Important: What follows is not a recommendation to buy or sell The Edinburgh Investment Trust. I’m just a private investor, storing and sharing notes. Read my disclaimer.

Name: The Edinburgh Investment Trust
Ticker: EDIN
Business: Investment trust
More: Trustnet / Morningstar
Official site: Invesco Perpetual

One of the UK’s best-known fund managers, Neil Woodford, has announced he is going to leave Invesco Perpetual, his employer, in 2014. The news has prompted countless articles and bulletins from pundits mourning Woodford’s departure, recounting his exploits and opinions, and debating whether or not investors should abandon the funds he manages.

For an investing nerd it feels a bit like when Margaret Thatcher died. Perhaps that’s not entirely inappropriate given Woodford launched his Invesco Perpetual High Income Fund way back in 1988 when she was still Prime Minister.

I suspect some news desks even had ‘obituaries’ pre-written for when this day came upon us. As a sort of UK Warren Buffett – albeit our investing Donavan to America’s Bob Dylan– the financial press quotes Woodford’s every utterance and hangs on his every purchase. It even celebrates his birthday.

“What would Woodford do?” they ask.

Get sick of the whole circus and leave to start a hedge fund, maybe.

Is it a bird? Is it a super-investor?

Anyway, this isn’t primarily an article about Neil Woodford. Monevator is not really a site about following fund managers!

True, long-time readers will know that unlike my co-blogger The Accumulator, I do a lot of active investing – despite believing that most people (perhaps including me) shouldn’t.

But I almost never invest in active funds, and have never yet done so on account of their supposedly great management.

I have sometimes invested in a few family-backed investment trusts in part because I like the way they’re run. But there’s always been a more compelling thesis, too – usually a discount to net assets, or perhaps a way to access an out-of-favour asset class like private equity was a few years ago.

I think profitable stock picking is hard, but picking winning fund managers is even harder. Studies have shown past performance is generally no guide to future performance from fund managers, even though that’s how all fund fan boys pick them.

You’ve also got the problem of having to find them when they’re still young enough to do the business for you for decades. As their fame spreads and their funds swell, they increasingly suffer from institutional problems that lead to things like closet indexing.

Finally, even if your chosen one overcomes these and other problems, they still have to outperform sufficiently to beat the fees they charge – a very rare bird indeed.

Because that laundry list is so daunting, even if you’re dubious about index funds for some reason, you’d be mad to put all your money into just one active fund. It’d be a needle in a haystack!

So you’d have to diversify between a few active funds, and at this point even if you’ve got some unquantifiable knack for spotting talent, the one or two inevitable duds are going to depress your returns.

At that point you might as well have invested via tracker funds all along, with the certain knowledge that fees would be low and your returns would follow the market.

Really that’s all most people want and need from their investing.

Good Woodford

You’ll notice that what I’ve written is different from saying: “I don’t think anyone can beat the market”.

I don’t think the market is completely efficient, personally, and I believe there’s sufficient evidence that some very small number of people can beat it. But it’s overwhelmingly unlikely you or I are one of them, and I think it’s even less likely you’re going to find half a dozen worth paying to do so for your investing lifetime.

I happen to believe Neil Woodford has as good a claim as any active investor to have potentially proven he has some market-beating prowess. Diehards will say this graph from Hargreaves Lansdown to celebrate his 25-year anniversary back in February attests to two and a half decades of luck and being in the right place at the right time…

… but I am not so sure.

I don’t think you should spend your time looking for the next Woodford though, any more than I think you should bet your two-year old grandson is going to be the next David Beckham.

Some scant few of us are touched by the gods of fortune, but you surely don’t want to gamble your retirement on it.

Run for the hills!

What’s interesting to me about Neil Woodford right now isn’t so much whether he can beat the market, but that so many people believe he can.

As a result, when he announced he was going to leaving his job next year, some of his investors began leaving his funds in sympathy.

This could be a big problem for his employer – the High Income fund mentioned above has nearly £14 billion in it, and that’s just one part of the roughly £30 billion empire that Woodford runs for Invesco. If investors desert these funds then the funds will shrink, reducing fees to the company.

It’s also a problem for those fleeing investors. Where do they put their money? Presumably with another equity income fund, but which? Your guess is as good as mine, as an expert quoted in the press – and as theirs for that matter.

What Woodford’s departure isn’t a problem for – in the short-term – is The Edinburgh Investment Trust (Ticker: EDIN), an income investment trust he has managed for the past few years.

Investors in this stock market listed trust started dumping it as soon as the news of his imminent offski-ing broke.

But investment trusts are closed-ended – there are a fixed number of shares in circulation, and their price is set by supply and demand. As scared investors sold their shares, no liquidation of assets took place. The shares simply changed hands at markedly lower prices:

What’s interesting here is that the price fell as much as 10%, but the holdings of the Edinburgh Investment Trust – and so what the shares are theoretically worth – hadn’t necessarily changed at all.

Instead, shares in the trust moved from being priced at a 5% premium to assets to a small discount. (Read that and my other articles on investment trusts for more on discounts and premiums).

In other words, a chunk of Edinburgh holders decided they no longer wanted to own what the trust owned, on the grounds the man in charge of picking stocks for it would probably be gone in six months time.

In the press they dubbed this “investors abandoning the fund in droves”.

But with an investment trust – because it trades via shares on the stock market like any other listed company – you could just as well write “investors bought cheaper shares in the fund in droves”, since for every share sold there is a buyer.

Who were those buyers?

People like me, I suspect, who sniffed an opportunity.

Emotional aptitude

A Monevator reader told me in the week that the Edinburgh sell-off was why he never bought investment trusts. He wasn’t prepared to see the value of his investment fluctuate according to other investors’ whims.

I can see his point of view, but in this case I took the opposite one. I think investors’ whims have provided my opportunity here.

Do you know who runs the City of London Trust? The Murray Income Trust? The Dunedin Income Growth Trust? The F&C Capital and Income Trust?

Unless you’re the editor of What Investment Trust? magazine, I’d wager you do not.

I haven’t got the foggiest, either. Yet all these trusts sell at a premium to their net assets – undoubtedly due to the hunt for yield in recent years.

Sure, a few income investment trusts are on a discount, but my point is it’s clearly possible to run an income trust and be well-regarded enough for investors to pay more for shares in your trust than the value of its assets, even if your name is not “Neil Woodford”.

And my bet – and the reason I bought the shares after the sell-off – is I believe the same will likely be true of the Edinburgh trust some time in the future.

In fact, I wouldn’t be surprised if the premium even comes back before Woodford has left in April!

There’s a chance that the board of directors that appoints the manager to Edinburgh will offer its management back to Woodford when he’s set up his new company, presuming he wants the gig.

If not, then his successor at Invesco, Mark Barnett, seems to be cut from the same sort of cloth. The trusts he manages are doing well right now, and the blue chip income variety (Perpetual Income and Growth) is, like most, on a premium.

But it’s also likely some investors wary of the premium on income in the past year or two will buy the Edinburgh trust simply because it now offers a higher yield, due to the discount, on the same asset base. That makes the trust a better buy for income than before the Woodford wobble, ironically enough, though I don’t suppose those selling saw it that way.

Anyhow, the following graph shows the gap that opened up between Edinburgh and its rival City of London trust on news of his departure, and how that gap is already closing:

I plan to sell as it narrows further, or if the premium returns.

A noble cause

This week Eugene Fama was one of three recipients for the Nobel Prize for economics, on account of his work on the efficient market hypothesis.

Perhaps Neil Woodford should be in line for a Nobel Prize next year, for proving that thousands of his investors couldn’t care less.

Me? I just want to make a bit of profit.

Good reads from around the Web.

I think successful DIY investing is within the grasp of at least 50% of the population, so long as they stick to the basic rules.

Provided you steadily put money into a simple and diversified portfolio over several decades, think about your risk tolerance, rebalance accordingly, and tweak as you age, you should do pretty well.

But I don’t think that’s true if you start to try to time markets, pick shares, or try to chase winning fund managers. Sometimes that will work for some people. But the evidence is it mostly won’t.

And if you do so stray from the right path, then managing your own investing could become a liability, and a risk to your wealth.

Rocking the status quo

Of course, for decades the alternative to DIY investing was at least as bad – the guaranteed impact of seeing huge swathes of your money go into the hands of fund managers or financial advisers.

Worse, that industry was built on getting you off the right path.

The financial services industry wants you to churn your assets for commission. It wants you to pay up for access to supposedly superior expertise. It wants its products to be opaque so you don’t understand them, and don’t believe you can replicate them more cheaply for yourself.

The Retail Distribution Review (RDR) has done away with some of that. Now fees are more transparent, and they’re becoming lower. Passive investors might begrudge annoyances like the introduction of platform charges, but overall it’s been a win for private investors.

But some are less happy. Because giving advice is now much less lucrative, plenty of financial advisers have given up on financial advising. And because index funds are growing in popularity in this cost-aware and self-educated world, fund managers also sense the game might be up.

Remember, the financial services sector has exploded over the past 50 years to capture a huge share of the slice of wealth generation that used to go into investors’ own pockets. If the gains are reversed, it will not be pretty for the incumbents.

The counter-revolution

We’ve already had the ‘index funds are parasites’ argument emerge even as the evidence that most active funds are inferior has become overwhelming, and more widely understood.

Now there’s a new line of attack: DIY investing is dangerous.

In today’s FT [Search Result – click the link at the top]:

Hugh Mullen, managing director, UK at Fidelity Worldwide Investment, says: “Most people would not dream of repairing their own car or fixing their own plumbing, yet more people are deciding against financial advice to save on fees.”

Fidelity, in conjunction with the Cass Business School, published a report earlier this year that warned millions of people could fall into what they called the “guidance gap” because of RDR. These are people who are left without professional financial help in the post-RDR world, yet need it badly – because they have experience of, or interest in, managing their own financial affairs.

Mr Berens [head of UK funds at JPMorgan Asset Management] says: “A financial adviser can take you down many more avenues. The biggest pitfall for many investors is getting the asset allocation right for the period of their life. A young person can afford to have a majority of their portfolio in equities and take the risk of losses as they have more time to recoup them before they retire or decide to cash them in. An older person nearing retirement should have safer bonds, cutting down on risks as they do not have the luxury of time should the market turn against them.”

Perhaps I’ve got delusions of grandeur, but when I read this sort of thing I wonder if the active management industry might put a price on my head.

There isn’t really much to know to get the basics of DIY investing right – especially if you don’t need to know why it works.

Ironically, Mr Berens sums up part of it in the few sentences above.

But the financial services industry wants you to believe that it’s beyond you to know these few salient essentials, and to act appropriately.

In my opinion, the FT article carries several unsupportable claims in defense of the status quo.

[continue reading…]

Few people are born understanding compound interest. As a result, some are seduced into buying things today using loans, and forgetting who really pays for their debts tomorrow.

An interest rate of 6% or 7% doesn’t sound so bad when you’re 21 and earning for the first time. But over the long-term, a life lived on credit will be very expensive and less rich than one where you live within your means.

• A £10,000 loan at 7% paid off over ten years costs £14,000

• The same loan over 30 years would cost £24,000

Sure you can get a lower loan rate than 7%, but for most of my life you could have paid a lot more, too.

The point is you spend a lot of your future income for the benefit of owning something now when you buy it via a loan, due to compound interest.

Compound consequences

Some people never do grasp how compound interest adds up over the long-term. They fail to get out of debt, and they end up in all sorts of difficulties.

However, most of us are at least bailed out by buying a house with a mortgage, which forces us to save for most of our working lives.

The average UK home has increased in real terms by 2.7% a year for the past 50 years, according to a report by Halifax a few years ago. Because of the power of compound interest, this seemingly tiny growth rate has made residential property a good investment for most homeowners.1

A minority of people also start saving into pensions early on the advice of an older family member, or even their employer. Assuming they are lucky enough to avoid being stuck in an expensive pension scheme, most early birds will again benefit from compound interest over their working lives.2

But some of us go further. We “get” compound interest the way other people get religion or vegetarianism or cross-dressing at weekends. It becomes a way of life, and an ever-present calculation.

If compound interest grabs you like this, then you start to see the whole world – certainly the world of money – in a new light.

Once you have seen the historical returns from shares – and you’re a believer – then it becomes much more difficult to splurge half a year’s salary on a new car or a fancy sofa, even if you’re paying with cash, not debt.

In your mind’s eye, you see the £3,000 you might recklessly divest yourself of at John Lewis one fine Saturday morning as the £40,000 it could become if you invest it for 30 years.

What’s wrong with sitting on old suitcases, anyway? It’s bohemian!

Warren Buffett’s Folly

If being in thrall to compound interest is a problem for you, just imagine how it feels for Warren Buffett. The world’s richest man has compounded his wealth by 20% since the early 1970s. Before that has was doing even better.

Every can of soda the notorious Coca-Cola fan swigged in the 1950s therefore cost him thousands of times as much as he paid for it, compared to if he’d put the money into his investments and had a glass of water.

Of course Buffett is well aware of this – and he was prescient about it, too.

From the excellent Buffett biography The Snowball:

The Buffett’s bought their first house [in 1957]. It stood on Farnam Street, a Dutch Cape set back on a large corner lot overlooked by evergreens, next to one of Omaha’s busiest thoroughfares. While the largest house on the block, it had an unpretentious and charming air, with dormers set into the sloping shingled roof and an eyebrow window.

Warren paid $31,500, and promptly named it “Buffett’s Folly”.

In his mind $31,500 was a million dollars after compounding for a dozen years or so, because he could invest it at such an impressive rate of return. Thus, he felt as though he were spending an outrageous million dollars on the house.

Now I’d say the opportunity cost of paying cash for a charming house that you live in for the rest of your life can be filed under ‘billionaire problems.’

But the point is clear. If compound interest really grips your imagination – and it’s clear from his biography that it had Buffett in a headlock by his teens – then spending money will never be the same again.

Frugal fundamentalists

Of course few us will be the exception that proves the rule when it comes to super-investing like Buffett. We will be aiming for perhaps 5-10% from our diversified portfolios, over the long-term, depending on how optimistic we are. Some are gloomier.

For us mere mortals then, a can of Coke today isn’t going to cost our future selves a car. But if we’re saving in our 20s, it might still cost us a couple of  pizzas delivered to the retirement home. Those Coca-Colas we skip will all add up.

How do we square this circle? It can only come down to personal choice, as we’ve seen in the excellent discussion among Monevator readers recently about what to sacrifice to achieve financial freedom.

For some people, saving more than the standard 10% to 15% for retirement smacks of being tight, not frugal. But for those who’ve really got the compound interest religion, almost any spending beyond housing, decent food and clothing and access to fresh air equals money wasted on fripperies.

True believers scoff at the latte factor, which is the idea that you can pay for your pension by skimping on Starbucks. Try the PG Tips factor, where you spurn expensive branded teabags for Lidl’s finest. Compound interest extremists use the teabags twice.

Clearly there’s a law of diminishing returns here. Personally I’m prepared to give up owning a sports car, but I’m not prepared to give up the occasional foreign holiday. Your mileage will vary.

Don’t be dead wrong

The other side of the equation is the iron law of mortality. As the famous economist Keynes pithily put it: “In the long run we are all dead.”

In the worst case scenario, there’s no point in giving everything up today for a future you’ll never see.

Plus all of the other cliches you hear:

• You don’t want to be the richest corpse in the graveyard.

• He who dies with the most toys still dies.

• Tomorrow you could get hit by a bus.

• Own-brand tea bags used twice taste like old socks. (Okay, I coined that one).

I’d add a few more truisms of my own.

Firstly, it’s good to plan and to stress test your calculations, but beware of spurious precision. You can’t bank on expected returns.

Forget about precise asset allocations. A cheap and well-diversified portfolio is your best bet, but every investment can fail you and in the end you can still be duffed up by sequence of returns risk.

If only we knew exactly what returns we’d get from investing and exactly when we would die, we could save and spend our money perfectly – and go on a giant bender if the prognosis isn’t so hot.

Unfortunately we don’t.

We could save for years only to die relatively young, as I saw happen to a close family member. Or we could spend like crazy and condemn our future selves to an even more difficult old age.

Or we could hedge our bets and strive for a sensible middle-ground.

Balancing your books

My own view is young people are already rich, middle-aged ones still have most of their health and non-financial wealth, so I’d rather save more today and have some extra money to splash out on a bionic Zimmerframe and luxury crumpets if I make it to my 80s.

But some things are clearly worth spending money on now.

I think memories are often overrated compared to what they cost, but I also believe that looking forward to 30 years in a bedsit is no way to live. If penury was the only way I could fund a pension, then I’d strive to boost my income. If that failed then, to be frank, I wouldn’t save at all.

The point is a little sensible spending goes a long way.

Money can’t buy you love. Just ask that world’s richest man. In 2011, Buffett touched on his former “folly”, revealing to shareholders that…

All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.)

For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.

…although re-reading that, I’m sure I hear the muffling impact of an octogenarian’s gritted teeth.

Do you think he really means it?

(Image by James Brown)

1. No, not all the people, all the time. But that is a discussion for another article. [↩]
2. Many of today’s 20-somethings will gain from the introduction of automatic enrollment into pensions. The scheme isn’t perfect, but from this perspective it’s much better than nothing. [↩]