Good reads from around the Web.

We’re all investing nerds at Monevator, so we love to dive into the minutia.

Take The Accumulator’s recent wide-ranging review of the various ways passive investors might get a slight edge over the market through return premiums – only to conclude at the end that perhaps it wasn’t worth the bother, anyway!

I love that we’re at a point where we’ve covered all the basics and can now indulge in these amuse-bouche.

But I also worry that newcomers might get the wrong idea.

Simple minds

Passive investing in broad index funds is extremely simple to implement, and it has the best shot of delivering what 98% of investors who stick with their plan require.

All the rest is so much noodling.

That’s one reason why I try to occasionally remind everyone that it doesn’t matter much what tried-and-tested asset allocation approach you pick, provide it’s cheap, sensible, and somewhat diversified.

Some asset mixes will of course prove more profitable than others over the long-term, but you almost certainly can’t know which in advance.

Baked potatoes

Another reminder comes from Canada’s finest index investing export – the Canadian Couch Potato – who has just revealed the 2014 returns for the various passive portfolios he tracks.

And this year, like most years, they all did about the same, returning from 9.8% to 10.8%.

Now if you’re already rushing over to see how to change your portfolio to be more like that 10.8% marvel, then you’re missing the point.

Next year the fortunes might be reversed. Or the year after. And anyway, it’s the 10-30 year return that matters.

As the Couch Potato himself says, the important thing is to just do it:

The point is not that cost is unimportant.

But if you’re just getting started and you’re intimated about building an ETF portfolio (and I’ve heard from many readers in this boat), a balanced fund is great choice, even if it isn’t the absolute-lowest-cost option.

The point is it’s easy to set up a portfolio to do 99% of what you need.

Indeed, Vanguard’s LifeStrategy funds make the entire thing trivial.

In contrast, I had a conversation with a good friend last night who again asked me how he should get started with investing.

I am not exaggerating when I say I’ve had this conversation with him for nearly a decade. He wants to get started, but he wants to do it best. So he puts it off until he has the time and interest to research it all properly (as he sees it).

A time that never comes.

Action paralysis has a cost. As Tadas Viskanta put it over at Abnormal Returns:

The pursuit of ever better outcomes is likely to lead to progressively worse outcomes.

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Our Slow & Steady model portfolio is now four years old. I doubt The Investor or I ever really imagined we’d see the day.

And how it’s grown! In four years our little snowball has swollen 24.92%.

That’s £3,651 in cash terms and an annualised gain of 9.49%.

This compares with the FTSE All-Share’s annualised growth of 9.8% over the same period.

Our portfolio has lagged the All-Share partly because of our allocation to government bonds. But please remember that we don’t hope to beat any particular stock market index over the long-term. This portfolio is designed to give us a strong chance of a good result, not an outside chance at the best result.

The very best asset class is unknowable 20 years in advance whereas good is good enough.

Also, most people can’t handle the volatility of an all-equity portfolio. They are helped by the stabilizing benefits of bonds in bad years for shares, even if bonds prove to deliver lower returns than equities over the long-term, as they have in the past.

That said, our portfolio has trounced the FTSE All-Share in the past year, growing by 10.43% versus the latter’s 1.18%.

Our geographic diversification and the healthy dollop of UK government bonds has kept us in the hunt.

The portfolio’s benchmark-busting performance was led by:

• The US galloping ahead 20%
• UK gilts put on 14%
• Emerging Markets spurted by nearly 9%
• Pacific Rim increased by 6%

Note, there’s nothing clever about this. We just stuck to the asset allocation we laid down in 2011.

The Slow & Steady portfolio is Monevator’s model passive investing portfolio. You can read the origin story and catch up on all the previous passive portfolio posts here.

Here’s the portfolio lowdown in mighty spreadsheet-o-vision:

New year, new you

So if things are going so well, why am I not happy?

January’s always a good month for making changes and I think the portfolio could be better diversified.

Our current set-up was the best we could do with commonly available index funds in 2011, but things have moved on for UK passive investors.

We’ve now got some good options that cover a broader range of asset classes:

• Global property – which tends to enjoy relatively low levels of correlation with equities.

• Inflation-linked government bonds – should stand us in good stead when inflation is high and growth low.

• Global small-cap – our existing equity funds are dominated by large firms. A small cap fund gives us exposure to a group of equities that might behave differently, even though the small cap premium is contested.

I’m going to add all these to the model portfolio. We like to keep things simple though, so to prevent it from becoming unmanageable we’ll replace our existing US, Europe, Japan and Pacific holdings with a single ‘Developed World ex-UK’ fund. This single fund maintains exposure to all four regions but rolls them into one faff-less vehicle.

Here’s a handy table to summarise the changes:

Old portfolio	Asset allocation (%)	New portfolio	Asset allocation (%)
Vanguard FTSE UK All-Share Index Trust	15	Vanguard FTSE UK All-Share Index Trust	10
BlackRock Emerging Markets Equity Tracker Fund D	10	BlackRock Emerging Markets Equity Tracker Fund D	10
BlackRock US Equity Tracker Fund D	25	Vanguard Developed World ex-UK Index Fund	38
BlackRock Pacific ex Japan Equity Tracker Fund D	6	Vanguard Global Small-Cap Index Fund	7
BlackRock Japan Equity Tracker Fund D	6	BlackRock Global Property Securities Equity Tracker Fund D	7
BlackRock Continental European Equity Tracker Fund D	12	Vanguard UK Inflation-Linked Gilt Index Fund	14
Vanguard UK Government Bond Index Fund	26	Vanguard UK Government Bond Index Fund	14

The total weighted OCF of the new portfolio is 0.18%

That compares to 0.16% for the old version.

We don’t incur any dealing costs for the switches because the portfolio is notionally held with Charles Stanley Direct who don’t charge for fund trades.

In reality you would face some risk of being out of the market for a day or two, but you can’t know if it’ll be positive or negative in advance. I ignore it here.

Reasoning

It’s important to remember that I’m not doing fiddling with our allocations because I think this new combination will outdo the old one in the next year.

Rather, this is a strategic change that spreads our risk and hopefully means the portfolio is better buffered against whatever the future has in store.

Previously we only had exposure to world equities and conventional bonds.

Now we’re exposed to property, small cap, and inflation-linked bonds as well as world equities and conventional bonds.

That’s five layers of diversification instead of two.

As ever, we use index funds to achieve our goals because the evidence shows that low-cost investments will, on average, give us the best return over time.

Risk management

The inflation-linked gilt fund comprises 50% of our 28% bond allocation. That bond allocation itself swells 2% every year as we’re lowering our exposure to volatile equities in line with our shrinking time horizon.

We’ve now got 16 years left on the Slow & Steady clock.

Meanwhile, to make room for the global property and small cap funds, I have carved a slug out of our equity allocation.

I want to give each of these diversifying assets a meaningful but not dominant role in the portfolio. So they get 7% each of the total, which amounts to 10% of our 72% equity allocation.

To make room, I’ve lopped big slices off the UK and Developed World allocations.

A purist’s asset allocation would heed the wisdom of the crowd – buying assets in line with global capital distributions.

UK equities are worth about 7% of the global market so by rights should have a 5% share of our equity allocation. We’ve always held a larger dollop in our home country though, partly because it slightly reduces our exposure to currency risk and partly because like most investors we suffer from home bias.

A desire to correct that bias accounts for the large chop in UK equities with this reshuffle – from 15% to 10% overall – but I’m not so rational as to drive it right down to 5%.

The Emerging Markets cut stays at 10%, which is now a 14% slice of our equity allocation and commensurate with the developing world’s greater role in the global economy.

So that’s the asset allocation logic in a large and hairy nutshell.

My actual index fund choices are either the only or the cheapest available in each category.

Incoming!

Q4 is income bonanza time. Our funds paid out £148.11 in dividends and interest, which we’ve promptly fed back into the growth machine courtesy of our automated accumulation vehicles.

Here’s how the income adds up:

• US equity tracker: £31.49
• European equity tracker: £38.82
• Japan equity tracker: £7.95 (Go Japan!)
• Pacific equity tracker: £17.40
• Emerging markets equity tracker: £30.67
• UK Government bond index: £21.77

Total dividends: £148.11

Finally, we need to lift our investment contribution in line with inflation.

Inflation erodes the value of money as surely as the wind and rain wears away rock. We up our ante by 2% to stay level with the latest RPI advances.

That means we now need to throw £867 into the pot every quarter instead of £850.

Let’s round that up to £870.

New transactions

That new £870 is divided between our funds in line with our asset allocation.

Here’s how it breaks down, along with the rest of the dozey-doe required to reshuffle our portfolio.

UK equity

Vanguard FTSE UK All-Share Index Trust – OCF 0.08%
Fund identifier: GB00B3X7QG63

Rebalancing sale: £630.90
Sell 4.12 units @ £153.03

Target allocation: 10%

N.B. Vanguard merged our old fund – the Vanguard FTSE UK Equity Index Fund into the Vanguard FTSE UK All-Share Index Trust on November 1.

North American equities

BlackRock US Equity Tracker Fund D – OCF 0.17%
Fund identifier: GB00B5VRGY09

Sell: £4,996.13

Replaced by:

Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.15%
Fund identifier: GB00B59G4Q73

New purchase: £7,289.80
Buy 33.69 units @ £216.35

Target allocation: 38%

Japanese equities

BlackRock Japan Equity Tracker Fund D – OCF 0.17%
Fund identifier: GB00B6QQ9X96

Sell: £1,041.27

Replaced by:

Vanguard Global Small-Cap Index Fund – OCF 0.38%
Fund identifier: IE00B3X1NT05

New purchase: £1,342.86
Buy 7.5 units @ £178.59

Target allocation: 7%

Pacific equities excluding Japan

BlackRock Pacific ex Japan Equity Tracker Fund D – OCF 0.19%
Fund identifier: GB00B849FB47

Sell: £1,077.30

Replaced by:

BlackRock Global Property Securities Equity Tracker Fund D – OCF 0.23%
Fund identifier: GB00B5BFJG71

New purchase: £1,342.86
Buy 894.05 units @ £1.50

Target allocation: 7%

European equities excluding UK

BlackRock Continental European Equity Tracker Fund D – OCF 0.18%
Fund identifier: GB00B83MH186

Sell: £2,008.79

Replaced by:

Vanguard UK Inflation-Linked Gilt Index Fund – OCF 0.15%
Fund identifier: GB00B45Q9038

New purchase: £2,685.72
Buy 17.98 units @ £149.39

Target allocation: 14%

Emerging market equities

BlackRock Emerging Markets Equity Tracker Fund D – OCF 0.26%
Fund identifier: GB00B84DY642

New purchase: £109.69
Buy 96.3 units @ £1.13

Target allocation: 10%

UK Gilts

Vanguard UK Government Bond Index – OCF 0.15%
Fund identifier: IE00B1S75374

Rebalancing sale: £2,147.76
Sell 14.93 units @ £143.88

Target allocation: 14%

New investment = £870

Trading cost = £0

Platform fee = 0.25% per annum

This model portfolio is notionally held with Charles Stanley Direct. You can use its monthly investment option to invest from £50 per fund. Just cancel the option after you’ve traded if you don’t want to make the same investment next month.

Take a look at our online broker table for other good platform options. Look at flat fee brokers if your portfolio is worth substantially more than £20,000.

Average portfolio OCF = 0.18%

If all this seems too much like hard work then you can always buy a diversified portfolio using an all-in-one fund like Vanguard’s LifeStrategy series.

Take it steady,

The Accumulator

Good reads from around the Web.

Many economists claim that all investors are rational and that all known facts are incorporated into prices.

I think differently.

That doesn’t mean it’s easy to beat the market – quite the opposite, it’s demonstrably incredibly difficult and most people shouldn’t try – but that’s another matter.

A suitably advanced alien onlooker or an all-seeing God could tell you how many people are standing on one leg on the planet Earth right now.

It’s a knowable fact, but you or I would just be guessing.

Faulty logic

People who write about investing (myself included, no doubt) detract even more credibility from the rational market school of thinking.

Frequently you’ll read statements that are just plain silly.

For instance, I regularly hear US ‘experts’ proclaim that the rise in popularity of index funds and ETFs in the past few years is due to the steady rise in the value of the stock market.

But that’s just a US perspective, with its main markets hitting all-time highs on a regular basis in 2014.

The growth of indexing has been just as visible in the UK.

Yet our leading market – the FTSE 100, down again in 2014 – is still below its peak achieved in 1999.

The active edge that isn’t

On the same note, we often hear some of those US pundits proclaim that people will abandon index funds for active funds when a bear market strikes.

Articles like this recent anti-indexing one in Market Watch claim that “stock pickers have an edge in a downturn”.

Are we really going to have to spend another year debunking this stuff?

Firstly, the market consists entirely of stock pickers and passive funds (the latter being by definition neutral)

So for every active stock picker who wins there must be a stock picker who loses.

The claimed “edge” is therefore a mathematical impossibility.

Secondly, you might ask why indexing is growing in popularity in the UK, where as I say our leading index is yet to recover from the past two bear markets?

The answer might be that at least some of those who tried active funds have discovered they were scant protection from the bear market in 2008 and 2009.

Market ups and downs are unknowable, but costs are nailed-on.

Why is this so hard for people to grasp?

Not quite a road to nowhere

Anyway, while the woeful headline performance of the FTSE 100 over the past 15 years seems about as good an advert for tracking an index as North Korea’s economy is for collectivism, it’s not been quite as bad as all that.

Why?

Dividends, dear boy, dividends.

Hargreaves Lansdown notes that:

‘It is easy to look at the level of the FTSE 100 and to conclude the market has gone nowhere for 15 years, but even someone who invested £10,000 in the UK market at the worst possible time would now be sitting on £17,206 with dividends rolled up.

That said, it has been a white knuckle ride at times, encompassing the tech crash, the global financial crisis and two bull markets. But despite all that, the equity market has delivered significant returns ahead of inflation for long term investors.’

The other thing to stress is a properly diversified passive investor would only have a portion of their assets in UK equities.

You’ll have made good elsewhere while the FTSE 100 has wobbled nowhere, just as the US markets will likely one day disappoint and the FTSE 100 prosper.

What nobody should be doing is looking for silver bullets.

As Ben Carson writes:

“There are no shortcuts to the process. It’s never going to be easy. No one is ever going to be able to guarantee you an extremely high return number year in and year out. The markets just don’t work that way.

But some people really want to believe that it’s possible. They want the Holy Grail of investing with all of the upside but none of the downside.”

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