Good reads from around the Web.

I don’t know about you, but the new iShares Exponential Technologies ETF has a sort of end-of-days feel to it to me.

Are investors really clamouring to put money into a basket of stocks exposed to:

“…robotics, artificial intelligence, machine learning, nanotechnology, bioinformatics, sensor technology, financial services innovation, energy and environmental systems, neurosciences and of course, medical sciences…”

…?

The ETF amassed $600m assets in just a couple of days – more than enough to propel it clear of the ETF dead pool for now.

That seems a little frenzied, certainly. But according to ETF.com nearly all of the initial money came from the firm of the ETF’s promoter, Ric Edelman.

And Edelman has only invested a relatively small 4% of Assets Under Management into his brainchild.

So perhaps not quite DotCom 2.0… yet.

Not your father’s ETF investing

It’s worth remembering all these bespoke ETFs when contemplating the growing popularity of exchange traded funds, as illustrated in this graph from MorningStar:

Click to see ETF AUM growth in widescreen!

Source: MorningStar

Conventional index funds and ETFs are both taking market share, sure.

But the explosion of ETFs is particularly marked in the sector-based category.

And this demand comes from active investors who are holding baskets like the Exponential Technologies ETF in place of shares in individual companies.

Or perhaps that should be “trading” rather than holding – because ETFs are also widely employed by hedge funds and the like to dial their exposure up and down on a dime.

It’s all why Vanguard’s Jack Bogle is skeptical about ETFs, of course. Bogle believes they are a gateway drug into active investing.

But most of Wall Street and The City isn’t concerned about what’s right for investors – more about what they can sell investors.

Not for nothing was posterchild Goldman Sachs described as:

“a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

Indeed, Goldman created the new Exponential Technology ETF, along with iShares owner BlackRock.

And why shouldn’t it? Financial engineering is part of Goldman Sachs’ job.

But it’s our job to decide the best way for us to invest our own money – which for the majority will be to ignore the whole hullabaloo and invest passively instead.

Big bucks for ETF wizards

That said… if you can’t beat them, maybe you could join them?

No, no, I don’t mean becoming a silly active investor chasing rainbows. We know most attempts at active investing fail to beat the market.

I mean getting a job dreaming up your own weird and wacky ETFs.

There’s a “battle for ETF brains” going on, reports the FT [Search result]:

Mutual fund shops are on the hunt for people with a track record of building products and relationships in the exchange traded fund market and are likely paying big bucks for that know-how.

Tempting!

I’ve actually got my own idea for an ETF. It would be a sort of world equity index tracker fund, that simply holds as many stock market-listed companies from across the globe as possible while also keeping costs low.

[continue reading…]

I assume every investment I make could leave me with nothing.

I don’t expect it – in the case of cash and UK gilts I think it’s extremely unlikely – but I don’t bank on 100% guarantees.

Apparently sensible people complain on TV watchdog shows about losing all their money on corked wine funds or punts on plots of greenbelt land or timeshare apartments without plumbing or an airport within 50 miles.

And we who-know-better feel sorry for them…

…but we also snicker a bit at their gullibility.

Didn’t they see the risks?

Wasn’t it obviously a gamble?

Well, yes. Yet you still see supposedly sophisticated investors calling for criminal investigations when any old high stakes blue sky penny share goes bust.

Or retired people on Radio 4 admitting they lost half their net worth when their shares in RBS or Barclays went into the dunk tank in the financial crisis.

Very often such people were employees at the companies during their working lives.

They’d never normally dream of putting so much money into one company. But their familiarity with its logo and the office wallpaper of yesteryear makes them contemptuous of the risks today.

I even see smart passive investors putting all their money into one fund, or one broker, or into the hands of one adviser.

Sure the risks of something going wrong seem tiny.

Yes your money should be ring-fenced, segregated, held in your own name if everything is properly in order.

But why take the risk that it isn’t?

Every investment can fail you

When I buy individual shares, I assume the company can go bust – even if it is one of the largest companies in the world.

But my prudent paranoia goes much further than that.

Here are just a few examples of how seemingly safe and widely-used financial products could conceivably damage your wealth:

• Stock markets can and will crash. (Obviously… but people seemed to forget it during the last crash).

• Inflation can devastate long-term bond returns. (Obviously… but people today are buying German 30-year bonds yielding 0.65%).

• ETF providers could get into trouble, putting ETF investments into jeopardy at worst, or at least disrupting their smooth trade.

• Banks who are not members of your country’s compensation scheme can go bust or suffer a bank run.

• Investment companies can perpetuate fraud, from dipping their hands in the till right up to a Madoff-style Ponzi scheme.

• Banks and other financial companies can fail, with knock-on consequences for the investment products they stand behind.

• Electronic brokers or registrars could get into difficulties or suffer some form of collapse that destroys or renders inaccessible a record of who owns what.

• Ring-fenced assets might not have been properly – legally – ring-fenced.

• Safeguards against these or other failures can break or be unable to deliver. Or – more likely – there can be big delays in getting restitution.

• Insurance schemes set up to compensate you can run out of money.

• You may not even be as well-protected as you thought because that harmless-sounding ETF you bought was actually domiciled overseas.

• Cash under the mattress can be stolen.

• A government could appropriate the money in government-backed bank accounts, or default on repaying its own bonds, or make holding gold illegal.

• Your country’s currency could be devalued, so that even though your nominal net worth remains the same, your wealth is diminished compared to your overseas peers.

• Your country could suffer an economic collapse, even if the rest of the world chugs along fine.

• The communists could take over and outlaw all private property.

Clearly some of these events are far more likely than others – most are very unlikely – and there are some real Black Swans in there.

(Good luck guarding against a revolution that starts in Surbiton!)

But it’s vital to consider all risks – however vanishingly remote – in order to appreciate the potential value of the safeguards against them.

How then can we protect our wealth?

Everything from portfolio diversification and investing overseas to dividing your cash savings between different banks are sensible steps towards protecting your wealth.

I use a few different stock brokers, for instance, and have cash in several different bank accounts.

However I know I am running risks.

I only have a paper share certificate in one company (a non-listed one). Everything else is held electronically with online brokers in nominee accounts.

If the electronic record system collapsed for some reason, my share investments could be in peril.

I have also held synthetic ETFs in the past – and would do so again in moderation – despite the risks of synthetic ETFs versus physical ones.

Indeed I have very few physical or real-world assets.

I don’t even own my own home – the one kind of asset that almost all flavours of government tend to treat more reverentially than they do ‘fat cat’ assets like shares, bonds, and cash (at least until you reach genuine fat cat levels and your house has a front lawn they can really park their tanks upon).

I do have a pitifully small amount of gold tucked away in a vault, but despite my best intentions I haven’t added to it.

I think there is a case too for keeping a few gold coins or similar fungible assets somewhere secure near to hand that you can access in a crisis.

Don’t be a loser

Ultimately, you have to be pragmatic and live in the real world.

Accept that every time you invest, you take a risk with your money.

Do all you can to minimize those risks. Work through the alternatives. Spread your wealth around. Look for antifragile opportunities. And banish the word ‘guaranteed’ from your mind.

If you do all that then hopefully we’ll never have to hear on the radio how you lost the lot, never have to sigh, and never have to feel guilty for snickering at your foolishness.

Study the table of asset class returns below. It is one of the most important graphics you’ll ever see in investing.

Created by Vanguard, the table ranks several of the main asset classes by historical performance – from best to worst – for each of the past 15 years.

• For instance, you can see that in 2014 North American equities were the best performer, delivering a return of 19.6%.

• The worst performer that year, and thus at the bottom of the 2014 column, were European equities. They returned just 0.2%.

The different asset classes are differentiated by colour.

Click to enlarge this table of historical asset class returns.

Source: Vanguard

Hunting high and low

Even without enlarging it you can see the table looks like a patchwork quilt embroidered by a drunken colourblind sailor in the dark.

One year’s winners can be bottom of the class just a year or two later.

Yet equally, sometimes the best performers continue to do better for several years in a row.

This volatility is what makes tactical asset allocation – that is, trying to chop and change ahead of the market – so tempting, and yet equally so difficult.

It’s also why most people are better of not bothering with such second guessing.

A bit of what you fancy does you good

With a well-diversified and occasionally rebalanced passive portfolio, you’ll always have some money invested in the best performing assets in any particular year – albeit at the cost of holding some losers.

And by tweaking your allocations according to your risk appetite – as opposed to doing so to chase higher returns – you can influence the overall volatility.

The big win of this balanced portfolio approach is if you avoid being the schmuck who sells everything when your ultra-risky portfolio plunges in a rough year.

The table shows many instances when hot money would have had a bucket of cold water thrown over it in the following 12 months, scaring many investors into selling – only for the asset class to bounce back the year after that.

It’s the reason for the so-called behaviour gap, which is the repeated observation that real-world investors do much worse than asset class returns would imply.

It’s all due to their woeful attempts at market timing their way in and out of the best investments.

Look at the table again and imagine trying to actively dance your way through its highs and lows.

Do you feel lucky? Well, do you?

Note: I’ll be back later this week with more thoughts on the asset class returns table and tactical allocation strategies, so I am turning the comments off until then.