Good reads from around the Web.

I know some people get fed up with the endless praise heaped upon billionaire octogenarian Warren Buffett.

And there’s clearly a bit of a contradiction in a blog that champions passive investing giving props to a super stock picker.

But Buffett bashers better skip down to today’s links, because I am about to salute the man again – and his sidekick Charlie Munger.

In my defense, as regular readers will know I do actively invest for my sins (it’s my co-blogger The Accumulator who is 100% pure passive). And if you’re going to try the near-impossible, it’s best to study the greatest of magicians. (Or the best illusionists, if you prefer).

Secondly, Buffett is so consistently logical and far-sighted, I doubt he’ll ever be bested as the exception that proves the efficient market rules.

Buffett: Saviour of pensioners

This week Buffett was in the news after it was revealed that The Washington Post’s pension fund is $1 billion in surplus.

That’s a far healthier state than most big companies, and the fund’s robustness lies in the actions of former board member Warren Buffett, who laid out a rescue plan in the mid-1970s.

I suggest you read his ancient letter to CEO Katharine Graham (on Scribd as a PDF) for a refresher both on how pensions work, and also on Buffett’s thinking.

Buffett himself has said many times that most investors should use index funds. Larry Swedroe even cheekily exploited this for his book championing passive investing: Think, Act, and Invest Like Warren Buffett.

In the Graham memo on pensions – written in the mid-1970s, remember, when active investing was at its height and Bogle has barely got started with index funds – Buffett warned:

“If above-average performance is to be their yard stick, the vast majority of investment managers must fail.

Will a few succeed — due to either to chance or skill? Of course.

For some intermediate period of years a few are bound to look better than average due to chance — just as would be the case if 1,000 ‘coin managers’ engaged in a coin-flipping contest. There would be some ‘winners’ over a five or 10-flip measurement cycle.

(After five flips, you would expect to have 31 with uniformly ‘successful’ records — who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)”

I love that last bit. Buffett has always been a weird mix of humble and arrogant.

Munger did it in 2008

One criticism often made of Buffett – which may well be right, though I doubt it personally – is that he just happened to pick a style that worked for 50 years, and this lucky break made his fortune.

One reason I don’t agree with this theory is that Buffett changed his style several times over his career.

Another reason I don’t give it too much weight is that value investing still works for the few who can genuinely do it.

Indeed, in the US the SEC recently investigated a Californian legal publisher called The Daily Journal on the grounds that it was secretly a hedge fund.

The reason? The Daily Journal has two times as many assets in equities than it does in the usual assets you’d expect to see at a publisher.

Well, it turns out that another wrinkly investor has been at it, and this time it was none other than Buffett’s sidekick, Charlie Munger.

Munger is a director at The Daily Journal, for convoluted reasons buried in an old investment he made. The important bit for today, as Bloomberg reports, is that Munger has tripled the value of the publisher through money he deployed into stocks during the financial crisis:

“Two of the company’s directors, Charles Munger and J.P. Guerin, selected the securities which, given their experience and knowledge of investing, required very little time,” Daily Journal said in the letter.

“Also, there have been only purchases and no sales, so no time has been spent trading or ‘managing’ these marketable securities.”

They don’t make them like Buffett and Munger anymore.

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As if identifying promising dividend shares wasn’t tricky enough, knowing how to properly assemble the shares in a portfolio can be an even greater challenge.

How do we assemble dividend shares in such a way that we maximise their value and utility?

The good and bad news is that there’s not a single answer to this question, as much will depend on your unique objectives.

As such, the first order of business when building a dividend portfolio is – you guessed it – establishing your aims:

• Is your primary goal dividend growth & capital appreciation, or is it to harvest high levels of current income?

• Do you usually base your buy decisions on screening results or do you like to roll up your sleeves and research individual companies?

• Do you want to passively or actively manage your portfolio?

Knowing the answer to these questions will help you evaluate what I consider the four broad approaches to dividend portfolio management.

Let’s briefly look at each turn.

1. Target yield approach

In this approach, you decide how much income you want the portfolio to generate this coming year, list the forward yields of the shares you’d like to include in the portfolio, and weight your holdings accordingly so that the average yield equals your desired income level.

Pros: It’s fairly straightforward and there’s a clear and quantifiable objective that can also serve as a guidepost when making future portfolio allocation decisions. When you’re looking to add fresh cash to the portfolio, for example, you can invest in such a way that your target yield is maintained.

Cons: First and foremost, it assumes that the dividends are sustainable and will be paid as expected. If you set your yield target too high and invest too much in ultra-high yield shares, there’s greater risk that one or more of the dividends could be cut, rendering the strategy less effective.

The target yield strategy can also be a bit short-sighted, with too much focus placed on near-term results at the expense of longer-term performance. And since higher-yielding shares tend to be found in only a few sectors (such as utilities and telecoms), you may be overexposed to certain industries.

2. Bucket approach

Divide the portfolio up into value, growth, high yield, and quality buckets and select shares that fit those categories.

The ‘value bucket’, for instance, may consist of shares with P/E ratios at least 15% below the market average, while the ‘quality bucket’ may only hold shares with high returns on equity and low leverage ratios.

Pros: The bucket approach forces you to focus on the type of shares you’re buying and helps you to avoid investing too much in one theme. You get to decide what qualifies for value, growth, high yield, and quality, so there’s a good amount of customisation available. As such, you can set up screens for each bucket that enable you to easily generate new ideas when needed or to know when it’s time to shift a share from one bucket to another.

Cons: Investors skilled at identifying shares within a particular theme (e.g. deep value or growth) may not feel comfortable buying shares that don’t fit their usual strategy. Consider that value investing legend Ben Graham wouldn’t likely have bought the shares that growth investing pioneer Philip Fisher liked, and vice versa. Investing outside of your specialty can result in sub-par performance.

3. Mechanical approach

A system of selecting shares and building a portfolio that’s primarily based on a specific screen or ranking system. The HYP method popularised by Stephen Bland and frequently discussed on Monevator is an example of this type of approach.

Pros: One of the great things about the mechanical approach is that it’s simple, consistent, and easy to put into practice. Just set up a screen based on a handful of financial metrics, rank the shares based on those metrics, and build a diversified portfolio of shares that score well in the screen. Wash, rinse, repeat.

Cons: A mechanical system that’s worked in the past may not work in the future. In other words, the parameters may be too rigid in a changing market environment. Also, if too much faith is placed on the screening results or the portfolio is managed too passively, you can overlook important red flags that might have been identified with a little sleuthing.

4. Custom approach

This is the freestyle version – select the best dividend paying shares you can find without adhering to a specific formula or strategy.

Pros: By definition this approach doesn’t have any hard-and-fast rules, so if you consider yourself a strong stock picker and aren’t concerned with generating a specific amount of dividend income, this might be the most attractive option.

Cons: Some parameters can be helpful when building a dividend-focused portfolio. Going in without a strategy can also result in poor decision-making in volatile markets.

At this point, you might be asking, “Couldn’t I just borrow a little from each approach?”

Absolutely you can! This is only meant to outline a few of the major schools of thought when it comes to dividend portfolio management. If you want to combine the bucket and target yield approach, for example, go for it!

How many shares is enough?

Investors building dividend portfolios are often concerned about being adequately diversified across industries – and for good reason – but I don’t think you necessarily need to own one or two shares from each industry to be properly diversified.

If you’re building a portfolio mainly of large cap shares, for instance, consider that larger companies are often internally-diversified. For example, Tesco has a bank division, GlaxoSmithKline has a consumer goods business, and Reckitt Benckiser has a pharmaceutical business. You might even be doubling up in certain sectors where you may not have meant to.

Also, if you’re not knowledgeable about a certain industry or morally-opposed to owning certain shares (e.g. tobacco, alcohol), you don’t necessarily need to have exposure to those sectors.

Personally, I’d rather own two stocks from an industry that I know inside-and-out than force myself to invest in an industry that I don’t know much about.

That said, I think you can have a diversified dividend portfolio with as few as seven large cap shares. If you’re including smaller companies in your portfolio, I believe that number will probably be closer to 20 given that many small caps have niche offerings.

Getting started

Whether you’re starting with a large lump sum or building your dividend portfolio one share at a time, the key is to go in with a strategy and objective in mind. The four portfolio management approaches outlined above will hopefully help get you started.

Please post any questions or comments below. It’d be great to hear how all you active dividend investors build and manage your own income portfolios.

Note: You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted. The Analyst owns shares of Tesco, GlaxoSmithKline, and Reckitt Benckiser.

Many people find it hard to accept an index tracking fund is the best way for them to invest their money.

And I have every sympathy for them.

It’s easy to forget just how counter-intuitive passive index fund investing really is.

Why would I choose a largely automated fund as the home for my hard-earned savings, merely on the grounds that it’s cheap? What if I am prepared to spend more for a touch of genius?

In most important aspects of your life, you go to the best experts you can afford. You expect superior results as you pay more. It doesn’t always hold, of course, but nobody would choose a burly man with a pair of pliers over a trained dentist on the basis of cost.

Active investing, though, is different. It’s a zero sum game. This simply means that for every winning pound – relative to the market – there must be a losing pound. In other words, winners and losers net out.

Subtract the cost of trading and the high salaries of those paid to choose the trades, and with active investing you’re in the hole and behind the market before you even start.

This means your active fund manager needs to at least recoup his or her costs just to keep up with the market. Research has repeatedly shown that over the medium to long-term, most fund managers don’t do this – which is no surprise, because fund managers are the market!

Average them all up, and they will achieve the same returns as the market, minus costs.

Hence fund managers lag the market on average, despite being paid a fortune and being in the main extremely clever and dedicated professionals.

Which really is weird, when you think about it.

Little costs make all the difference

Investing is also odd because few people think naturally in terms of compound interest. Active managers’ charges of 1-2% a year don’t sound like much when you start investing, but they make a massive difference when compounded over time.

The result of such charges is consistent market-lagging returns from the very firms that set out to beat it.

Which? for example found that only 38% of active fund managers in the UK managed to beat the market in the prior 10 years.

And as we know you know, this is the reason to be in tracker funds. Why risk being in the losing two-thirds?

We aren’t investing to give fund managers gainful employment. We just want exposure to the different asset classes in order to get a decent long-term return for our pensions or other goals.

Since most attempts to beat the market fail, it therefore makes sense to aim for an average return, if it means we can keep costs as low as possible to avoid reducing our returns more than we have to.

Thus the road leads to cheap index tracking funds with charges of less than 0.5% a year, which simply aim for that average return in order to keep as much of it in your hands as possible.

By aiming to be average, you paradoxically do better than the majority of investors who try for more.

Weird!

Top of the drops

Most Monevator readers are familiar with the tenets I’ve just run through. If we were the Boy Scouts, we’d chant some version of them every Tuesday before getting down to business.

But have you tried to explain the case for passive investing to others?

I have, and let me tell you it’s not easy.

I’ve already discussed how most people believe they’ll get a better result by paying more for an expert. It’s perfectly understandable if they don’t know any better.

But even outlining the ‘zero sum’ nature of investing often doesn’t change their view – because most people think they can do things they can’t, like picking a winning fund manager that will be better than average.

This shouldn’t surprise us either. People also think they are better than average drivers, lovers, humorists, and investment blog writers. We’re all deluded.

Emotions come into it, too. Our national sport revolves around a league of football teams dominated by four giants who’ve won nearly everything for many years. And yet up and down the country every Saturday, millions of fans believe something different will happen, and become despondent when it doesn’t. Year after year after year.

Still, even here investing is the funnier old game.

Looking at past results works really well in football. Anyone who studied the past couple of decades for ten minutes would see that supporting Arsenal, Chelsea, Manchester United, or Liverpool is the best bet for fewer tears.

Similarly, you wouldn’t bet against the Harlem Globetrotters or the All-Blacks or Roger Federer in their heyday.  If you see a top athlete or team win one week, you’ve every reason to expect them to win the next.

Yet a good spell for a fund is worse than useless as a guide to its future excellence.

S&P’s latest Persistence Scorecard in the US found that:

“Very few funds can consistently stay at the top.

Out of 703 funds that were in the top quartile as of March 2011, only 4.69% managed to stay in the top quartile over three consecutive 12-month periods at the end of March 2013.”

Read that again. Less than 5% of the top quarter of funds stayed that way for three straight years.

In football terms – in spirit if not in exact mathematics – this is like all but one Premier League team being relegated at some point within just three years.

It’s like Andy Murray winning Wimbledon this year, and this year’s world number #43 winning next year, and then someone we’ve never heard of winning it in three year’s time.

The poor persistence for winning funds gets even worse over the long-term. For example, S&P found that fewer than one in 25 large-cap funds managed to stay in the top half of the tables for five years in a row.

We know why it happens, but it’s still downright contrary to our everyday reality.

Passive parasites

Finally, there’s the contradiction at the heart of passive investing.

This is that passive investors need active investors to be out there hunting for superior companies in order for the market to be efficient.

No active fund managers, no tracker funds – or at least not any that I’d like to invest in.1

To quote Tardas Viskanta of Abnormal Returns:

“The passive investing crowd should be wary of trying to derail active management. The fact is that active managers make the market, to the degree to which it is efficient, efficient.

We can all declaim the hordes of hedge funds out there that are charging their investors 2&20% with little to show for it. But they are the crowd that tries to keep thing from getting too far out of whack.”

Again, this runs totally different to most of our real-world experience.

Doctors do not rely on quacks for a living. And we don’t appreciate a top restaurant only because we are forced to eat cardboard the rest of the week (well, at least not in my house).

Those aren’t great analogies, because I’m struggling to find a real-world parallel. Perhaps quantum mechanics has something similar in the uncertainty principle.

Yes, it’s that weird!

Weird science

Passive index fund investing is logically right, but emotionally and in terms of common sense, it often feels wrong.

I’m not suggesting we abandon it!

But I do think it’s worth remembering now and then just how strange it actually is, particularly when trying to persuade others to the cause.

It’s also perhaps worth feeling just a smidgeon of pride at circumventing your human emotions and apparent common sense to make the leap to passive investing.

It’s logical, after all.

Spock would be a passive investor. Kirk would run a hedge fund.

1. Theoretically passive funds would still win provided there were at least two active funds trading against each other to make a market, and charging for it. But I strongly suspect the asset class would have become un-investable long before that philosophical point! [↩]