Good reads from around the Web.

I really enjoyed today’s spirited column by Ken Fisher in the FT [Search result] on the doomster-ism implied by the negative bond yields we’re seeing across Europe.

Monevator started life a year before the financial crisis, and its early articles were often trying to help people understand that the case for buying shares hadn’t changed just because they’d crashed – quite the opposite – and that the elevation of gold and the likes of Zero Hedge to cult status were typical over-reactions to a severe market dislocation.

A couple of years later, and the fight had turned to making the case for developed market shares – US and European companies.

Many out there, including some readers and Monevator commentators, were convinced that everyone should sell out of supposedly sclerotic mature markets in the West because the emerging markets were going to overrun us.

(A few of these Monevator commentators seem to have forgone their previous certainty, as we may well see again in comments on this post… 🙂 )

Of course, emerging markets have underperformed since then and the US has shot the lights out.

I didn’t know that was going to happen, but I was pretty convinced the doom-and-gloom theory was bogus.

A decade ago I was having arguments with people who thought peak oil was about to cripple us (never even slightly likely in our lifetimes, even back at higher prices) and a couple of years ago The Accumulator was arguing that most investors should still have money in bonds.

He was called irresponsible and reckless or worse; bonds went on to deliver excellent returns (which was unexpected and wasn’t his point, but it goes to show…)

You usually sound like a happy-clappy idiot if you take the opposite side in these arguments.

The bear case always sounds smarter.

A balanced mind and a balanced portfolio

None of this is about being particularly clever, or being seen to be clever.

It’s just a reminder that betting on extremely bad and unusual outcomes is very rarely a winning strategy.

The flipside is true, too.

For instance, those believing dotcom valuations in 2000 were justifiable because the world had changed forever were making a similar mistake.

But to stick with the doomsters, Fisher writes:

If it’s Armageddon or total societal collapse you fear, you don’t want any securities. Not stocks. Not bonds. They’ll just be worthless paper, no use for anything except lighting fires. Gold? You can’t eat gold bars.

If you really fear the total collapse of western civilization, then invest in canned food, bottled water, armour, guns, bullets, bows, arrows, knives and a bunker. Do you need a cave? Can I sell you a rock to crawl under? A shovel to dig your moat?

Does that all sound crazy? If so, go back to question one: why buy a negative-yielding long-term bond

If you do, you’re betting on a scenario you don’t remotely believe in.

Markets move on probabilities, not possibilities. If you don’t think economic doom has a snowball’s chance, don’t invest like it is inevitable.

Put your money on what’s likeliest — the world keeps turning, advancing and growing.

The unpalatable fact for the perma-bearish is that it pays to be optimistic as an investor.

Also, the most sensible hedge to that optimism being misplaced is a diversified portfolio – not a theory that everything is rigged / about to crash  / unsustainable / different this time.

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Liquidity indicates how quickly an asset can be converted into cash. Liquidity is a desirable trait in an investment.

In general, the more liquid an asset, the lower the return it offers. Investors bid up its price because they value owning assets that can be quickly converted into cash.

Coins and banknotes are the most liquid assets. They do not pay interest and in normal times they do not appreciate in value, unless they become old and of interest to collectors.1

Selling antique coins will require a trip to a specialized dealer, a valuation, and a sale by auction or commission, all of which take time and cost money, and so reduce liquidity.

A collection of rare coins is therefore far less liquid than a holdall stuffed with dollar bills, since it is expensive to turn a coin collection into ready money.

Liquid markets

The term liquidity is also used to describe how easily assets can be traded. The markets in which those assets are traded can be described in terms of this liquidity.

The most liquid markets have a high turnover of assets and many participants, and the cost of doing business in them is lower.

To return to the example of a coin collection, even big towns will usually only have one or two coin dealers. Those dealers will only be able to trade in a limited volume of coins.

Thus the antique coin market is many times less liquid than the international currency markets, in which billions can change ownership at a keystroke. The market in government bonds is similarly extremely liquid.

With shares, the situation varies.

Millions of shares in the leading blue chip companies are bought and sold every day. In normal circumstances this market is very liquid. This means the difference between the buying and selling price of the shares (known as the bid-offer spread) is usually tiny, as market makers in large caps can do profitable business on small margins due to the sheer volume of shares being traded.

In contrast, the shares of small companies are typically traded in lower volumes. In some instances, just a few thousand shares might change ownership in a typical day. Perhaps on some days no shares are traded at all.

As a result, market makers need to charge more to cover the cost of providing a market in these small cap shares. This is reflected in a wider spread.

An investor buying a tranche of shares in a particularly illiquid small cap can easily see their capital eroded by 5% or more in switching from cash to such shares because of this spread. The small cap market is far less liquid than that of large cap shares.

Prices are usually more volatile in less liquid markets, as a small number of participants can have a great influence on the price.

Academic research has pointed to an illiquidity premium for shares. This relationship suggests that owners of less liquid shares will earn a higher return than more liquid ones, as investors demand a higher return for not being able to use their rarely-traded small cap shares as a costless ATM.

A six month trade with a £5,000 spread

Assets can be very widely held but still not be very liquid.

Most people in the UK own their home, but residential property is not an especially liquid market. Relatively few homes change hands each year, buyers and sellers must pay all kinds of fees, and it can take months for a house to change hands.

When house prices fall and nobody wants or can afford to move, turnover may grind to a near-halt. At such times the market has become illiquid.

Master more financial terms with the Monevator glossary.

1. In deflationary times, cash does increase in value in real terms, because prices are falling and so your cash buys you more each year. [↩]

While it happens less often than it used to, some people still roll their eyes when you suggest they simply start investing via a mix of index funds and cash.

• Why aren’t you telling them about the special snazzy funds?

• Don’t you think they’re smart enough to pick up some hot stocks?

• Why are you telling them to buy a poor man’s fund?

Are you saying they’ve failed in life, and that they should start buying Value branded canned tomatoes and scavenging for the Financial Times out of the wastepaper bins?

Yes, I’ve had that when I’ve tried to explain the virtues of cheap passive investing.

Perhaps it’s my fault for talking about investing at parties.

Index funds: The experts’ choice

While newcomers still tend to believe they should invest their money with clever fund managers – and why wouldn’t they, given all the hype and the fact that index investing seems so wrong – I’ve noticed more and more seasoned private investors are switching to index funds.

You might call it throwing in the towel, except that sounds so defeatist.

When you consider that active investing is a zero sum game at best – and that high fees make it a losing game for the vast majority of funds and their investors – switching to a passive approach is a smart and proactive decision, not a sign of retreat.

And plenty of investing experts feel the same way.

In fact, I’ve decided to start a roll call of the more surprising fans of index investing, which we will update as more are outed!

Warren Buffett

The greatest investor of all-time and one of history’s best stock pickers made waves in 2014 when Buffett revealed he didn’t trust anyone to pick winning stocks after he was gone.

Instead, he said that on his passing, 90% of his wife’s estate would be put into a very low cost S&P 500 index tracker, and the rest held in cash.

Buffett said:

“I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers.”

It’s easy to create a similar passive Buffett portfolio with off-the-shelf index funds in the UK.

David Swensen

As the manager of the prestigious Yale endowment fund, David Swensen beat the market by investing some of its billions into hedge funds, private equity, and real estate.

The best-selling books he wrote on the back of his market-beating returns – of which Unconventional Success is the most accessible to oiks like you and me – changed how big pension and endowment funds ran their money.

Yet in that book and elsewhere, Swensen has repeatedly said most people (and most institutions) should stick to index funds.

Here’s an extract from a Bloomberg report on a conference where Swensen spoke about the virtues of indexing:

David Swensen […] said investors who don’t have access to top managers are best off using index products.

“There are two sensible approaches to investing — either 100 percent active or 100 percent passive,” [he said].

Unless an investor has access to “incredibly high-qualified professionals,” they “should be 100 percent passive — that includes almost all individual investors and most institutional investors.”

Most active mutual funds are more interested in collecting fees than in boosting returns for investor, Swensen said.

You can get a passive approximation of Yale’s asset allocation via a similarly-weighted Ivy League ETF portfolio.

Just don’t expect it to achieve exactly what Swensen achieves.

Paul Wilmot

Oxford graduate Paul Wilmot is one of the leading experts in quantitative finance, a field which typically seeks to use applied mathematics to discover and profit from the financial markets, often through discovering pricing anomalies or other inefficiencies.

Wikipedia tells me Wilmot also founded a hedge fund.

So I’m grateful to a Monevator reader, Robert, for highlighting the following quote from page 116 of Paul Wilmott Introduces Quantitative Finance:

“[The] vast majority of funds can’t even keep up with the market.

And statistically speaking, there are bound to be a few that beat the market, but only by chance.

Maybe one should invest in a fund that does the opposite of all other funds. Great idea except that the management fee and transaction costs probably mean that that would be a poor investment too.

This doesn’t prove that markets are random, but it’s sufficiently suggestive that most of my personal share exposure is via an index-tracker fund”.

I admire Wilmot’s candour here.

And as our reader Robert says: “Nice to get (yet more) vindication from someone who knows all about the most esoteric financial wizardry…”

Harry Markowitz

The Nobel prize winning economist Harry Markowitz is one of the father’s of modern portfolio theory, so it’s no surprise he likes index funds.

What is surprising though is that the the inventor of the Markowitz Efficient Frontier of portfolio construction took a far simpler approach to creating his own simple portfolio, with Markowitz admitting:

“I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.

But I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it.

So I split my contributions 50/50 between stocks and bonds.”

Keeping things simple. That is a sign of real genius at work.

Lars Kroijer

While he’s hardly a household name, Lars Kroijer came to UK investors’ attention when he published Confessions of a Hedge Fund Manager a few years ago.

It was a down-to-earth explanation of how he made a fortune in the active fund industry, with an inspiring ‘almost anyone can’ back story that has no doubt encouraged a few wannabes to try running a hedge fund for themselves.

It was surprising then when just a couple of years later, Lars came out with Investing Demystified, a book saluting passive investing in index funds as the most logical choice for almost any investor.

Lars writes:

“A one-time hedge fund manager writing about investments without edge may seem like a priest writing the guide to atheism.

In my view, however, it is not at all inconsistent.

The fact that some investors have an edge on the market does not mean that most people have it. Far from it.

‘Edge’ is confined to a very small minority of investors who typically have access to the best analysis, information, data, and other resources.

Most other investors simply can’t compete, and would be worse of trying.”

For more of Lars’ wisdom, read his articles on passive investing on Monevator.

The dumb money isn’t so dumb

As you can see, deciding to go for index funds is not like shopping for tat in the pound stores.

Some of the smartest and/or richest brains in finance have looked at the evidence and decided passive index investing is the best way forward.

No wonder 98 cents in ever dollar that went into US mutual funds in 2013 went to Vanguard, which dominates the index investing space.

That momentum continued last year, too, with data showing US investors pulled $12.7 billion out of actively managed funds in 2014, while putting $244 billion into passive index funds.

In the UK too, the amount of money put into tracker funds hit a new high in 2014.

Of course I expect the trendiness of index funds will hit a bump some day – most likely at the next bear market.

When that happens, different experts will come to the fore to say they told us so.

But remember while they laud the virtues of active management in the fearful aftermath of a crash that it’s impossible for actively invested money to on average outperform.

Unlike investing in a broad stock market index, active investing is a zero sum game – and that’s before high fees make things worse.

For that reason, I expect this roll call of tracker fund-loving experts to grow over the long-term.

Got an idea for a surprising investing expert we should add to this list? Let us know in the comments below.