I am delighted to welcome a new occasional contributor to Monevator! Lars Kroijer was a successful hedge fund manager but he now advocates passive index investing as the best approach for most people. You can read more from Lars in his book, Investing Demystified.

The vast majority of people have no edge over others in the stock market. Even professional fund managers who have demonstrated skill in picking stocks in the past struggle to beat the market once their high costs are taken into account.

This may sound like a counsel of despair, but it’s just a call to accept reality. You don’t need to beat the market to invest successfully in shares and other assets. But you do need to try to get the average return from the different asset classes as cheaply and effectively as possible.

I have a term for those wise people who have accepted this – I call them Rational Investors.

The way of the Rational Investor

In my book Investing Demystified I explain how to be a Rational Investor:

1. As a Rational Investor you realise you can’t outperform the markets, neither do you know someone who can.
2. The Rational Portfolio therefore consists of funds that track broad indices of equities as well as risky government and corporate bonds, and an allocation of “minimal risk bonds”1.
3. Think about your other assets in a portfolio context.
4. Think hard about your risk levels.
5. Be clever about tax.
6. Implement the portfolio as cheaply as possible.

Keeping costs low is vital to being a Rational Investor. Since you are not going to try to outperform the market, it makes no sense to pay a penny more than you have to in order to achieve as close to the market’s return as you can.

Ironically, this will be your edge over those non-Rational Investors who are striving to do better.

By keeping costs low, you can end up richer than those who pay a high price to try to beat the market and fail.

Active management comes at a cost

There are too few people from the world of finance who are interested in emphasising the importance of low fees to investors.

Perhaps that’s not surprising – they are after all the ones making money from those same fees.

Fees are always important in finance, but even more so for the Rational Investor. Since we don’t think we’ll be able to outperform the market, we’re not asking anyone to be particularly clever about investing. We just want someone to replicate the market.

As a result we should expect to pay very little for it.

Inertia is a powerful force. It either makes us leave our investments where they are or makes us buy the well-known active funds like so many others.

Many people are aware of the extra costs of these active funds, but often they don’t seem to act on it. Instead, they accept the status quo – please don’t let that be you.

It seems paradoxical that people spend countless hours comparing the price of computers or holidays, when the same time spent researching better and cheaper financial products would far outweigh the cost savings they make elsewhere.

The price of active management

The following table compares the cost of investing in a passive index-tracking product with investing in a typical active fund tracking the same index.

			Active			Tracker
Up-front fee			2.00%2			0.00%
Annual
Management fee			1.00%			0.20%
Other expenses3			0.20%			0.15%
Trading costs:
	Bid/offer	0.35%			0.25%4
	Commission	0.15%			0.10%5
	Price impact	0.25%			0.25%
	Transaction tax	0.25%			0.00%6
	Total per trade	1.00%			0.60%
	Turnover	1.25x			0.1x
	Total trading costs		1.25%			0.06%
Additional taxes			0.00%	(*)		0.00%
			—-			—-
Annual cost			2.45%7			0.41%

*Additional taxes may be payable with some even more active strategies.

Paying initial fees just to get into an active fund – the up-front fee of 2% in my table above – is becoming a thing of the past8, but you can see from this example how you might still save another 2% a year by investing in an index tracking fund, compared to an active one.

If a 2% annual saving does not seem like a lot to you, then you’re forgetting the power of compounding returns.

Let’s assume that you’re a frugal investor who diligently puts aside 10% of their £50,000 income from the age of 25 to 67 (we’ll assume your income will go up with inflation, and to simplify our example we’ll also assume that this is an average over a lifetime – obviously few 25-year olds make £50,000!)

Let’s say you aggressively put all your savings into equities (this is just for illustration – in virtually all cases you should have a good portion of your savings in lower risk assets like government bonds).

How much of a difference would you expect your decision to invest in an index tracking product as opposed to an active fund to make?

For this example we’ll assume the following nominal cumulative returns before fees (and we’ll ignore taxes for now):

Minimal risk rate	0.5%
Equity risk premium	4.5%
Annual inflation	2.0%
	——
Total	7.0%

 

So, we’re going to model for 7% returns from this investing plan. Where does this leave you in our example?

Well, as you get ready to retire at age 67 after 42 years of diligent index tracking, the difference in your savings pot is staggering compared to somebody who invested in active funds. All told you are better off by £643,000 by investing with an index fund as opposed to with an active manager.

Adjusting the £643,000 for inflation, that extra amount is still around £280,000 in today’s money.

• If you took the active route and managed to avoid paying the up-front charges, your active fund investment would have been higher by about £23,000 at age 67. That demonstrates the advantage of at least avoiding the initial charge.

•  If you had avoided the up-front charge AND if there had only been a 1.5% annual difference in costs, then the difference in savings at retirement would still amount to £494,000.

If you think you have great edge in the market and you could easily make up this 1.5% to 2% annual cost difference by picking stocks or choosing superior active fund managers or timing the markets or whatever other approach you take, then good luck to you. All the odds and evidence are against you.

If you don’t have an edge, then the sooner you get out of the expensive investment approaches and into cheap index tracking products, the better off you will be.

(I’ll discuss exactly which index you should track in a later article).

Note: Shouldn’t I expect an active fund to make higher returns? In a word, no, you should not expect your active manager to outperform the index before fees. Obviously some managers will do so, but in aggregate the active managers together perform in line with the index before fees. It is because of their significant trading and management costs and other fees that active funds under-perform so starkly compared to index tracking products.

How to get an active manager’s sports car

By not giving money to an active manager (who probably was not able to outperform anyway) you saved £280,000 in today’s money in our example.

Just imagine the difference in quality of life that kind of money would make in retirement, or for your relatives after you are gone.

Conversely, consider the 85-90% of investors who invest in active managers as opposed to index tracking funds, either directly or via their pension funds. (Index tracking may be popular among Monevator readers, but it’s still a minority sport in the wider world!)

Over the long run only a very small percentage of investors who take the active approach will be lucky enough to invest with managers that give better returns after fees.

The rest have simply paid a staggering amount of money to the financial industry over their investment lives, and will have less money in retirement as a result.

To put things into perspective, the next time you see a finance person driving a Porsche or jetting off to a holiday home in Spain,  consider that the additional and unnecessary active management fees paid by just one individual saver – added up over their investing lives – could buy seven to eight Porsches! And that paradoxically this is money paid to the finance industry by a saver who typically could not afford to drive a Porsche themselves.

If you know all this and are still happy paying high fees, then at least stop complaining about people in finance making too much money and driving fancy cars.

Note: What about picking your own stocks? You are not forced to choose between an active manager or index tracker. As many people do, you could manage your own portfolio with your own individual stock selections. This decision goes back to the question of having edge in the first place. If you don’t have edge – and the vast majority don’t – then this “do it yourself” approach is a loser’s game for you, as you will not be able to pick a superior portfolio to that of the market. Buying the market via index trackers will be far less hassle and much more cost effective. (If you do have edge, then I look forward to reading about you in the Financial Times.)

Passive investing requires patience

Focussing on fees when we seek investment success does not deliver instant gratification. As index investors there is no stock that doubles in a month. To really notice the additional profit we gain from being clever about expenses takes years or even decades.

The key to reaping the greatest savings is to have the patience for the compounding impact of the lower expenses to take effect. It is like making money while you sleep; lower fees make a little bit of money, all the time.

Consider the following chart that illustrates the aggregate savings from the two investing approaches we just examined.

In the early years you can barely see the difference between the active and index tracking investment approaches.

In the later years the benefits are obvious – but they are only there for the investor who kept his or her discipline with lower fees.

Ignore the siren songs of sexy managers

Once you understand the power of compound interest and how it adds up over several decades, then saving 2% or more a year in fees will sound like a much bigger deal.

But even then, you must remember it will take discipline to stick to this approach.

After all, 2% sounds a lot to you now when reading this article, but will you really notice the 2% you saved amid the noise of the investment markets?

In any given year – probably not.

The index tracker will perform slightly better over the long-term than the average active fund, and that outperformance will come from the cumulative advantage of lower fees.

Meanwhile the performance of the many active funds out there will be all over the map. Along the way the best performers will try to scream the loudest about how their special angle or edge has ensured their amazing returns that year.

We might even be tempted to believe these managers and abandon our boring and average index tracking strategy.

But please stick to your index investing plans unless you can clearly explain to yourself why you have edge.

The chances are you don’t, and you will be wealthier in the long run from acknowledging this.

Lars Kroijer’s Investing Demystified is available now from Amazon. Lars is donating all his profits from his book to medical research. Check it out now.

1. For UK investors, these would be UK government bonds, a.k.a. gilts. [↩]
2. Do Not Pay This! [↩]
3. Audit, legal, custody, directors, etc [↩]
4. Rebalance at times of liquidity [↩]
5. Trackers don’t pay for research etc [↩]
6. ETFs can typically avoid stamp duty etc [↩]
7. Or 4.45% if you pay an up-front fee. [↩]
8. Some active funds even have exit fees, but those are increasingly rare. [↩]

Good reads from around the Web.

Only a hedge fund manager could be arrogant enough to make a bet about investing returns with super investor Warren Buffett:

Results are in for the sixth year of the competition sometimes called the $1 million bet, and Warren Buffett — once a piteous straggler in this 10-year wager on stock market performance — has opened up a sizable lead over his opponent, New York asset manager Protégé Partners.

Buffett’s horse in the bet is a low-cost S&P index fund, and Protégé’s is the averaged returns to investors (after all fees) of five hedge funds of funds that the firm carefully picked for the contest.

The hedge fund partner who made the bet, Ted Seides, seems like a good sport, and by now he’s probably older, wiser, and ruing his foolishness.

Still, you have to wonder whether all publicity is good publicity, given the massive lead Buffett’s chosen tracker fund has opened up over its hedge fund rivals:

At the end of 2013, Vanguard’s Admiral shares — the S&P index fund that’s carrying Buffett’s colors — were up for the six years that began Jan. 1, 2008 by 43.8%.

For the same period, Protégé’s five funds of funds, on the average, gained only by an estimated 12.5%.

The index fund is beating the hedge funds by an extra 30% of return.

Oops!

I cannot tell you how many smart and sophisticated investors told me I was a simplistic fool for recommending tracker funds as the best vehicle for the investing majority six or seven years ago.

That doesn’t happen so much these days. Buffett’s bet is probably one reason.

Of course some hedgies will argue their funds reduce volatility, and that the price paid is lower returns.

But that only makes this bet a dumber one. It’s also not a good strategy for their clients, since as we often discuss here on Monevator, a good dollop of cash and government bonds will reduce volatility far more cheaply and consistently than an expensive hedge fund.

There may be times when the more exotic hedge fund strategies can deliver uncorrelated returns, which is indeed a useful thing.

But few people will ever invest to see it, and none of them are likely to be reading this website. (More likely a 1%-er who spreads his money across 10 invite-only small new hedge funds, and strikes it lucky with the 10th.)

In any event, I certainly wouldn’t bet on a bunch of hedge funds ever beating cheap index trackers over the long haul.

And I’d never bet against the master odds-juggler, Warren Buffett.

[continue reading…]

Move over Michael Lewis. His cautionary tale about Wall Street greed – Liar’s Poker – proved to be a great recruiting tool for the mega banks.

When gobsmacked readers discovered the vast riches being made by Lewis’ crazy cast of characters in the biggest money casino going, they flocked to New York and London to claim their share.

Lewis was horrified. But not so horrified that he hasn’t written a string of other excellent books about the so-called Masters of the Universe.

Check out The Accumulator’s review of The Big Short for one passive investor’s take.

A wolf in wolf’s clothing

It’s a good thing Lewis banked his royalties while he could, because now director Martin Scorsese has given stockbroking a sordid, glittering makeover that no novel could compete with for sheer flair.

The Wolf of Wall Street is a spectacular celebration of excess in all forms, with a tiny bit of morality tacked onto the end.

It’s almost – but very definitely “not quite” – a combination of Ferris Bueller Grows Up and Scorsese’s own Goodfellas – without the pasta!

It’s a love letter to greed that will send thousands of young cubs to The City and Manhattan in search of their own fast cars and mansions in the Hamptons.

Here’s the trailer:

Yes, I realise the Wolf, Jordan Belfort, ran a boiler room for illegally ramping stocks for profit, not a blue chip stock broker. I spent 30 minutes explaining the difference to some friends afterwards.

But there’s a sliding scale from good to unethical to illegal, as the financial crisis so recently reminded us.

Besides, while a revolving door of prostitutes, midgets, and drug dealers is what made Jordan Belfort’s world go round, it’s always the money that grabs a certain kind of mind’s attention.

And money is back in abundance in finance today by the measures of all normal people, if not quite by Wall Street’s owned distorted measures.

Wolfing it down

The Wolf of Wall Street is a classic, but it’s not a truly great movie. Clips will be shown for the rest of our lives whenever there’s a financial scandal and some of the set pieces are spectacular, but it lacks the narrative arc of, say, The Godfather.

I’m not sure it’s any the weaker for it, though.

The message of the movie is that greed is more or less universal, and that out-of-kilter appetites cannot be satisfied by feeding them. Sticking a clever plot twist onto that might actually have undercut the film’s whole point.

I’d suggest you go and watch it if you’re at all interested about money and markets (although the superb Margin Call is a far more realistic depiction of a legitimate Wall Street firm in meltdown).

But you should know The Wolf is not a traditional morality play.

Sure the (anti) hero comes unstuck at the end, but not before he’s had a three-hour blast. The film says these pump-and-dump masters were stupid to get caught. It doesn’t really say they deserved it.

And again, unlike some reviewers I think The Wolf of Wall Street is a better movie for it.

The reality is we live in a society that celebrates and rewards outrageous financial success with yet more success.

The schmucks who go to work for Leonardo DiCaprio’s penny stock peddling firm were crooks, but the film shows how the line separating them and the salesmen at the fancy blue chip firms can be more one of opportunity than ethics.

Who’s the sucker?

Scorsese’s truly masterly touch comes the final few seconds. It’s not a spoiler to reveal that the end of the film focuses on a room full of eager everyday people, desperate to learn how to sell dreams for profit from Belfort – who’s by that point a convicted felon.

The Wolf exists because too many of us are willing lambs to the slaughter. But we all have at least some of the Wolf as well as the Lamb in ourselves.

Yes, that goes for the excesses, too.

The Accumulator is a higher being than me and will probably find the hedonistic madness beyond the pale. I don’t mind admitting I could see some of the appeal.

I’d never live like it – heck, I saw the film mid-afternoon because it was a cheap ticket – but I can easily envisage why living like medieval princes at the height of their power in the capital of the intoxicating elixir of money can warp minds.

Sadly, I was saddled at birth with crippling disabilities when it comes to pumped-up hedonism, such as empathy, sentimentality, and a paranoia about my health.

Plus I don’t consider the chance to punch a co-worker in the face for access to a Bloomberg terminal to be a perk of the job.

Just say no

The Wolf of Wall Street is too long, the characters are only redeemed by the comedy, and the revelry eventually drags.

But even if the spectacle isn’t enough to make up for that for you, it should at least be an effective vaccination against ever – ever – giving any money to anybody who cold calls you on the phone

No exceptions – never do it!

Living in a capitalist society means questioning the other side of every financial transaction you ever make.

Take no-one on trust when it comes to your money.

Especially if you trust them.

Postscript

Curiously, when I got home from my trip to the Wolf’s fantasy land, I found I’d been emailed two article suggestions for our Weekend Reading links that covered the flip side of the excessive pursuit of profit.

I’ve already featured the one on mindless accumulation.

But it – together with this confession from a former hedge fund manager who admits he was furious at getting “just” a $3.6 million bonus in his final year – will be vital reading for any Monevator readers who go to see The Wolf of Wall Street and then afterwards find themselves clicking on the Goldman Sachs’ website.

At least you should know how far – or not – making money can get you.

Still, let’s not be too disingenuous. As one reader replied to the author:

I am sorry I took the time to read this article.

You quit after making several million, have set yourself up and now throw darts at the industry.

Give all the money away and start from scratch again and lets see how you feel.

And he’s right.

There will always be money making opportunities, and people who will bend the rules, and cycles that of booms and bust. It will never ever be regulated away, because you can’t legislate away need nor greed. It will always be with us.

That’s the ultimate takeaway from The Wolf of Wall Street.

p.s. Before anyone says the days of hedonism in The City are over – I say give it five years!