Every now and then someone sends me their portfolio for thoughts and suggestions.
One particularly stuck in my mind because it’s the type of portfolio I could have had if events had turned out differently.
Reviewing it made me feel like I’d been transported to an alternate timeline.
One of those parallel universes where the US and UK had fallen to fascism. Everybody wears military uniforms and clipped moustaches, including the women.
The letter ‘K’ has replaced the letter ‘C’ to prove we no longer live in the free world. Y, know – people get their burgers from MkDonalds, and their propaganda updates from Fakebook. (And there’s one fewer episode of Sesame Street.)
I’m not saying this portfolio was overweight authoritarian states (unless you count contemporary Britain, right kids?)
But this is the place I might have wound up in if I hadn’t found the passive investing [1] freedom fighters early on.
Where – instead of the Bogleheads [2] – I’d fallen under the sway of nefarious choice architects such as newspapers and stock brokers – all broadcasting their wealth-lists like martial marching music across every channel.
Time for a debrief.
What a state
The portfolio under interrogation comprises 25 actively managed funds.
Now to be fair, some of these funds handed out a beating worthy of a brownshirt to anything I own.
Beneath those headline victories, though, all is not well.
Alarm bells ring for me when I see a long tail of micro portfolio allocations as in the screenshot below.
Dwindling portfolio weights undermine the overall contribution each holding can make, and imply a chaotic strategic approach.
Do not adjust your set! The holding names have been redacted for privacy reasons. The red box shows the majority of holdings make up less than 5% of the portfolio’s weight, while 44% of holdings weigh under 1%.1 [3]
[4]
Remember those winning active funds I mentioned? Alas these stars made only a minor overall contribution, because they were typically held in very small amounts.
This doesn’t say much for the forecasting skill of whoever picked most of these funds. Spray a target with enough bullets and you’ll get some hits.
The offset, I suppose, is that the dogs also only inflicted flesh wounds.
The majority made a marginal difference to overall returns – for better or worse – so what was the point of them?
What’s the strategy here?
Big bother
Overall, the portfolio has done well. It’s netted double-digit nominal returns for a decade.
So what am I complaining about?
Well, the snag is this active assortment was comfortably beaten by a world tracker [5] index fund. A simple choice that would have saved money and bother.
[6]
(Specific holdings again redacted. It adds to the crypto-fascist theme of today’s post, wouldn’t you agree, citizen?)
I’ve ranked the portfolio’s funds by performance (best to worst) and noted the OCF, too.
We can see that only seven out of the 25 active funds beat the simple MSCI World ETF I used as a benchmark (the green row in the table).
I knew the funds 10-year annualised return in most cases, but where I only had the 5-year return I’ve shaded the cells grey. I’ve rounded the returns and Ongoing Fund Charge (OCF) to the nearest quarter point, except the portfolio’s average OCF.
A crude projection of this portfolio back ten years sees it lag the MSCI World ETF by a few percentage points annually. It trails by about half that against Vanguard LifeStrategy [7] 100.
I don’t know the trading history of the portfolio – and not all the funds were available 10 years ago – so my estimate is not the realised return. It’s useful only to see whether these active managers together would have added any value versus a passive investing strategy.
Also, I should state this portfolio is over 90% equities. Most of the remaining allocation is in high-yield fixed income.
I’m not saying this portfolio was fated to trail a standard issue index tracker.
What’s the complexity adding?
My question is what is this investor getting for all the cost and risk of holding this motley crew?
It’s not adding diversification compared to a global tracker, that’s for sure.
The portfolio is tilted 60% towards Blighty. It would have made mincemeat of my comparison ETF if UK plc had trounced the US this past decade.
Alas, the opposite happened.
Moreover it’s not blind chance this portfolio under-performed.
Global capital simply wasn’t lining up to back Britain ten years ago. The world market told us that an 8% holding in UK equity was about right back then.
The sub-text read: “Don’t overdo it.”
Today UK stocks weigh in at around 4% of the global benchmarks.
So why is this portfolio stuffed to the gills with British-focused funds?
Perhaps because UK broadsheets and brokers are primarily incentivised by what sells. And that’s typically recent winners and the reassuringly familiar.
Such a pitch – ten years ago – got you a portfolio that banked too much on the UK, and funds vulnerable to a mean-reversion smackdown.
To emphasise the redundancy here, Morningstar’s Instant X-Ray tool [8] found the portfolio’s top ten (underlying) share holdings present in anywhere from four to seven of the portfolio’s constituent funds.
Feeling all the fees
You may also have noticed that even the cheapest active fund in the mix costs more than three times the fee charged by the ETF.
The most expensive fund charges you more than 11 times the tracker’s fee! Yet it delivered less than half the annualised return over the decade.
For simplicity, imagine this portfolio’s weighted total OCF was 1% (instead of the 1.2% it actually sums to).
Let’s also generously assume returns were the same between the active funds and a global tracker (rather than the case study lagging, like it did in reality).
If the portfolio’s gross annual return was 10% for each of the next 10 years, its 1% charge would consume 10% of the profits.
The index tracker’s 0.15% fees would only eat 1.5% of the profits.
This cost differential makes all the difference [9] when compounded over the years.
Price does not equal quality
Still, those skilled active managers will justify their fees eventually, right?
Well, 18 out of the 25 failed to match a simple tracker, over a meaningful time period, despite their proprietary trading strategies, PhD-bedecked support teams, and glossy brochures.
Worse, the performance ranking above sees the most expensive funds clustered in the bottom half of the table.
Granted, my case study is a random snapshot.
Better evidence comes from the long-running, regularly updated SPIVA analysis [10] that confirms the best performers are not the ones that charge you the highest fees.
Back in the real world
If all this is true then there’d be an outcry, wouldn’t there? The hard-charging active fund industry would be found out, surely?
Yep, just like ageing women stopped buying expensive anti-wrinkle products years ago.
The evidence has favoured passive investing for even longer than Monevator has been blogging – coming up to 15 years for us – and yet the gravy train rolls on.
At least fit your own oxygen mask first. If your portfolio exhibits traits similar to this case study then I’d urge you to benchmark it against a global tracker [11] using Morningstar’s Portfolio Management [12] and Instant X-Ray tools.
And if that sounds like we’re on some kind of deal for Morningstar endorsement, know we’re not, sadly. I just genuinely think you can learn a lot from using those tools. (A similar analysis of my own portfolio prompted my recent investing mistakes [13] post.)
I don’t pretend passive investing is perfect. Maybe you’ll own some over-bloated winners. Perhaps it encourages hands-off capitalism. Indices stuffed with sin stocks. Pick your poison.
Indeed just like democracy, passive investing is probably the worst strategy – except for all the others you could try instead.
(With grateful thanks to Winston Churchill [14].)
Take it steady,
The Accumulator
- Some shares and even an ADR add to the fund fun, if you’re wondering why there are more than 26 holdings. [↩ [19]]