The videos we’ve been featuring every week on Monevator from Sensible Investing TV have done a sterling job of reminding us why passive investing via index funds is the best bet for most people.

Index investing makes sense mathematically – because active investing is a zero sum game – and also because the vast majority of active funds fail to beat the market over the long-term, not least because their higher costs turn that zero sum game into a markedly losing one.

Even Warren Buffett – one of the greatest stock pickers of all-time – says you should probably use index funds.

But most people don’t, perhaps because:

• They’re not aware the theory and evidence favours index funds.

• They want to try to beat the market anyway.

• They find active investing more enjoyable, despite the downsides.

• Passive investing just feels wrong.

Does that sound like you? This video has a few tips on what you might consider if you’re determined to invest in active funds:

A few things to consider with active funds

It would take multiple articles to really dig into investing in active funds – and to be honest I’d probably outsource writing them to somebody keener – but I will share a few thoughts.

The first thing I’d say is that unlike some of the more extreme passive investing propagandists, I don’t think investing in active funds is a nailed-on road to ruin.

You can invest steadily in a portfolio of active funds for the long-term, and end up with a good result. Yes, very likely not as good as if you used index funds due to active funds’ higher fees, but that’s what the other videos in this series have been about so we won’t repeat it here.

Investing in active funds is at least a bit cheaper than it was now initial fees have been scrapped. Note though that some pundits believe annual costs have actually increased, albeit in a sneakier fashion.

And costs as always matter when investing.

Many of those who tout active funds – particularly expensive hedge funds – say that once you go active you shouldn’t be concerned about costs but simply performance, but that isn’t true at all.

The same remorseless maths that makes trackers the optimal choice also helps lower cost active managers in their quest to beat the market. So I’d avoid any expensive funds, especially those with performance fees.

I’d also avoid most new funds, fad funds, closet trackers, and investing in anything you don’t understand.

What have you done for me lately

What about past performance? Should you pick a past winner?

This is a thorny subject. On the one hand, as Oblivious Investor put it in his overview of research into this area:

“…picking funds based on superior past performance proved to be less successful than picking randomly.”

That’s hugely counter-intuitive, but many things about investing are.

I’d be lying though if I claimed that I wouldn’t check out past performance if I was looking into an active fund (and I have done previously where I’ve bought, say, closed-end funds). Hey, I’m only human.

And also, you know, Warren Buffett…

Still any such peek would only be one part of my wider research into a fund’s strategy, its positioning, what risks it’s taking for its returns, and so on.

As discussed below, I would explicitly not be looking for a strong recent performer and piling in!

Income investment trusts

I’ve previously admitted to a soft spot for investment trusts – ideally bought on a discount – and in particular I think well-established UK equity income trusts are a good option for private investors who want to pursue an active route.

Make sure you understand how discounts and premiums work if you do invest in them, and be sure you’re bedding in for the long haul.

One reason I like income investment trusts is that there are quite a few established funds out there.

Also their mandate to deliver a growing income focuses the manager’s minds, and keeps them largely sticking to the knitting. This is important because a consistent management style is one of the most important factors in an active fund.

In contrast if you buy into a flighty fund manager, you’re in danger of investing in one who shifts style at the wrong time to chase performance, reducing the fund’s returns.

Of course theoretically a very skilled manager might shift style at the right time.

But I wouldn’t fancy your odds of finding one.

Mind the behaviour gap

On that last note, remember that investors can be their own worst enemies.

They chase performance and dump funds at the wrong time, which means they don’t even enjoy what gains active investing might deliver them. (Yet another reason why the strategy of passively rebalancing is such a potent concept).

Blogger Ben Carlson recently showed how poorly an average investor in the highly-regarded but also highly-volatile US Fairholme Fund had done, compared to the returns posted.

This graphic gives a summary:

The table shows that over 10 years the Fairholme Fund delivered 10% in annualized returns, but the typical investor actually achieved around 5%.

Investors’ attempts at timing in and sell out of the fund halved their returns.

I believe this sort of thing is more likely to happen when you invest in active funds, because you’re inevitably going to be thinking a lot more about whether your manager has still ‘got it’ when they go through a tough spot, and so on.

In contrast, a good index fund investor accepts they know nothing, and instead just invests passively and rebalances occasionally, which reduces the risk of performance chasing.

Still, despite their strategy many passive investors do suffer from these behavioural problems too, and so they’re not an automatic strike against active fund investing. (We’ve got enough of those to be going on with, anyway!)

If you want a few more thoughts on pursuing an active fund strategy, please see my commentary after the third video in the series.

Check out the rest of the videos in this series so far.

The momentum factor is one of the most frustrating forces at work on our portfolios. Frustrating because it can be a potent return enhancer – yet it has historically been difficult for an ordinary investor to actually exploit.

Momentum is one of the mighty return premiums that sit like gods in the pantheon of portfolio power-ups.

By tilting towards equities that are especially risky, or mispriced (because humans are serial dunces) these premiums have historically unlocked the door to market-beating returns.

Momentum has returned some of the biggest rewards of all: 9.62% annually in the US between 1927 and 2014.

What’s more, it’s been shown to exist in the UK since the Victorian era, and just about everywhere else bar Japan.

So what is momentum?

Momentum is the financial equivalent of a pitch invasion, where everybody crowds around the victors, hoists them shoulder high, invites them home to meet their mam, starts to dress like them, buys their fragrances, asks their opinion on the West Lothian question, and so on.

Success leads to greater success. Meanwhile the losers are shunned, despised, spat at, set upon by dogs…

Put more plainly, momentum is the tendency for winners to keep rising and losers to keep falling over periods of 12-months or less.

A momentum strategy buys the winners while selling or shorting the losers.

Why does the momentum premium exist?

Unlike with the value premium or the small cap premium, few researchers think that the momentum premium is a reward for taking greater risks.

Instead, momentum is about exploiting human weakness – specifically our inability to respond to news quickly and an inclination to under react or overreact to new information.

The idea is that lackadaisical investors digest news over the space of months, rather than incorporating it into the share price in nano-seconds, efficient market-style.

• Impulsive types might drive prices way beyond fair value while the sluggish might cling on to losers for a while before being forced to concede defeat further down the line.

• Momentum may also be partly due to forced selling from active funds that fall out of favour, or leveraged investors who face margin calls in bear markets.

• Yet another cause may be forced buyers who bid up prices further as they try to escape a short squeeze in a bull market.

Regardless of the explanation, the momentum premium has not been arbitraged away in the 20 years since its discovery – although it has weakened to a 6.3% annual return in the US since 1991.

Diversification

What makes momentum even more valuable is its low or negative correlation with other premiums.

Finding negative correlations is the Holy Grail of asset allocation. Holdings that act as counterweights can reduce your portfolio’s volatility when markets are turbulent.

Momentum is particularly interesting to value investors as the two factors have historically been negatively correlated (-0.27% in the US from 1927-2013).

Of course, like all the return premiums, momentum can fail to deliver.

It dished up an unsavoury annualised return of -1.3% a year from 2004-2013, which is a timely reminder that trying to capture return premiums is not a game for the fainthearted.

The momentum everyone’s been waiting for

The biggest problem with momentum is that it’s like a rare herb, with fabled medicinal qualities, buried deep in the Amazon jungle. It’s well known but very difficult to get hold of.

Currently there are only two momentum index trackers available in the UK, and they’re mere hatchlings with no track record to speak of.

Both are available in ETF form:

• iShares MSCI World Momentum Factor ETF – OCF 0.3%, ticker IWMO

• db X-trackers Equity Momentum Factor ETF – OCF 0.25%, ticker XDEM

Both ETFs cover the developed world including the UK and apply a formula to identify the highest momentum equities in the MSCI World index over the last 12 months. The equities that are judged to be on fire go into the ETF.

I’ll compare the chops of these two ETFs at a later date, but it’s important to understand that you shouldn’t just plump for the cheapest product and be done with it when it comes to risk premiums.

FTSE All-Share trackers tend to be much alike, whereas there are many different ways to slice a risk factor. Some products may be better than others at creaming off the extra return.

Make sure you understand:

• How the tracker intends to capture the risk premium.

• Compare those rules with independent definitions of the factor to try to assess whether it’s going to do a good job.

• How diversified is the product? Is it so concentrated that it’s more like a bet on certain industries?

• Is the index independent of the product provider?

• Is the tracker available at a reasonable cost?

• Does it have a good track record in comparison to other similarly styled products and indices? (Obviously that’s impossible to gauge for these new products).

If the product provider isn’t transparent about how its flashy smart beta tracker works then forget about it. Also, don’t rush into new products. They often need several months to bed in, so hold your fire until those bid-offer spreads settle down.

Multi-factor options

Given the proliferation of risk factors and firms racing to provide smart beta ETFs to track ’em, most of us will probably find it a lot easier to invest in a multi-factor ETF that combines value, momentum and other factors in one handy package.

If so, then the Amundi ETF Global Equity Multi Smart Allocation Scientific Beta UCITS ETF not only has a name longer than the average Welsh town but also attempts to capture momentum in its dragnet.

Sadly this tracker is only available on the NYSE Euronext Paris for now, but it’s probably only a matter of time before it, and other looky-likey products, are available on the LSE.

Dimensional Fund Advisor fans have no need to fret though as DFA funds already include a momentum screen as part of the service.

DIY momentum

You can capture some of the momentum premium by making sure you don’t rebalance too frequently.

Keep your moves to once a year, or even stretch it to every two years if you can. Or, if you use threshold rebalancing then keep your trigger points relatively slack (for example rebalance when an asset class moves 20-25% from target).

Take it steady,

The Accumulator

Good reads from around the Web.

The clever bods at The Value Perspective have been doing a sterling job recently in tackling the weird world of the average and what it means for returns.

From writing here on Monevator, I know a lot of people get confused when it comes to how average returns work in practice – or more specifically about the different kinds of average – and what it implies for our investment decisions, whether it’s asset allocation or investing a lump sum or confronting sequence of returns risk.

And when I say “a lot of people get confused”, I’ll admit that can include me!

So most people could do with a refresher on the maths.

Start with this Value Perspective article on the law of averages, which begins:

Let’s play a game we will call ‘Russian dice’, the rules of which were invented by a physicist/economist called Ole Peters. They are pretty simple – roll a dice and, if it comes up ‘one’, I will shoot you.

Do you fancy playing? It does not sound very appealing but, if you were a nihilistic mathematician, you might be tempted because – in the very strictest terms – on average you will be absolutely fine.

The word ‘average’, however, can be somewhat misleading if not defined very precisely. If 100 people roll the dice instantaneously, the average result is ‘three and a half’ – that is, (1 + 2 + 3 + 4 + 5 + 6) ÷ 6 – so, if you are judging the game on the average result, everyone survives.

However, if I asked you to roll the dice 100 times in a row, it is extremely unlikely you could do so without at some point seeing a ‘one’ come up. Bang. You do not get a chance to see the result of the 100-roll average over time.

Intuitively, we all know there is a difference between these scenarios without any complicated maths or concepts. Mathematically speaking, it is known as the difference between an ‘ensemble average’ (the average of an event happening many times concurrently) and a ‘time average’ (what happens when you do something a lot of times consecutively).

However, this concept and its implications are not well understood in investment.

After that first article provoked a fair bit of debate and confusion, their follow-up tried to explain it with a diagram:

[This time] you simply start off with a stake of, say, £100 in the pot and we toss a coin. Every time the coin comes up heads, you increase what is in the pot by 50%; every time it comes up tails, you lose 40% of whatever is in the pot.

The coin is a fair one – so it is always a straight 50/50 chance – and there is not a firearm in sight.

Would you like to play?

At first sight, there appears to be no reason not to play – after all, if on each coin toss the only two possibilities are going up 50% or falling 40%, then surely, on average, it is a winning game. And indeed it is. No matter how long you play it for, on average, the expected return is positive – but, as we argued in the previous article, the word ‘average’, if not defined very precisely, can be misleading.

In this particular example, the average obscures a pattern where the majority of people who play the game actually end up losing.

Here’s the pattern:

It reveals:

In the above example, 11 of the 16 possible sequences of coin tosses are losing permutations and, the longer the game goes on, the more money is lost.

In a game where the only possible outcome each time is a 50% upside or a 40% downside, that would appear counter-intuitive so what is complicating matters?

It is that difference between time and ensemble averages.

Read the whole article for a deeper explanation.

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