Good reads from around the Web.

I have mentioned before that I think I am wired differently to most people I meet, and I believe that this makes me a better investor.1

I don’t think that I’m smarter or wiser than the smartest or wisest person in the room.

Far from it!

But I do think I am close to what some people have described me as: Contrary, difficult, stubborn, argumentative, self-centered, arrogant, a loner, and a little bit heartless. (I prefer “coolly logical”, but then who wouldn’t?)

So the following passage concerning Bill Bernstain’s new book jumped out at me when I read a review at MorningStar:

In Rational Expectations, Bernstein painstakingly explains what was mostly implicit in his first book: Emotions destroy investment performance.

Somehow, some way, investors must suppress them.

The suppression might come from the blessing of nature; from ongoing investment education; through shielding mechanisms such as holding a blind trust; or, most commonly, by cutting back on stocks and holding a lower-volatility asset allocation. One way or another, though, it needs to happen.

Paradoxically, writes Bernstein, the task is hardest for people who are otherwise admirable.

He states, “The most emotionally intelligent and empathetic people I know tend to be the worst investors. After all, the very definition of ’empathy’ is to feel the emotions of others, which is deadly in investing.”

Bernstein relays the story of hospital patients who have brain lesions that disconnect their sense of fear; in investment simulations, those patients handily outperform the general population.

For most people, investing successfully is a deeply unnatural act.

Thinking about the people in my own life, this rings true.

Most of the ‘people persons’ I know are terrible investors. I do know some self-made warmhearted wealthy people, but they all got there through entrepreneurship, not investing.

Where the big empathetic hearts are doing okay as investors, it’s generally been because they are utterly disinterested in the subject but see its importance. They set up tracker funds and automatic contributions and then forget all about them.

Are you nuts?

In the wider world, I can’t think of a famous stock picker who you’d describe as the life and soul of a party. Few Whoopie Goldbergs, many Christopher Walkens.

(Don’t be fooled by the bonhomie of Buffett or Soros. It’s clear from their biographies that the social veneer came later).

This is a blog about investing, so perhaps some of you are thinking hopefully: “Oh yes, I’ve got the rational, obsessive, borderline aspergic mindset of a born contrarian!”

To which I say: Be careful what you wish for.

There’s much more to life than investing. 🙂

On that note, I loved this quote from a very cautionary Guardian article:

You remember that kid in elementary school, the one who would argue during a game of tag:

“You said you have to tag the person. Well you only touched my clothes. That isn’t a person.”

Remember that kid? That kid is Wall Street.

Ouch!

[continue reading…]

1. Of course, this could just be a behavioural bias – over-confidence – that shows I’m exactly like everyone else…! [↩]

Important update on 26 July: So you can see I’m not the expert on funds on this blog — it turns out Woodford isn’t including stamp duty and dealing fees in his charges, which I missed in the hype and which largely explains why his costs compare so well to direct investment and yet fund managers make millions. As such, the maths below is off. I will try and update the piece one evening next week. Sorry!

Alright, so I’ll start with a shorter version of today’s rather meandering thought piece.

The long version that follows the short take is just a wander through the weeds to think about why cloning Neil Woodford (his fund, not his flesh) looks like a fruitless faff.

But some people like me might find it interesting to muse about, anyway.

Here’s the short version

Unusually for a fund manager, superstar stock picker Neil Woodford has decided to reveal every one of the holdings in his new income fund, and also the proportion of each share held.

Woodford also says he will update us on his exact portfolio every month, so you can follow any changes he makes.

There’s only 61 holdings as of the first reveal, and Woodford doesn’t trade much.

I’m not going to suggest anything clever – I’m not a quant-with-a-plan or similar.

I’m just going to point out you could buy the shares Woodford has unveiled in the same proportions he did, keep tabs on any big shifts he makes, and enjoy similar-to-Woody returns (in theory).

And all without any of your hard-won money going towards bumping up his management fees (although you will certainly incur trading costs of your own).

Oh don’t worry about Neil’s rainy day fund, he’ll get by.

Woodford is charging between 0.6% to 1% on the £1.6 billion of assets he’s already gathered for his retail fund – and he is running money for others, too. He should be able to keep the lights on at Woodford Funds with I’d estimate £10 million in charges coming through the front door from Joe Public alone.

The institutional fees paid to Woodford for managing pools of money for others (such as fund manager St James Place and maybe others to come) are just gravy!

How to clone Neil Woodford’s fund: The long version

Still with me? Okay, let’s get a virtual pint of beer, put our feet under a metaphorical pub table, and discuss the ins and outs of mimicking Neil Woodford’s new fund, the CF Woodford Equity Income Fund.

First things first, why would somebody want to copy Neil Woodford?

A good question – one that could take more than a pint to discuss in itself.

Indeed you could say most of this very website is dedicated to arguing you shouldn’t even want to copy the likes of Neil Woodford. Instead of giving money to expensive fund managers or picking shares yourself, you’re likely to do better via passive investing.

However I have two prevarications that together allow me to indulge this cloning-a-fund ramble.

Firstly, the fact Woodford has attracted £1.6 billion of retail money proves the man’s appeal. (And remember, he was managing nearly 20 times that at Invesco Perpetual.) Like it or not, self-evidently many people want some of what he does.

Of course, most like what he does, and have no desire to do any share research for themselves, nor to schlep around buying shares. They are happy (/disinterested) enough to pay him to do all that malarkey for them.

So you might only want to clone Woodford if you fancied his stock picking skills more than your own, and yet you are more happy owning a portfolio of individual shares than a fund. A rare combination perhaps?

The other reason for cloning might be if you thought it would save you money.

More on that later.

Is Woodford worth cloning?

I happen to believe Neil Woodford is the real deal, and that his great returns are unlikely to be all down to luck:

Now that isn’t me saying he’s sure to repeat the feat at his new fund.

Strictly-speaking, past performance is no guide to future performance, and passive investment mavens such as my co-blogger The Accumulator are quick to point out the lack of persistence in fund management returns.

The not-altogether-satisfactory retort would be that an active investor doesn’t care if the pool of winning fund managers will continue to win. They only care if their winning fund manager continues to win (with some down days/years, naturally).

And some research does suggest there may exist a tiny number of skilled alpha deliverers – 0.6% in the most recent piece I happened to read – though sadly there’s no definite way of finding them in advance.

So perhaps luck explains most managers’ ephemeral winning streaks, but not the handful of mega-winning runs from certain big market-beaters like Woodford, Buffett, and a few others?

Well, perhaps. We’re into the realms of faith here.

Passive investors will look at the graph reproduced above and see an exceedingly lucky tosser. Others (most?) will see all the evidence of skill they need.

Few managers outperform for decades, so perhaps it’s curmudgeonly to question the few that do.

I for one am happy to applaud Woodford’s past achievements, without at all feeling that he has justified the entire fund management industry single-handed by racking them up.

We’re going off-topic. Suffice it to say that plenty of people admire Woodford and want to invest their money with him.

A Woodford fund I did earlier

As it happens, I too admire Woodford – I like his calm, long-term methods, and his sometimes contrary thinking – but I am not at all interested in having him manage my money.

I enjoy doing that for myself. If I didn’t, I’d use trackers and find something else fun to do with the time it freed up.

Still, even I have made some money from his once ubiquitous funds.

The last time I wrote about Woodford, it was in the context of betting against the negative reaction we saw when news broke that he would no longer be managing the Edinburgh Investment trust.

That sent its shares lower. I thought it was overdone, and it was a decent bet.

Since my article:

• The Edinburgh Trust is up 9.9%
• The City of London Investment Trust (for comparison) is up 4.3%
• The FTSE All-Share is up 3.3%

Going against the panic won the day.

Of course I was being a rather cheeky with my headline for that article in claiming I was ‘betting against Woodford’.

In reality, he makes long-term investments, and it was unlikely his successor would derail the portfolio too quickly.

More importantly, Woodford continued to run the trust until April this year.

So my bet against Woodford was really a bet on his investments enduring – and on the closing of the discount that was opened up by prematurely ejecting Woodford fans.

Back to cloning Woodford

On to the matter at hand: Cloning Woodford’s new fund.

To do the deed we just need a cheap share trading account and a list of Woodford’s holdings.

• If you need a dealing account, you can peruse some examples from our broker table (note it is biased towards featuring those that are good for trackers).

• As for the buy list, Woodford lists his holdings on his website.

In practice, cloning is only going to be feasible in a tax-exempt account (an ISA or SIPP). While Woodford isn’t known for frenetic activity, he will certainly add, reduce, and swap about his holdings over time, and it’s imperative you don’t pay capital gains tax when replicating such changes.

Paying capital gains tax on portfolio changes will greatly reduce your returns – in which case you should have stuck with the real deal and invested with Woodford. (Plus there may be tax on dividends for you to avoid, too.)

Let’s say then that you have a large ISA account with iWeb, which charges just £5 for trades and only levies a small initial charge (£25) to get started.

If you buy all 61 of Woodford’s holdings, that’ll cost you about £310, plus 0.5% stamp duty on your trades.

Easy?

Not quite, there are further wrinkles:

• Some of Woodford’s holdings – such as Roche and Sanofi – are overseas shares. These will incur currency conversion fees, which vary from broker to broker. I see iWeb says it charges 1.5%, on top of whatever exchange spread it gets. Hefty, but par for the course for retail discount brokers in my experience.

• 20 of the 61 holdings are currently at weights of 0.5% of the portfolio or less. Woodford has a 0.01% holding of sausage maker Cranswick, for example. Not exactly a fatty pork belly of a position.

• Woodford may eventually buy into unquoted companies, and take part in early stage fund raisings or IPOs that are barred to retail investors. (However I suspect any such holdings will be very small, at least initially.)

With respect to the currency hit from overseas shares, a Woodford cloner is going to have to bite the bullet. About 20% of his holdings are listed outside of the UK, which is too big to be ignored. Even buying only the heftiest holdings will add a chunk to your dealing costs.

What about those smallest holdings? Do you need to clone them?

Initially, probably not. According to Trustnet over 50% of the CF Woodford Income fund is in the top 10 stocks. These are the ones that will dominate returns.

However you can only expect to get Woodford performance with Woodford’s holdings, warts and all. Buying just the top 20, say, will save you fees, but it could cost you in terms of returns.

By the same token, you might do better should the smaller holdings you ditch fare less well than the bigger ones – and presumably Woodford is less confident about them, otherwise he’d hold more of them. But you can’t know whether or not this will be true in advance.

The bottom line is holding just the top 10 positions would be more of an Etch a Sketch impression of Woodford’s fund, rather than a facsimile.

That said I’d be very tempted to ignore the very small holdings at first. Of course they could perform and grow – which means your DIY Woodford Fund will start to diverge from his, and you’ll maybe need to top-up on them, and take the hit – but as things stand any one of the smallest five holdings could be a ten-bagger and not impact your returns by much.

These are not Woodford’s most confident picks – otherwise he’d have some of the 8.3% he holds in AstraZeneca, for instance, allocated in them. They are far safer to skip than the big boys, from a cloning perspective.

How much would it cost to clone Woodford?

I’m not going to do this precisely, that’s not my forte.1 I just want to convey a taste of the calculations.

Let’s assume we buy all 61 of Woodford’s listed holdings.

Let’s also assume that 20% of our initial investment will incur an extra 2% cost of investment on account of its overseas nature. The 80% of your initial investment in UK shares will incur a 0.5% stamp duty charge. However overseas shares will be assumed not to pay this. So we’ll net that 0.5% back off the 2% surcharge for foreign holdings to give us a 1.5% extra cost there.

Here’s a rough reckoner of the cost of cloning for various sized portfolios:

Amount	Dealing Fees	Stamp Duty	Overseas fees	Total
£10,000	£305	£40	£30	£375
£50,000	£305	£200	£150	£655
£150,000	£305	£600	£450	£1,355
£250,000	£305	£1,000	£750	£2,055
£500,000	£305	£2,000	£1,500	£3,805

Note: Indicative guide.

How does that compare to investing directly into Woodford’s fund?

Well, there’s no initial charge with Woodford – commendable if unavoidable in 2014, really – but there’s an ongoing charge (OCF) of course.

How big is this charge? Here we get into the fun reality of post-RDR Britain.

According to Trustnet, the fee is 1%. According to This Is Money, it’s usually 0.75%, and over at the usual suspects, it’s 0.6%.

Woodford’s own site lists a range of fees for different classes of the shares if you select Professional Investor, but on the same page the fees table vanishes if you declare yourself to be a Private Investor. (I suspect this is a consequence of regulation, but I am not sure. Perhaps it’s due to the various deals?)

My co-blogger The Accumulator is on holiday, so I have no-one to guide me on what are the best assumptions to make about the OCF – nor the annual platform charges you may pay. And then there are the distinctions between ISA and SIPP charges with the myriad different brokers to consider.

The Telegraph ran a couple of tables courtesy of Mark Polson of Lang Cat, which gave total costs of anything from 0.75% to 1.35%. Polson also stressed some good news in that piece, though – that Woodford’s management fees are pretty much all-in, so there’s no extra expenses to consider to work up a true OCF.

For instance, here’s Lang Cat’s table of charge figures for running Woodford with various SIPP providers:

So what figure to use?

Well, this piece isn’t about the perfect way to buy Woodford’s fund for every situation – I just need a ballpark figure. So I’m going to assume a 0.65% OCF and a 0.25% annual platform fee, which is roughly in the middle of estimates.

Here’s what you might pay in charges in year one with variously sized portfolios:

Amount	OCF (0.65%)	Platform (0.25%)	Total
£10,000	£65	£25	£90
£50,000	£325	£125	£450
£150,000	£975	£375	£1,350
£250,000	£1,625	£625	£2,250
£500,000	£3,250	£1,750	£5,000

Note: Example only. Shop around!

Don’t go cloning on a £10,000 photocopying budget, that’s for sure. On these rough and ready numbers, it looks like the crossover point for initial investment favours directly owning the shares around the £150,000 mark.

Even this may be overly generous, because while you could probably hold the fund cheaper with some platforms, I’m not sure you could buy the portfolio of shares for much less than my estimate. I don’t think you could use ultra-cheap Sharebuilder services for instance (at least the one I use isn’t permitted for ISAs or SIPPs).

You could buy fewer of the individual holdings to reduce costs, at the expense of tracking error versus the real fund. Cutting off after the 50th position takes us as far as the 0.31% that Woodford has in insurer Hiscox, which is a pretty tiny holding. So anything below there isn’t likely to hugely move the dial.

Remember though that dropping holdings only saves on dealing fees. Stamp duty and currency costs are paid as a percentage of money invested. Overall it isn’t going to make much difference.

More importantly, initial investment is just the start!

Ongoing cloning

It’s been an interesting thought experiment so far, but let’s face it, nothing too exciting – cloning or buying into the fund for a year looks like a wash.

The good news is this is obviously only part of the story when it comes to investing costs, presuming you intend to invest The Woodford Way for years to come.

The bad news is that the good news cuts both ways.

And the really bad (good?) news is this discussion is already 2,100 words long, so I’m going to have to be quick from here.

Neil Woodford doesn’t plan to set-and-forget these 61 investments. He’s a long-term investor, but he’s also an active manager. Over time the allocations will change, and so will the actual companies he’s investing in.

This means a cloner will need to be ready to do more more trades to track Neil. This is going to be expensive if done in any number.

If Woodford tinkered with every holding just once a year, that alone would roughly double the costs – or triple them or more if you need to make sales to raise money for buys, too.

Ouch!

Clearly exact cloning at home is not going to be possible. Instead, a DIY investor is going to need to turn to judgement, not science, to try to keep pace with Woodford’s monthly updates.

This will mean using your best guess to decide when a change is material enough to warrant a trade. For instance I maybe wouldn’t bother adding a new holding until it got larger than 1% of the fund. It’s going to be harder to decide when to follow his adding or reducing his positions.

A dedicated Woodford cloner will need to read his pronouncements in the press, and follow the many investment websites that hang off his every move for clues as to which way he is taking the portfolio. With luck, your wayward judgements will cancel each other out and you’ll get something like Woodford’s performance.

It would also be helpful if you were still adding new money regularly to your portfolio. You could then use this new money to buy into any new positions, which at least saves you the cost of selling others to raise funds.

But however you cut it, it’s all going to add up.

On the other hand, those dusty traditionalists who invest via Woodford’s fund will have to pay those annual fees every year, whereas those with portfolios of shares held in a platform-fee free (or negligibly low and fixed-rate) account only need to pay for their additional trades.

This means you’ll have some spare money to play with for your cloning trades in the years to come, versus an investor paying 1%-ish in annual charges.

Is Neil Woodford wise to reveal his holdings?

In truth I don’t think it’s practical to try to exactly clone Woodford’s holdings.

If you’re a mega-fan – yet one who can’t stand to invest in funds for some reason – then you could use his monthly updates for research and to heavily shape your own portfolio.

But if you want the genuine Woodford experience, for good or ill, you’re best off investing with him and being done with it.

I’ll admit I initially questioned Woodford’s judgement when I first heard he was revealing all his holdings, if it meant his potential investors could do it for themselves.

But in reality, cloning is tricky.

Woodford says he’s revealing all his holdings in the name of transparency. Commentators such as Simon Lambert in This Is Money have applauded him for it, saying:

“Neil Woodford deserves plenty of credit for taking the unusual step of revealing the full holdings of his new fund.

Amid all the hype about the new Woodford fund, this is a genuinely noteworthy move.”

I understand the sentiment – that after the horrors of Bernie Madoff’s pyramid scheme and the like, it’s important for investors to know what they’re buying.

However if you invest in an active fund, you are implicitly trusting the manager. I am not sure second-guessing his or her investments is very logical.

Also, even monthly updates don’t tell you what Woodford is doing in the 30 days in between.

What’s more, beating the market is hard. Simon Lambert asks why investors shouldn’t know what Woodford is holding? One reason is that other of his investors might prefer he kept it secret if it improved his returns!

Woodford presumably thinks it makes no difference, and he may well be right. Some cynics have even suggested he’s listing the holdings to pump up their value. Perhaps that could work for the smallest companies, though it seems an unlikely motivation.

I’d be more worried about someone stealing my alpha if I was Woodford. Writing this article has persuaded me that small investors aren’t going to be lost in vast numbers due to his transparency, but professional managers could copy his ideas.

Or, as Lambert concedes in his piece, a Woodford Clone ETF could aim to copy his holdings, but charge a lower fee.

Seeing the Woodford for the fees

It will be fascinating (okay, only if you’re nerdy like me) to see if a Woodford-cloning culture takes off in the years ahead, in the UK.

Cloning Warren Buffett has been attempted for decades, with paid-for services claiming decent results, but nobody has managed to copy his folksy anecdotes.

Will people manage to do Woodford without paying Woodford? Will they be called Woodfakes? Will they beat the market, or beat themselves up?

Time will tell.

1. If this offends you and you fancy having a bash in a Google document and sharing it with us in the comments, that’d be great! [↩]

Small ones are more juicy is the phrase that comes to mind when thinking about the effect of the size (or small cap) premium on your portfolio. It’s long been contended that smaller companies deliver better returns for investors over time than their bigger brethren, albeit at greater risk.

The size premium is thus one of a quiverful of return premiums that have the potential to arrow you towards your investment targets – or indeed, to give you the shaft.

Each return premium comes with a cortege of risks and controversies. Size is no different.

Reasons for the small cap premium

The underlying explanation for the size premium is that companies with a small market capitalisations (small cap) are inherently riskier propositions than large cap firms. Therefore investors should expect to earn greater returns from investing in tiddlers, or else why would you bother?

In the US, this expectation of a juicier reward has averaged out as a 1.99% annualised premium for small cap firms over large caps between 1927 and 2012.

Evidence for the size premium has been found in most markets outside the US, too.

It’s important to note that the size premium is a reward for taking risk. This means that the small cap rollercoaster is more sickening than the regular stock market ride. You can wait years before the premium shows up, if it does at all.

The risks of small caps are well known:

• Smaller companies tend to be more vulnerable in straitened economic times.

• They find it harder to get credit and are more likely to go bankrupt.

• Weeny firms are more costly to trade – a lower volume of shares means they have wider bid-offer spreads, and it’s harder to liquidate your position without moving the market against you.

Some commentators suggest that the size premium is actually a liquidity premium – compensation earned for investing in illiquid equities.

Does the size premium exist?

Some question whether the size premium actually exists at all.

The arguments swirl around whether the premium has offered superior risk-adjusted returns, whether most of the outperformance occurred during a historical golden age of small-caps, and over whose methodology is right.

Even a small cap proponent like passive investing guru Larry Swedroe agrees that investing in the rise of the midgets is done at your own risk.

It’s important to know that the size premium is strongest in the small cap value sector of the investing universe.

In other words, you should look for funds that invest in small and unfavoured companies. I’ll look at this in greater detail in my next post.

Larry Swedroe argues that it’s the anomaly of small cap growth companies that drags down the size premium, as wannabe Googles and Amazons blaze across the sky before crashing to Earth.

Investing in small cap value funds is the best way to avoid these small growth companies.

The small print

Regardless of the outcome of that debate, there is no guarantee that a return premium will continue to deliver just because it has done so in the past.

The size premium is widely considered to be the weakest of the set. It managed a 26-year period of underperformance between 1982 and 2008.

Worse still, most of the figures you’ll see bandied around for return premiums don’t take into account the real world bogeymen of expenses and taxes.

Moreover, the small cap and value investing styles have attracted large inflows of investor cash in recent years, as evidenced by the recent smart beta hype.

A more sober estimate of the potential is Rick Ferri’s forecast of a 0.3% annual premium for small cap investments, rising to a 1% premium if you focus on small cap value equities.

Size is no guarantee of satisfaction

Regardless of the eventual triumph of the minimalists – or not – investing in small companies does diversify your portfolio.

If mega caps have a mediocre year then teeny caps may well take the edge off it, as the size factor has a relatively low correlation with the performance of the overall market.

Just remember that investing styles drift in and out of fashion like hemlines. To truly benefit from any size premium, you’ll need the discipline to commit to it over those many years when it seems about as real as the leprechauns.

Take it steady,

The Accumulator