Good reads from around the Web.

There’s a certain kind of private investor who is drawn to ‘story stocks’ such as:

• Hyper-growth loss-making companies.
• Tiny mining outfits.
• Revolutionary app developers.
• Aggressively accounted roll-ups.
• Radical hemorrhoid cream suppository manufacturers.

That kind of thing.

Very occasionally one of these makes its early investors a mint. Much more often, they become the latest cautionary tale against jam tomorrow gambling.

Except they don’t, exactly. The general idea that it’s a risky game is reinforced, but the specific firm that failed is soon forgotten.

Who remembers the microcap companies that went bust in 2003? Not me.

I think this is one reason why it’s so hard to make story stock fans understand the risks they’re taking. Like budding authors who see bookstores full of best-sellers, they see only the ARM Holdings and the Vodafones of the world – the once tiny companies who made it huge.

The myriad failures are lost in the memory even of those who watched them fall.

Tragic reading

The Internet can help to change that. Reading old bulletin boards that chart the demise of doomed companies is a sobering experience that I highly recommend for preventative medicine purposes.

For example, White Coat Investor featured a sad summary this week of posts from investors in GT Advanced. The firm made a material called sapphire crystal, which is used in high-end devices like the iPhone. It went bankrupt in apparently controversial circumstances.

GT Advanced is as much a tale of danger of getting so wrapped up in a story that you invest far too much in it; the company’s value peaked at over $1 billion, so this is not a classic small cap bear trap.

Here’s one post that White Coat Investor highlights as the sort of terrible thing that can happen when you bet all on red and lose:

I am totally numb. Just got home after working.

I saved this money for over 25 years and it is gone in a day.

I haven’t sold my shares because I just don’t know if the shares will be worthless soon or any chance that they may come back.

I bought at $18 and $18.25 and have about 4,700 shares. This is everything. My retirement and my savings for my son and me. This is so hard for me to take in because my son has special needs and this was for him and his future, especially when I’m not here any longer. He is getting of the bus soon so I need to dry my tears and put on a smile.

He is the best son a mother could ever wish for. I just feel and know that I have failed him and trying to figure out what to do.

Should I sell now and at least have a couple thousand for us to at least have a few weeks to figure out what to do. I feel for everyone on here who lost.

I was advised by someone who I trusted dearly not to sell. My instincts told me otherwise but I put my trust in this individual because I just felt so inept at trading and believed he knew much more than me. I will more than likely have to sell our home and struggle with this only because change is so difficult for my son.

I apologize for venting but I am too ashamed to share this with my family or friends. I shared this with the person who advised me to hold and my messages go unanswered.

This sort of thing makes for heartbreaking reading. No ifs or buts.

Position size is everything

I have seen countless story stocks dwindle to nothing or go bust over the years. Many were the subject of frenzied interest from private investors. Very often any warnings about the wisdom of investing or criticism of a company’s performance or practices were shouted down.

Indeed, a bulletin board full of evangelical supporters is pretty much a contrarian ‘avoid’ signal for me these days.

Now, you know what I’m going to say next – the best way for most people to avoid this sort of thing is to invest in passive funds, which will never have more than a tiny smidgeon devoted to companies like these.

And that’s true. But I’m an active investor for my sins, and I do steer my little ship through some of these choppy waters.

Totally avoiding dubious story stocks would be a good rule of thumb, but my idea of a dubious story stock is someone else’s idea of a great growth opportunity.

So my best blanket advice for investors drawn to microcap, loss-making, or one-shot wonder type shares is to limit your exposure, no matter how much you like the company or the price.

I’m talking initial 0.5-2% positions here, not the 10-30% you’ll see touted as ‘safe’ in some dark corners of the Internet.

Also, I think you should rarely add to risky loss-making story stock winners, at least not until they’re years out of the incubator stage.

Just let the winners run. Just in case your wrong.

• If a story stock defies the odds and eventually lives up to its hype, you won’t need much to make a big return.

• If – as is far, far more likely – it goes tits up, you’ll be glad you didn’t own much in the first place.

[continue reading…]

The long con is the most dangerous kind of confidence trick. It’s not nice to lose a tenner to a street hustler or even £500 to a door-to-door swindler, but the long con – the swindle that runs for weeks, months, or even years – can be a much more deceptive and fatal affair.

The long con – where you’re played as a mug by a whole crew of rip-off merchants – is how you lose thousands of pounds. It’s the stuff of boiler room scams that steal your nest egg, agents who sell you a house they don’t own, maybe even a spouse who only wanted you for your ISAs.

In the hands of truly gifted grifters, you might even reach the end of a long con without realising you’ve been the victim of a scam at all.

Is the active fund management industry a long con?

Perhaps. Sort of.

To be clear, I’m not talking about frauds like Bernie Madoff, or even foul-ups like the split cap trust debacle, the Equitable Life scandal, or sub-prime mortgages, dubiously sliced and diced debts, and dodgy ratings agencies.

I just mean the everyday business of managing our money and charging for it.

The con is on

Most investment bankers, fund managers, or others in the City are definitely not crooks. Far from it – I think they’re overwhelmingly law-abiding citizens and upstanding members of the community.

(A cynic might say they’ve every reason to uphold the Law of the Land, given their place near the top of the tree!)

But much of financial services does look like a giant machine designed to skim billions off a mass-market of oblivious mug punters.

As for the elite, they can give their money to hedge funds and get fleeced in style.

An extreme argument?

Well, we know that the majority of active funds do not beat the market.

All the data shows that. Yet we also know the total weight of money in active funds still greatly outweighs the money in passive funds.

Therefore most private investors are paying for a service that doesn’t deliver what it promises.

They are paying much more than they would if they’d invested passively via the cheapest intermediaries, and simply accepted the market return, minus low tracker fees.

Ring any alarm bells?

Here’s the definition of a confidence trick from Wikipedia:

Confidence tricks exploit typical human characteristics such as greed, dishonesty, vanity, opportunism, lust, compassion, credulity, irresponsibility, desperation, and naivety.

As such, there is no consistent profile of a confidence trick victim; the common factor is simply that the victim relies on the good faith of the con artist.

Victims of investment scams tend to show an incautious level of greed and gullibility, and many con artists target the elderly, but even alert and educated people may be taken in by other forms of confidence trick.

Accomplices, also known as shills, help manipulate the mark into accepting the perpetrator’s plan.

In a traditional confidence trick, the mark is led to believe that he will be able to win money or some other prize by doing some task.

The analogies write themselves.

You’ve got to pick a pocket or two

Now, it’s true you won’t lose your life savings by investing in a portfolio of decent actively managed funds.

Your pension is just likely to be a bit smaller than if you’d gone passive.

Even if you do the maths and discover just how much of your return you potentially give up in paying the costs of active management, your final nest egg probably won’t look too bad, thanks to compound interest.

Indeed the genius of the operation is that rather than financially ruining you by taking you for all you’ve got and then quitting town overnight, active fund management fleeces us for a couple of per cent each year, every year.

But when you add up all the proceeds, you end up with one great tithe on our savings.

Here’s John Bogle, the father of the index fund, on the subject:

“The function of the securities markets is to allow new capital to be directed to its highest and best use.

That’s true, but think about the maths for a minute.

We probably have about $300 billion a year that goes to new and additional offerings.

We trade $56 trillion, and that means something like 99.5% of what we do as investors is trade with one another. And 0.5% is directing capital to new business.

There is a system that has failed society. Period.”

That’s a powerful argument, though I do think Bogle over-eggs the pudding.

For starters, a certain amount of trading is required to have a liquid secondary market in shares. Without that, nobody would put fresh money into newly-listed companies in the first place.

Equally, some measure of trading is required for us to have efficient markets, although nobody knows how much. In the video below, Sensible Investing cites ‘academic consensus’ that a global fund industry of 20% the size of today’s would be sufficient, but I have no idea how reliable that figure is.

But plenty smaller, I’m sure.

Bigger and biggerer

This graph from The Economist from back when people were worried about how vast the financial services industry had become – you know, 2009 – reveals a part of the reason why the rich got so much richer in the past few decades.

Financial services swallowed up an ever-increasing share of GDP:

Did we ever need so many people shuffling money about for a productive planet?

Or did they perhaps – like the infamous bank robber Jesse James – go where the money is?

Some of the increase in GDP share for financial services may be warranted. It might for instance represent the more sophisticated allocation of capital towards higher return investments, with a decent pay-off for our economies and for society. Greater leverage will play a role, too.

Another chunk of it is the West being the banker for the faster-growing wider world, which is a boon for cities like London.

Still, it’s hard to believe we need Wall Street to make the $26.7 billion in bonuses it clocked up in the year to March.

And it’s hard to believe the many billions spent in the UK on the zero-sum game of active fund management – £18.5 billion of it in hidden charges, according to the True and Fair Campaign – isn’t many billions bigger than it needs to be.

I admit fund management is probably grand fun – I’d imagine I’d love running an active fund – but as I used to rant about bankers before I started feeling sorry for them, wouldn’t it be better if our brightest were curing cancer or solving global warming?

This final video from Sensible Investing TV has plenty more thoughts on the subject:

Ultimately, I think the fund management industry prospers because its practitioners really seem to believe what they’re saying.

Their belief in the face of all that contrary evidence is what makes the whole rigmarole so authentic.

The Fisher king of active management

For example, here’s active fund management company owner Ken Fisher writing in the FT [Search result]:

“One view regularly rendered by supposedly learned finance experts is a tell-tale tip that the deliverers of the following drivel are communists at heart, disbelieve in markets and will surely rot in hell.

It’s simply the leap from the (quite true) observation that active money managers as a group lag passive management returns to the conclusion that active fees must fall from current levels. Finance professors say it, as do journalists and consultants. They’re all wrong.

[…]

The US has nearly 30,000 investment advisory firms, over 4,100 securities firms, 6,700 banks and 16,000 funds. You have fewer but similar choices. English-speaking firms cross borders regularly. Buyers weigh overly abundant choices.

How long should prices take to fall if you believe in capitalism and market mechanisms?

Surely not the 30 years that active management has publicly lagged behind passive? Those who claim that prices must fall obviously have no faith in markets and competition.

Commies at heart, headed for that above-mentioned hell thing.”

That sounds to me like a man jumping through hoops to believe the unbelievable.

Now, I happen to enjoy the writings of Ken Fisher. I own and enjoyed his myth-busting book, Debunkery.

Fisher is typically candid and entertaining, and the piece from the FT quoted above pulls no punches.

He freely admits passive investing beats active investing in aggregate, and I admire how he discloses he’s a “richer than filth” owner of an active fund management firm, too.

However as a defence of active management, his article represents something of a new stretch for the final, flimsy straws of justification.

When not condemning the likes of Monevator to burn in hell for our supposedly communist tendencies, he makes a heroic leap of faith that only a truly believer could ever manage in claiming that active management fees are higher because:

“Most active management includes the cost of high customer service levels.

To date, passive doesn’t.”

Does anybody out there think this statement is correct?

I don’t.

I do agree with Fisher’s further argument that behavioural flaws – our tendency to buy high and sell low – is as much a threat to long-term returns as fees.

So I can see his argument could justify the cost of a skilled independent financial adviser managing a portfolio of passive funds, though you’d need to have a lot of money invested to get to the point where it would be economical for the adviser to call you up and talk you down off the ledge in a bear market.

But what does that have to do with active funds? Or with getting mailed an active fund’s report every six months that spends dozens of pages trying to obfuscate the fact that you would probably do better long-term if you went passive?

Fisher genuinely seems to believe people are paying higher fees because they are rationally gravitating towards this alleged higher service.

I think they’re paying higher fees because they’re ignorant of the maths, and because passive investing feels so wrong. More people now know better – and passive is gaining market share every year – but the race is not yet done.

Also, the irony of an active fund manager arguing ‘the price is right because the price is always right unless you’re a communist’ is, well, priceless.

Is that how you gee up active fund managers in their Monday morning meetings?

Don’t bother looking for opportunities, brave stock pickers! The price is always right!

Perhaps not.

Eyes wide open

I get the appeal of trying to beat the market, I really I do. I’m an active investor myself, though I invest directly in shares rather than using a fund manager.

I would never tell somebody they shouldn’t try to do the same if they fancy the challenge – provided they’re aware of the risks and the high likelihood of failure.

But an industry of thousands of expensive fund managers bankrolled by a nation of savers paying billions upon billions over the odds for a service that mathematically cannot in aggregate justify what it charges them?

If it didn’t already exist, it’d seem pretty audacious to think you could pull it off.

As the physicist Richard Feynman once said:

“The first principle is that you must not fool yourself, and you are the easiest person to fool.”

If you’re in a con game and you don’t know who the mark is… you’re the mark.

Check out the rest of the videos in this series.

When an investing concept is designed to appeal to your emotion, tread carefully. We all want security and nourishment and that’s precisely the draw of the low volatility – market-beating returns with less risk than yer average clutch of ticking time-bomb equities.

There are known problems with low volatility, but if you still want a slice of this action then what do you need to know?

The two faces of low volatility

Below you’ll find a handy list of the low volatility Exchange Traded Funds (ETFs) available to UK investors.

But before we get into it, you should know that – like the other return premiums – there’s more than one way to skin the low volatility cat.

In most cases, a low vol ETF will track an index that falls into one of two broad categories:

• Low volatility index: Ranks the equities of its parent index according to their return volatility over the last 12 months or 24 months or whatever timeframe the rules dictate. Lower volatility equities are over-weighted in the index and higher volatility members are under-weighted.

• Minimum variance index: Also weights equities according to their historical volatility, but then analyses the correlations between the equities in order to reduce volatility at the portfolio level.

Which is best? Well, according to the paper A Study of Low Volatility Portfolio Construction Methods from Research Affiliates:

We find no evidence that one low volatility portfolio construction methodology stands out from a returns perspective.

Okay, that makes things  easier – but it doesn’t mean you should just pick any ETF out of a hat.

So how do they differ?

All low volatility ETFs are known to skew towards defensive sectors of the economy, such as healthcare and utilities.

However minimum variance strategies typically impose greater constraints on the concentrations of individual equities, sectors and countries within the index. For example, MSCI rules that sector weights must remain within 5% of the weights in the parent index.

By contrast ‘naive’ low volatility strategies generally do not cap constituents. This means they can become highly concentrated in the healthcare and utility sectors at times. Similarly Japan will often loom large in World ETFs that follow low volatility strategies.

The Research Affiliates paper found the minimum variance approach is likely to be:

• More diversified.

• More costly, due to higher turnover.

• More effective at reducing volatility where the index tracks dissimilar markets, such as emerging markets.

While there wasn’t much in it, the authors tentatively concluded:

While [minimum variance] portfolios generally have the lower volatility, heuristic approaches [naive low volatility] tend to have the higher long-term returns. (We caution against comparing low volatility strategies on the basis of short-term performance.) The resulting Sharpe ratios are statistically similar.

The historical record of low volatility shows that it’s generally beaten the market during declines and taken a beating during upswings.

This means your blackest periods of doubt are likely to come during extended bull runs when the low volatility slice of your portfolio is lagging the herd like a lame elephant.

You’ll have to resist the temptation to abandon it at its lowest ebb if it’s ever to come good for you.

What should I look for?

While the research concludes that there is little to choose between the various strategies, you should know what matters to you as an investor.

• If you don’t like concentrated bets then err towards minimum variance.

• If return is all that counts then naive low volatility may be the way to go.

Of course, there aren’t any guarantees – fate does not give us advance notice of its plans. But at least you’ll know you’ve put out the welcome mat.

And such good value, too

It’s thought that low volatility outperforms partly because it overlaps with the value premium. So you could compare the value signal strength of your target low vol ETFs using Morningstar’s Fund Compare tool.

Jump to the equity valuation section and look for the lowest numbers in the following categories:

• Price/Prospective Earnings
• Price/Cash Flow
• Price/Book

You can compare sector and country concentrations using Fund Compare, too, although past returns will be of little use because low volatility ETFs are still very young.

Check out the ETF’s factsheet for important info such as how many holdings it has (the more the better) and make sure you read up about the index on the index provider’s site, so you broadly understand how it works.

A low volatility ETF hitlist for UK passive investors

Here’s the low volatility range currently available, organised by asset class:

Global Low Volatility ETFs 1	Index strategy	OCF 2
iShares MSCI World Minimum Volatility	Minimum variance	0.3%
Ossiam World Minimum Variance	Minimum variance	0.65%
Lyxor MSCI World Risk Weighted	Minimum variance	0.45%
db X-trackers Equity Low Beta Factor	Low volatility	0.25%

Source: Author’s research.

UK Low Volatility ETF	Index strategy	OCF
Ossiam FTSE 100 Minimum Variance	Minimum variance	0.45%

Source: Author’s research.

US Low Volatility ETFs	Index strategy	OCF
iShares S&P 500 Minimum Volatility	Minimum variance	0.2%
Ossiam US Minimum Variance	Minimum variance	0.65%
SPDR S&P 500 Low Volatility	Low volatility	0.35%

Source: Author’s research.

European Low Volatility ETFs	Index strategy	OCF
iShares MSCI Europe Minimum Volatility	Minimum variance	0.25%
Ossiam iSTOXX Europe Minimum Variance	Minimum variance	0.65%
SPDR Euro STOXX Low Volatility	Low volatility	0.3%

Source: Author’s research.

Emerging Markets Low Volatility ETFs	Index strategy	OCF
iShares MSCI Emerging Markets Minimum Volatility	Minimum variance	0.4%
Ossiam Emerging Markets Minimum Variance	Minimum variance	0.75%

Source: Author’s research.

Low volatility in your portfolio

Regardless of the comfy name, low volatility ETFs are equity products and they will still take a hit during a market tumble. If you decide to use them in your portfolio, the money should come out of the equity portion of your asset allocation.

If you think you’re likely to regret a long period of market lagging performance – and few of us wouldn’t – then I’d suggest you limit your low volatility bet to a 5-15% slice of your equity allocation.

Take it steady,

The Accumulator

1. Note: Global usually means developed world.[↩]
2. Or TER. Learn more about the difference[↩]