Lars Kroijer on…market timing, currency hedging, and active managers

Way back in the mists of time spring we solicited questions from you for Lars Kroijer, our favourite hedge fund manager turned promoter of passive investing.

You replied with dozens of queries. Almost hundreds. Enough to make us pause and consider how we should go forward.

With the markets riding high, you asked, was it better to wait for a fall before investing? Active managers might lag the market overall but why not invest in those who are winning? And should you hedge your currency exposure?

The questions piled up in comments and over email.

Hence we’ve decided to try something a different – a tie-up between Monevator and Lars’ popular YouTube channel.

Every month we’ll pick three or four of the questions and answer them individually, in video form, as below. If this works then it will hopefully become a regular series. We’ve already got enough questions to last until 2023 or so, and I’m sure more will come in over time.

So let’s get started!

Please note that embedded videos are not always displayed by email browsers. If you’re a subscriber over email and you can’t see the three videos below, please pop over to the Monevator site to read this: Q&A with Lars Kroijer.

Why not wait for the market to drop before investing?

Congratulations to Monevator reader Steve L. who pops the champagne bottle on our series with a question about market timing:

Lars replies:

The question for this video pertains to a reader who has been wanting to invest in equity markets but has been waiting for a dip to get in at a more favourable price. That dip has failed to materialize and he’s wondering what he should do now.

Yhe first thing I would say is nobody knows what’s going to happen in the market in the future, whether it’s going to be dipping in the near-term or in the long-term.

If you had that knowledge, it would be incredibly valuable, and I suggest you go get rich on the base of it!

What we do know is that the equity markets historically have gone up about four or five percent above inflation per year. This is based on hundreds of years of data and it’s perhaps not unreasonable to guess that markets in the future over the long-term are going to go up by roughly what they had done in the past, given a similar kind of risk profile.

Of course, markets are going to be extremely volatile in the short-term. Nobody knows what’s going to happen and that’s important.

Now, just the fact that in the past you’ve been unlucky and failed to invest right before markets went up does not mean that you should not invest now.

I’d say my view would be there’s no time like the present to get invested in the equity markets, assuming you have the kind of risk profile that allows you to make those kinds of investments. And if you do so of course there’s a risk that you invest right before a market crash and you can be unlucky in doing so.

If you want to avoid this risk, you can spread out your investment over in blocks of three or four. So, say you have $100 to invest you can do that in four blocks of $25 instead of one block of $100.

That does however increase transaction costs and potentially increase tax and other admin costs to you as well.

So, that’s my advice. Get invested and if you can’t afford the near-term risk spread it out over several [time periods].

The pros and cons of currency hedging

The next question is from Richard J., who is concerned about the exposure that his passive funds have to foreign currencies:

Lars replies:

Richard asked whether you should really be hedging currency investments in global equity trackers. This applies to other non-domestic investments too, I assume.

Just to explain what I think he means: If you take an example of someone who invest a £100 into a global tracker – it doesn’t quite work this way but it’s a way to think about it – the provider will take the £100, FX’s the money into various currencies and buys the underlying stocks for those currencies.

So, for example they would take your £100, they FX it into dollars and among other stocks buy Facebook shares.

This would create a dollar-sterling exposure and the question is should you be hedging this exposure?

So, on balance I don’t think you should.

Now, there are a couple of reasons for this.

One is it’s actually really hard to know exactly what your FX exposure is. The reason for this is that the companies that you’re buying shares in themselves have a lot of FX exposure they might be hedging.

You can take Facebook as an example. They have operations all over the world, including in the UK, and it can be hard to know exactly what you should be hedging. Furthermore, I think something like 50% of the earnings of [a market] like the S&P 500 are actually made outside of the US and in a wide array of currencies and so that slightly mitigates the issue and could actually mean that your currency hedging is done wrong.

The second reason you shouldn’t be currency hedging is that it can really be quite expensive and as I alluded to, quite imprecise, not only for the reasons I mentioned but also even if you did get the exposure right you should really constantly be trading around this, as shares and the various currencies move up and down. This would lead to very significant transaction and admin costs which would impair your returns in any currency.

The third argument why I don’t think you should be hedging your FX exposure is that FX exposure can actually be a diversifier.

So, if you think of your £100… You’re buying not only exposure to companies in many, many countries but you’re also buying exposure to many currencies, so if there is a shock in your local currency – in this case sterling – the fact that you hadn’t hedged the currency actually means that you’d be better off. Shocks in currency markets tend to move against your local currency and are really a ‘shock up’. So actually, this is not only cheaper and less cumbersome et cetera, but it’s actually probably a good thing to not be currency hedging.

The argument for currency hedging is that you should be investing your money in the currency where you eventually need the money and I think there’s some truth to that.

But […] there’s the admin, transaction costs, that natural diversifier… and at heart that it’s hard to know what actually what the right exposure is.

If despite these facts you still want to currency hedge, I would question whether you really should be investing in as risky an asset as equity markets can be.

Why not invest with a winning fund manager?

Finally for this month, why not run your money with a star fund manager like Nick Train or Terry Smith, asks reader Paul K.?

Lars replies:

The question in this video comes from a reader who although he is a fan of passive investments asked why should we not just invest our money with a star active fund manager? He says Fundsmith or Lindsell Train but there are many.

So, first of all he’s saying he’s a fan of passive which I take to mean that he doesn’t think we should go and invest and try to pick Facebook versus Google versus Apple and a thousand of other stocks but instead invest in markets as a whole and sort of take a passive approach.

But the question is then why not get someone to make our investments for us? Someone who’s presumably done very well in the past.

The answer to the question really has a bit to do with statistics.

If you look at it over a ten-year horizon, only ten to 15% of active fund managers outperform the index of the markets that they operate in.

So, if you think of the S&P 500 or someone that is operating in those markets, only 10 to 15% of them will actually do better than that index over the decade.

Now that’s not necessarily because they’re bad managers. It’s just that because on top of the fees that they’re charging you they incur other costs, like bid-offer spreads, sometimes auditing, trading costs and so forth. It all adds up over time.

[The reason] we often think that the active managers do better than they actually do is because of a huge selection bias.

So, if you go ten year back in time and look at the top hundred managers then only, statistically, ten or 20% of those are still around and because [the industry] focuses on those we tend to forget all the ones that didn’t do well and think therefore that everyone did well. So that’s a typical selection bias.

I’m not saying that the ability to pick individual stocks or indeed [successful] active managers doesn’t exist.

I’m just saying it’s a very tall order to claim that you have [that edge], and particularly the ability to pick the ten to 15% top managers ahead of time is a very, very tough tall order to claim.

Until next time

We know it’s been a bit of a wait to get started with these questions. But hopefully the news that reader favourite Lars will be a regular feature on the site for a while makes up for it.

Let’s hear what you think about Lars’ replies – and any other feedback please – in the comments below.