Good reads from around the Web.

After we updated the lazy portfolios for UK investors the other day, some readers asked good questions about how the different strategies had done in terms of returns and risk over the years.

I say good questions partly because I don’t have good answers!

But I do know the different allocation strategies all did fairly well – and fairly similarly – over the years1. That’s one reason I suggest people don’t sweat their micro-asset allocation.

The other reason is that even if some particular strategy does deliver higher gains – and some will, due to how small differences in compound annual returns can make a big difference over 30-40 years – I don’t believe you can reliably predict which one in advance.

Remember these are long-term plans that you’ll rebalance for decades. If you think you can run the numbers and come up with anything other than broad guesses as to whether, say, equities in the UK will do better than those in continental Europe, then I believe Steve Hawking has some work he needs help on with super-string theory.

Don’t worry, be lazy

If you do want to have a try – or you want reassurance that it probably doesn’t matter – then Mebane Faber has come out with comprehensive data for the US versions of the lazy portfolios.

Here’s a table showing his findings – see the full post for precise details of the allocations:

Returns from lazy US passive portfolios (click to enlarge)

Faber notes that:

People spend countless hours refining their beta allocation, but for buy and hold, these allocations were all within 200 basis points of each other!

…over the long term, Sharpe Ratios cluster around 0.2 for asset classes, and 0.4 – 0.6 for asset allocations.  You need to be tactical or active to get above that.

I’m sure the same is true of UK equities, though I’d love to have hard data to share with you some day to show it.

The law of diminishing returns

Once you’ve got a basic passive portfolio strategy in place, you’re better off focusing on keeping costs low, reducing your losses to taxes – and maybe trying to earn more money!

It’s either that or follow me down the dark path of running some of your money actively. You might beat the market if you try, but it will prove a seriously bad move for most.

So why risk it?

The lazy portfolios will deliver for as long as the markets do. Some will turn out to be better bets than others thanks to the way compound interest works, but it’s impossible to be sure which ones in advance.

They really do make investing simple, and it’s almost a crime that as a reader of this blog you’re among the relatively few who even know they exist in the UK.

[continue reading…]

1. Sequence of returns risk notwithstanding [↩]

A few canny value investors like Warren Buffett have beaten the market for decades by buying cheap shares.

More recently, academics noticed what they were up to and identified the value premium – the excess return over the market that you’ve earned by zeroing in on shares that looked cheap on measures such as price versus assets, or which sported a higher dividend yield.

Now passive investors like our own Accumulator are in on the act, adding a value tilt to their portfolios through ETFs that favour value shares over their growthier brethren.

But I think Mr. Buffett can probably rest easy.

Leaving aside my skepticism about recent attempts to reduce the legendary investor’s achievements to a formula, even data-driven academics concede that value investing is as much about emotion and temperament as it is about numbers.

Why? Because the worst companies in the value bucket often look one short lurch from the coffin. And even the best of them are seldom the sort of companies you’d brag about owning in a City bar.

It takes commitment to stick to value fodder when all else are abandoning dull companies for revolutionary electric car makers or sexy yoga pants vendors.

Indeed, even Warren Buffett found his market-beating record counted for little in the late 1990s. Buffett was ridiculed as yesterday’s man when he warned the financial world that the Dotcom bubble would end in tears. He refused to change his investing methods even as he badly lagged the market.

Of course, the 1990s stock market boom subsequently burst and Buffett was vindicated as his ‘boring’ stocks rose.

But in 1999 he wasn’t to know that would happen. He could only believe it.

European value versus growth

You and I also believe we’re made of the right stuff, right? Like Buffett, we’d have loaded up on value shares or funds in 1999 and concentrated on the long-term returns, wouldn’t we?

Well, I wonder.

We’re nearly all prone to behavioural quirks. Our minds are an orgy of competing biases that conspire to do in our best plans, whether we’re buying shares or trying to resist that fateful “one more” beer after work.

This is why the value premium persists. It should have been whisked away by the efficient market years ago, as it’s hardly a secret. Everyone should be buying value shares.

But like the poor and Bruce Forsyth, value is always with us.

Don’t believe me? Take a look at the following chart, which shows the performance of the iShares European Large Cap Growth ETF (Ticker: IDJG) versus the value one (IDJV) over the past five years:

European large cap growth versus value (click to enlarge)

As you can see from the graph:

• The blue line – the growth ETF – is up 20%.

• The red line – the value ETF – is down around 30%.

Growth has been smacking value for five years, by a 50% differential over the period.

How can this be?

Smokestacks on sale

If you look more closely at the graph, you’ll see the divergence began in early 2010.

This coincides with when bailouts for the peripheral European countries and even the break-up of the Eurozone went from nerdy financial columns to the mainstream nightly news.

Europe entered crisis mode, and people started to fear the worst. European markets fell, and some have yet to recover. The Italian market for example is still down by a quarter since the start of 2010, compared to the UK market that’s nearly 30% higher since then.

At first blush, the out-performance of growth companies compared to the value ones in Europe might seem surprising. Why would investors prefer to own more expensive growth shares if they were worried about the future? Wouldn’t it be better to focus on ‘safer’ value stocks?

It’s a sensible-seeming thought, but it’s not what happens. To understand why, you have to realize that ‘value’ as, say, Warren Buffett has popularised it, is not quite the same as an academic understands it – and hence not the same as you’d buy in a value ETF.

Early Buffett – or better yet hardcore value investors like Walter Schloss or John Templeton – did indeed buy baskets of beaten-down value stocks on the strength of cheap-looking company fundamentals.

But an older Buffett has warned us that the first rule of investing is “not to lose money”. And rule two refers back to rule one.

Stock picking value investors say they “focus on the downside”, too. What’s the most I could lose if my investment goes wrong? In the worst case, would anything be left if the company keeled over?

This sort of investment thinking – when applied to an economy headed into turmoil and recession – will often take you away from so-called value shares, and into growth shares.

I don’t mean flighty blue sky stocks with no real business to speak of. Such speculative shares are invariably decimated when bull markets end and recessions strike.

Rather, I mean good quality growth companies that look like making some progress whatever the economic weather.

Investors start to favour these stronger companies whose futures are more under their own control – ones where people really want to buy their products, and so they can to some extent control their margins and earnings.

An extreme example would be a company like online clothes retailer ASOS, whose shares are up 12-fold since 2009.

Recession, what recession? The compelling ASOS proposition has seen it take money off the many stagnant High Street retailers who’ve struggled as belts have tightened.

On the other hand, all the physical assets and stodgy revenues that define a value share are pretty onerous in a downturn. Sales fall as the wider economy stumbles, and profits can collapse. Production lines become a rusting liability. The company may theoretically have valuable factories or oil in the ground or what have you, but nobody wants much of that in a recession.

Value companies may also have big debts, which are about as attractive as concrete wellies on the Titanic when the economy darkens.

For all these reasons and more, value shares are often dumped in recessions.

Value isn’t just for Christmas

So value shares sell off, even though people know that if they buy and hold them for the long-term they’ll probably do better. And that’s just what has happened in Europe.

Interesting lesson, I hear you grumble. But how can we make money from it?

Well, the first thing to realize is that those European investors are no less smart than you or me. They have sold their value shares in the face of the storm, just as most of us will sell ours the next time things get rough here.

But more immediately interesting, perhaps, is that this could be a great time to go shopping for European large cap value shares.

I suspect most people invest in value on some sunny day thinking idly, “Don’t be silly – of course I will hold through the rough as well as the smooth!” They probably believe so, too, after looking at a few years of graphs showing excellent out-performance of value over growth to-date.

Sure they’ll see some glitch back in the midst of time, if they pan the graphs back far enough. Fine, they think – they’ll hold through a glitch. They’re no mugs!

Well, now we have a chance to buy value in the middle of the glitch – or just maybe as it’s coming to an end.

I’ve noticed over the past few months, European large cap value has kept the pace with growth:

European value versus growth over the past three months (Click to enlarge)

Moreover, I think the European economies are looking up, and long-term readers may remember I was always disdainful of the extreme break-up fears anyway.

When investors regain their confidence and those European factories start to hum, I’d bet good money Europe’s large cap value shares will close the gap and beat growth shares and the wider market.

In fact, I am betting good money.

US shares look a bit expensive,  and even the UK looks a little heady in places, but European value shares look cheap.

So I’ve been buying in Europe – both in individual names and through European tracker funds.

And I’m taking a slug of that European value ETF, too. It’s yielding nearly 5%, and it’s packed with solid companies that will one day do the business again.

Academics take note: I’ll be available for interviews and your rigorous hindsight biased data-mining in a few years time! 😉

Ever considered an Exchange Traded Fund (ETF) only portfolio? For many DIY investors, it could be the cheapest way of owning a diversified portfolio of index trackers.

Now that the era of passive investors being subsidised by their wide-eyed active investing cousins is over, it is still possible to avoid platform charges altogether by owning a portfolio invested 100% in ETFs.

Execution-only brokers TD Direct Investing and Sippdeal both currently waive platform fees for ETFs. You’ll only pay broker fees when you trade and even that hit can be softened by exploiting regular investing schemes.

More on that below.

So what would an ETF-only portfolio1 look like? Here’s a pretty diversified slate:

* A cheaper UK equity fund is VUKE – Vanguard’s FTSE 100 ETF (OCF 0.1%).

** VWRL is approximately 10% in emerging markets. Add VFEM for a stronger dose.

Buyer beware

Despite all this platform fee chicanery, an ETF-only portfolio won’t always make sense. It’s only worthwhile if the portfolio’s total cost (i.e. the weighted sum of the fund OCFs) is less than the platform fee you’d have paid for a portfolio including funds (plus the difference in trading charges).

If you’re stuck on TD Direct then that’s easy. TD’s 0.35% platform fee2 means that every fund you own effectively costs 0.35% more than its advertised OCF. That’s a high bar to get over and you’d have to own a portfolio smaller than around £10,000 (or be a trading fiend) not to do better in ETFs.

On Sippdeal you pay a fixed platform charge of £50 per year plus trading fees on all investments. If your ETF portfolio’s average OCF siphons off £50 more than its fund-based counterpart then it’s not worth it.

The bigger your portfolio, the less likely you are to benefit because it’s quite common for index funds to be cheaper than ETFs in the UK, unlike the US.

Charles Stanley overlooks its 0.25% fee on ETFs if you trade six times or more every six months. But a flat £10 dealing charge means you’re better off with TD Direct.

Sippdeal and TD Direct are both better prospects for an ETF-only portfolio because they enable you to set up a regular investment scheme that only costs £1.50 per purchase.

Gaming regular investment schemes

To keep costs down, I’d buy one ETF every month for my portfolio. For example, I’d buy my entire year’s worth of property ETF in June and my FTSE All Share ETF in July and so on. There’s no need to drip-feed into every ETF every month.

Your broker can’t make you invest every month either, so once you’ve had your fill, just cancel your regular order, and replenish your reserves if cash is tight.

It doesn’t matter to me that regular investing means I buy on a fixed date in the month that’s decreed by the broker. Passive investors don’t believe in market timing, so I wouldn’t lose sleep over picking my moments.

Sell orders are conducted at full price with these regular services, but if you rebalance with new money then you can largely avoid selling until your portfolio gets mahoosive. (Some brokers, notably Halifax, also offer monthly special deals where their usual trading fees are discounted for a few hours. You could time your rebalancing to exploit this).

The technical differences between ETFs and funds are practically negligible for most passive investors, too. The hoo-ha about synthetic ETFs was overblown, and I don’t have any qualms about using them when they best track the asset class I want a piece of.

No straight answers

As ever, by the time I’ve written up an investing stratagem, I’ve thought of half a dozen ways to undermine it and I can’t help but ‘fess them up. Such is the tangled web of investing!

Personal circumstances are everything in the field of cost bullet-proofing and the chances are that most small investors will do better in funds with Charles Stanley Direct, if their portfolio is likely to remain under £20,000 for a good stretch.

Meanwhile large investors will generally profit from choosing a fixed fee broker and investing in the cheapest trackers they can get – whether a fund or an ETF.

Let our broker comparison table be your guide.

The best advice is not to sweat it too much. Low cost is good, but endlessly fiddling in pursuit of perfection is a waste of life.

Take it steady,

The Accumulator

1. An even simpler portfolio would be to simply combine VWRL with VGOV. [↩]
2. Payable from August 1 2013. [↩]