails to accurately track its index in any particular year [↩]
3. Some investors keep close tabs on investment trust trackers to see when their value deviates from their underlying value, but that’s not really what passive investing is all about! [↩]

Good reads from around the Web.

A short article in The Economist this week entitled Keeping Up With The Karumes (search result) provided an interesting look at happiness and inequality.

If you’ve been reading the personal finance blogs for a while, you’ll already know that after a certain point more money supposedly no longer makes you happier.

Moreover, it’s impossible to determine from existing studies whether already happy people get richer – rather than people being made happier because they get richer.

Maybe if you’re happy you have more successful friends who are happier to introduce you to their own friends or employers who have access to the better paid jobs, for example?

Or maybe happier people make their own luck in other ways?

Heaven knows I’m miserable now

The new study cited by The Economist tried to disentangle all this by randomly distributing money to some households in Kenyan villagers but not to others, like some mercurial minor god with a clipboard.

It found that people who got the money were indeed made happier – and less stressed – by it.

Those who got nothing felt worse.

So far, so “they get paid for this?”

But the interesting part for soppy-minded fools like me who worry about rising inequality is that the unhappiness downside apparently outweighed the happiness upside.

…the satisfaction of those who did not receive anything fell sharply as their neighbours’ fortunes improved.

The decline in satisfaction prompted by seeing one’s peers get $100 richer was bigger than the increase of satisfaction from getting a handout of the same size.

And pertinently, it wasn’t inequality itself that seems to have bothered the villagers, so much as the notion that they were suffering from it:

Participants in the experiment shrugged off changes in the Gini coefficient of their village, which measures overall inequality.

Take the example of a village in which one person gets richer, and another gets poorer. The village is less equal, but the mean income is unchanged.

In the Kenyan experiment this did not matter to the rest of the village.

Instead, participants compared how well everyone else was doing (the village mean) to themselves.

In other words, inequality is alright as long as somebody else is suffering from it.

We hate it when our friends become successful

Of course, as an ardent capitalist I’d point out this experiment is an imperfect reflection of the real Western world, which tends to inequality for a variety of different reasons – some good, some random, and some undesirable.

For example, capitalists play a big role in innovating and improving everyone’s lot through their risk taking (no, not every last capitalist, but in general that’s what the system does).

So in a real-life society, feeling unhappy that some capitalists are millionaires and the rest of us are relatively poorer might be outweighed by the improvement to our standard of living from having running water or electricity from local capitalists if you’re growing up in Africa – or by getting iPhones and Amazon Prime from Silicon Valley from the perspective of suburban Britain.

The ‘regular windfall’ experiment didn’t reflect that at all. It just made some people richer for doing nothing other than being lucky – as opposed to being seen to have made at least some sort of contribution or difference to justify their greater wealth.

The experiment if anything was a bit more like the ovarian lottery of inherited wealth that I’m so against…

…but we’ve just done that debate recently, so let’s put it to one side this week!

Stop me if you think that you’ve heard this one before

We might also wonder about the ethics of distorting the social politics of a bunch of Kenyan villagers to research whether comfy Westerners should be more laid back about oligarchs.

Good news, then, that the impact of extra money doesn’t last…

A year later the happiness of both the recipients and those who did without had returned close to its initial level.

…which is why the rat race is run on a treadmill, rather than to the victory line.

As the article concludes:

…when our own lot improves, we shift our reference group to those who are still better off.

In other words, we are never satisfied, since we quickly become accustomed to our own achievements.

[continue reading…]

This post on the equity risk premium is from former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.

We’ve previously seen how the equity risk premium was 4.3% during the period 1900-2014.

All very interesting – but what’s it got to do with you?

Well, I’d argue we have good reason to expect global equities to outperform UK and US government bonds by a similar magnitude of 4-5% in the future, too.

This means you can plug this sort of real return figure – say 4% – into your compound interest calculators and other such tools when working out how equities fit into your investment strategy.

It’s a practical way of dealing with the uncertainty of shares.

A real return, but not a certain one

Now, some people do criticise this approach.

They argue that using historical returns to predict future returns will lead you to expect higher returns at peak markets, and lower returns at market lows.

And to be sure, historical returns from UK equities looked a lot better on 1 June 2007 – before shares crashed in the financial crisis – than on 1 March 2009, in the depths of the aftermath.

Even worse, perhaps it was because you were attracted by the high historical returns you saw in the data in mid-2007 that you decided to invest in equities – retrospectively right at a market peak.

Combining high historical returns with low expected risk made equity markets look most attractive, just when in hindsight they weren’t.

I understand this criticism but – aside from the general unavailability of crystal balls to predict short-term stock market crashes – I think the length of data mitigates it, at least when we’re involved in long-term planning, not market timing.

With hundreds of years of data across many geographies – incorporating spectacular rises, huge falls, and everything in between – I think historical data is the best guide to the kind of risk and return we can expect from the equity markets going forward.

A more practical complaint is that in the past investors couldn’t actually buy the whole world of equities.

One of the leading index providers, MSCI, only started tracking a ‘world index’ in the late 1960s.

Easily investable products that followed this or similar indices did not arrive for decades after.

So perhaps investor expectations have changed – and the equity risk premium shifted – due it being easier and cheaper to invest in globally diversified equities now than was previously the case?

Time will tell.

Alternative approaches

It’s worth noting there are other ways to derive a figure for your expected returns from equities.

For example, you might look at the dividend yield of the stock markets, or the average P/E ratio.

Combining either of these measures with longer-term earnings growth estimates can yield you an estimate of projected stock market returns.

The problem with these measures is they use quite short-term financial data, and combine it with a highly unpredictable long-term growth rate in order to extrapolate something as uncertain as future stock market returns.

To be honest, I don’t see that as an improvement on looking at historical data.

Other people suggest conducting surveys asking investors what their projections are for the markets, to try to gauge what returns they’re demanding.

While an interesting idea, these surveys are criticized for being heavily sentiment-driven.

They might also tell you more about investors’ desired returns than what they actually expect to earn.

Lars’ predictions

On average I expect to make a 4-5% real return per year above the minimal risk rate (that is, the return I can get from short-term US government bonds) from a broad based world equity portfolio.

This is the figure I’d use in my financial planning when figuring out what I hope to achieve over the long-term.

Of course I do not expect this return to materialize every year.

However if I had to make a guess on the compounding annual rate from global equities going forward, I would plump for this sort of range.

Expected future real returns

Note that while the equity premium here is compared to short-term US bonds, I would expect the same premium to other minimal risk currency government bonds.

This is because the real return expectation of short-term US government bonds is roughly similar to that of other highly rated countries such as the UK, Germany, and Japan.

Apologies in advance

By the way, if you consider these expected returns to be disappointing, I’m sorry.

Writing higher numbers in this article or putting them into a spreadsheet won’t make them true.

Anyway a 4-5% annual return premium to the minimal risk asset if achieved will quickly add up to a lot. You could expect to double your money in real terms roughly every 15 years.

Indeed, some people would suggest that by expecting equity markets to be as favourable in the future as in the past, I’m indulging in wishful thinking!

Why the risk premium exists

It may sit wrong withyou to have something as important as what you can expect to make in the stock market be based on something as unscientific as historical returns – or for that matter my ‘guesstimate’.

Perhaps so, but until someone comes up with a reliably better method of predicting stock market returns it’s the best we have, and in my view a very decent guide.

Also, it’s not superstition we’re dealing with here.

We know that the equity premium should be something – because if there were no expected higher rewards from investing in riskier equities, then we would all simply keep our money in low risk bonds.

Another argument with simplistically predicting a stable risk premium is that we don’t change it much with the world around us.

It doesn’t seem right that the expected returns going forward should be the same in the relatively stable period preceding the deep stock market crash of 2008, say, as during the height of panic in October of that year.

Did someone who contemplated investing in the market in the calm of 2006 really expect to be rewarded with the same return as someone who stepped in during the despair and frenzy of October 2008?

Very probably not; someone willing to invest at a moment of high panic would likely expect to be compensated for taking on that extra risk.

This suggests the equity risk premium is not a constant number, but is somehow dependent on the risk of the market.

At a time of higher expected long-term risk, equity investors will likely be expecting higher long-term returns.

We might therefore think of the 4-5% equity premium I’ve outlined as an expected average based on an average level of risk.

Putting the risk premium into practice

In the interest of trying to make something as complicated as the global financial markets into something almost provocatively simple, here is a chart showing what we can expect in terms of returns after inflation.

The equity risk premium in graphical terms.

The graph shows how as risk increases, so does our expected return.

So if you’re an investor who wants to achieve returns in excess of the minimal risk return, you can invest in a broad portfolio of world equities.

In my opinion you can reasonably expect over the long-term to make a real return of 4-5% per year above the rate of minimal risk government bonds, which I expect to be about 0.5% per year.

However you can also expect your annual return to vary significantly, with a standard deviation of about 20% per year.

If that sounds too risky to you, you can combine an investment in shares with an investment in minimal risk government bonds to find your preferred level of risk (that is, volatility).

By varying the ratio of equities to bonds, you can blend your portfolio to suit your best guess of your individual risk tolerance.

Adding a greater percentage of bonds reduces the volatility in your portfolio, at the expense of reducing your returns.

Simple is best

I believe by following such a strategy you will do better over the long term than the vast majority of investors who pay large fees needlessly to earn consequently poorer investment returns.

Such a strategy can be enabled by combining just two index tracking securities – one tracking your minimal risk asset, and one tracking the world equity markets.

If this seems just too simple then remember your simple portfolio hides a lot of complexity below the surface.

Your world equity tracker is giving you exposure to a large number of often well-known companies, operating in many currencies all over the world. From just your two securities you are therefore getting amazing diversification, along with a minimal risk security in the shape of government bonds that give you the greatest amount of security possible.

An excellent portfolio made up of just two securities… Who said investing had to be complicated?

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.