Good reads from around the Web.

A research company called Mebane Faber wins my lesser-spotted post of the week award this Saturday for You are not a good investor, its disassembling of the vanities of stock pickers. ¹

First, the article calls up a fascinating study – The Capitalism Distribution – which examined stock returns from the top 3,000 stocks in the US from 1983-2007 and found:

• 39% of stocks were unprofitable investments

• 19% of stocks lost at least 75% of their value

• 64% of stocks underperformed the index

• 25% of stocks were responsible for all the market’s gains

Mebane Faber notes:

Simply picking a stock out of a hat means you have a 64% chance of under-performing a basic index fund, and roughly a 40% chance of losing money.

Ah, but we stock pickers have no use for a hat! We select shares carefully!

Sadly, whatever I think of my skills and whatever you know about yours, we can say with certainty that most people are terrible at managing an active portfolio.

This is brutally shown in a follow-up chart from Business Insider, which uses data from BlackRock and the famous Dalbar Study of investor returns:

Incidentally, check out the return on homes.

I told you guys homes have been better investments for most people, but you insisted on making it into a debate about house prices… 😉

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1. Full disclosure: I am such. For my sins.[↩]

One of the big surprises of the 2013 Budget is the new Help To Buy scheme. This will see the government topping up deposits of home buyers in a way more commonly done by parents via the so-called “Bank of Mum and Dad.”

There will be two strands to Help to Buy:

Help to Buy: equity loan – Starting 1 April 2013, the Help to Buy: equity loan will be opened up to provide equity loans worth up to 20 per cent of the value of a new build home, repayable once the home is sold. The eligibility criteria for shared equity will be widened, with the government saying the scheme will be open not only to first time buyers but also to all those looking to move up the housing ladder. The maximum home value will be £600,000 and there will be no income cap constraint.

Help to Buy: mortgage guarantee – The Government plans to create a mortgage guarantee scheme to “increase the availability of mortgages for those with small deposits across the UK”. This scheme will begin in January 2014 and will run for three years. It will offer a Government guarantee to lenders who offer mortgages to people with smaller-sized deposits of 5-20%.

The big potential benefit of these schemes will be enabling those with smaller self-saved deposits to access lower mortgage rates, thanks to the Government taking a share to raise the overall deposit.

Read the details for yourself by downloading the 2013 Budget document in full.

Why Help to Buy?

Cheerleaders for the new schemes will point out that not everyone has rich parents, and that even modestly well-off parents are becoming less able to remortgage their own homes to provide deposits for children due to rising living cost.

Critics of Help to Buy will argue that it looks like more support aimed at keep UK house prices inflated. That might be justifiable given our economic predicament, but would it not be more sensible to increase social housing provision to support housebuilders and provide plenty of new jobs and homes, without encouraging people to take out ever-larger mortgages in a market charging even higher prices due to this influx of new money? Such newly State-built homes could have been sold off into private hands at a later date via the Right to Buy scheme.

Surely the last thing we need is a new house price boom?

Help to Buy explained

Regardless of the rights and wrongs, many will want to know how to get their mitts on this government money, and whether it’s a good idea from their own perspective.

The scheme has only just been announced, but the Treasury has already released the following graphic to help us understand what’s on offer:

So what do you think about Help to Buy? Is it a sensible way to tackle Britain’s arguably iniquitous housing issues?

And would you consider using Help to Buy, or would you rather own all your own home for yourself?

Read any decent book on passive investing and you’ll learn about clusters of equities with the potential to turbocharge your returns. These equities deliver return premiums, and by favouring them you can customise your portfolio much like a car modder might bolt a giant spoiler onto his Vauxhall Astra.

Modifying your portfolio like this unlocks the potential for greater performance in exchange for extra helpings of risk.

But how big are these premiums, and are they worth playing for?

Return premium size and volatility

Return premiums have historically been handsome. And they’ve delivered over prolonged periods of time, too, although we can’t know if their pep will stretch into the future.

The table below shows an example of US return premium pay-offs. It’s taken from a paper published by Robeco Asset Management and is available in full from the Journal of Index Investing:

The excess return column on the left shows the result delivered by each return premium portfolio over and above the return offered by ‘risk-free’ government bonds, between 1963 and 2009.

If you swoosh your eye to the right-hand column, CAPM Alpha, you can see what each return delivered on top of the broad US equity market, after adjusting for risk.

Particularly eye-catching is the extra 4.6% annualised excess return from the value and momentum portfolios – albeit at the expense of extra volatility.

Very tempting.

Risk it for a biscuit

That volatility column is not to be dismissed lightly. It shows that only the returns of low volatility stocks are subject to less violent swings than the equity market. (The clue is in the name, I guess).

Investors in return premium strategies therefore have to be able to tough it out when the market gives your cunning plan a right booting. Individual premiums have lagged the market for 10-20 years during the roughest patches.

But what the Sharpe ratio tells us is that time spent adrift in the choppy seas of risk has proved worth it for the higher overall returns.

The higher the Sharpe ratio, the better the risk-reward trade-off. And every return premium portfolio beats the market in this respect.

Indeed, the momentum and value portfolios deliver a risk-adjusted reward that’s almost double the market index.

Correlation

It gets better. There’s plenty of evidence that the pitch and yaw of multiple return premiums has diversification advantages when combined in a portfolio.

The Robeco paper illustrates this nicely by showing the relative lack of correlation between the return premiums:

• A correlation score of 1 means that two assets move up and down together.
• -1 means they move in opposite directions.
• 0 means that the relationship is random.

Any score from around 0.3 to -0.3 implies a lack of correlation, which accounts for most of the relationships above, bar value with low volatility and small cap stocks.

However, value has been known to decouple from low volatility when recession strikes and value stocks come under pressure.

The lack of correlation between the different premiums implies that some may wax while others wane, rather than all plunge together like climbers on a rope.

Diversification

Here’s another study from the Journal of Indexes (Europe) that shows the diversification benefits gained by melding return premiums into a joint portfolio, between 1990 and 2011:

• The S&P 500 stands in for the market portfolio.
• Fundamentally Weighted is a value premium strategy.
• Equal Weighted is a small cap strategy.
• Alternative Beta Composite is a portfolio that is divided one quarter each into the value, small cap, low vol and momentum strategies.

Note that the combined portfolio beats the market by 2% a year and with much better risk adjusted returns (see the Sharpe Ratio).

Even the overall risk is slightly lower – 14.2% as compared to 15.1% – indicating that the different equity strategies mesh together to create a stronger, more stable package.

We can see that the low volatility strategy has the best risk-adjusted returns and lowest risk overall, but it would be a courageous investor who hangs their hat on that bravura performance continuing. As always it’s best to spread your bets.

To illustrate the point, investment strategist and Larry Swedroe’s co-author, Jared Kizer, has analysed the likelihood of return premiums triumphing over longer time frames.

Kizer looked at US stock market data between 1927 and 2011 and came up with this table:

Over monthly periods, you can see that the chances of positive returns for size and value are only a smidgeon over 50-50.

Happily, performance is more satisfactory over longer horizons, though you still have to be prepared for size and value to lag the market 25% of the time over five-year periods.

More interesting still is the table below from Kizer showing that one of the premiums will bring home the bacon 96% of the time:

If diversification is a free lunch then let’s make it bacon sandwiches!

Caveat City

The strength of the return premiums change over time, by country and indeed according to how each premium is defined. So the numbers above may well differ from the results of other studies, and from the results in the UK.

Moreover, strategies that attempt to capture return premiums in reality tend to have bigger holes in their butterfly nets than is allowed for by the academic studies that originally pinpointed the opportunities.

There is though plenty of evidence to show that the premiums have persisted across international markets and the historical record.

I’ve seen enough to make me believe that it’s worth tilting my portfolio to collect at least some of the extra return juice. We’ll delve deeper into the possibilities in forthcoming posts.

Take it steady,

The Accumulator