Tim Hale’s classic book Smarter Investing
It answers more questions than an energy company boss before a Parliamentary Select Committee – except that with Hale the answers are usually satisfactory and the light bulbs should stay on.
Perhaps the most important question of all is: “Does the 2013 third edition contain new insights that may change a passive investor’s strategy?”
And the answer to that is: it may well do because Hale has updated his advice on bonds.
A shortage of interest
Historically low interest rates, vast amounts of QE being forced into the vaults of the financial system like fracker’s slurry, and investors clamoring for yield have put the why bonds? conundrum at the top of the agenda.
Hale’s response is – like a number of American commentators – to go short-dated and to consider diversifying your bond holdings.
Short-dated means holding bonds with maturities of between one and five years. That way the losses you suffer will be staunched in comparison to longer bonds in the face of interest rate rises.
Short-dated bonds are less vulnerable to interest rate risk because they mature relatively quickly. You get your capital back and can reinvest it in new bonds with higher yields – hastening your recovery from losses.
Hale has nixed his earlier talk of long bonds for aggressive investors intent on accumulation. The losses you risk are no longer worth the incremental returns.
Cautious investors should err on the side of short-dated inflation-linked bonds. Although this is easier said than done.
Index-linked National Saving Certificates would be the ideal bolt-hole but have been cast into deep freeze by the Chancellor.
The other options aren’t great either. Index-linked gilt trackers generally have maturities around the 17-year mark, so could be hit pretty hard if and when rates go north. And investors are so desperate for linkers that available yields are generally negative in the secondary market. In other words, it costs you to hold ‘em.
Faced with this, Hale turns to heresy, suggesting investors throw in their lot with active managers who offer short-dated linker funds.
Credit controller
Note that we’re no longer talking about investing purely in UK gilts.
The UK’s downgrade from triple-A status frees Hale to offer an additional fixin’ of global and corporate bonds scored AA and above by the credit rating agencies.
The benefits are extra diversification and yield, though Hale emphasises the importance of ensuring global bonds are hedged to Sterling. (There’s no point taking on currency risk in the portion of your portfolio that’s meant to cushion you against volatility.)
Commodities are also off Hale’s menu of acceptable assets.
He cites doubts over the counter-party risk and conflicts of interest that may compromise the structure of Exchange Traded Commodity (ETC) funds run by large investment banks.
Hale is clearly ambivalent about these risks, as he continues to make a good case for the role of commodity futures in a portfolio. However, when forced off the fence he decides that discretion is the better part of valour this time.
He has no such doubts over the merits – or not – of gold and structured products.
Hale sets about dismantling the case for both with the speed of a bomb disposal officer who wants to get home in time for EastEnders.
Outlook moderate
Hale has also downgraded the return expectations for his range of model portfolios that form the centerpiece of the book. The effect is most pronounced on portfolios with a heavy bond allocation, but the drag was enough to make me wince even on a 60:40 equity/bond allocation.
Of course, nothing is certain and Hale’s underscoring of the investing vagaries is one of the great favours he does DIY investors.
He takes pains to show that you may hit the jackpot over an investing lifetime, or you may hit the skids. Even reasonable return numbers are a 50:50 punt.
In other words, he does a great job of trying to stop investors anchoring themselves to a notional number peddled by a calculator, brochure, or book.
Sadly, this effort is downplayed in the 3rd edition of Smarter Investing
I think this is a product of brevity. The 2013 edition
Indeed given the paucity of UK books on passive investing, it’s worth us taking a detour to see what else has gone walkies from the 1st edition.
First edition Smarter Investing
The main reason to read the 1st edition is for several lost passages on the behaviour of UK bonds between 1900 and 2004.
My hair does a Van de Graaf every time I see the -74% real loss of the 1900s or the -73% shaft on the graph that is the 1940s.
More chilling still is the -4% real loss p.a. that occurred over the worst 30 years of UK bond investing history or the 47 years it took to recover the real purchasing power of your bonds lost during the bear market of the 1940s to 1970s.
It’s a graphical insight into the havoc that financial repression and inflation can wreak upon bond investors – a topic with particular resonance today.
What’s more, this is insight into UK historical data that you can’t get from US investing books.
That’s why Hale’s work is so valuable to British DIY investors and why I think it’s worth tracking down a copy of the 1st edition for the bond section alone.
Better still, if Hale doesn’t intend to restore these passages in a future edition, it would be wonderful to see them pop up as bonus content on his website.
The extended look at property as an asset class is also worth a read, as are stiff draughts of reality like the real return of 2.5% p.a. that investors earned from the worst 35 years to afflict UK equities.
But most of the other cuts from the 1st edition make sense, and amount to a sanding down of the material into the sleeker 3rd edition available today.
All UK passive investors owe it to themselves to read Smarter Investing
Take it steady,
The Accumulator
Hi Accumulator,
I was wondering whether you will be taking Tim Hales advice and include corporate bonds in your portfolio,given your stated lack of enthusiasm for this type of fixed interest product?
Slightly annoyed I bought the second edition last week, didn’t know a third edition was incoming.
I’m invested in Vanguard’s LifeStrategy 40% Equity fund, partly because of Accumulator’s earlier post at http://monevator.com/vanguard-lifestrategy/.
What does Tim Hale’s new advice imply for the fund’s 60% bond allocation? I shall have to read the 3rd edition and see if I can answer my own question!
I have an uncrystallised AVC currently in a linker fund: presumably actively managed, but anyway their average maturity is long. Oh dear; now what? They do have a conventional gilts fund and its average maturity is much shorter. Should I plump for that or just put it into international equities and attend to bonds elsewhere, where I have a better choice? I may have persuaded myself of the latter.
So much for an AVC, but what about an ISA? If the Chancellor were to permit transfers from S&S ISAs to Cash ISAs, would it be wise to sell bonds and go to cash?
(I’m assuming that when an ISA cap is imposed, whenever that will be, some “sweeteners” will be added.)
@ roconnor – I don’t think I will be getting into corporate bonds. I’m happy to live without the extra complexity. However, if Total Bond Market funds were more prevalent in the UK (as they are in the US) then I wouldn’t have any objections to getting a small dose that way.
@ Chris – The LifeStrategy funds use Vanguard’s intermediate bond funds to cater for their bond allocation. There is nothing wrong with this. Plenty of US commentators are sticking by intermediate bond funds. However, if you’re adverse to volatility and not particularly in need of growth then you could change your allocation by adding a short-dated bond fund.
@ All – none of the above is intended to panic anyone out of bonds. No one is saying don’t hold them, least of all Hale. You just need to be aware of what you’ve got, what role they perform and how they will respond in different market conditions.
Very interesting, made me check to see that I actually have the second edition.
> Hale has nixed his earlier talk of long bonds for aggressive investors intent on accumulation.
Is this purely due to preferring short bonds to long bonds in the current climate, or is it a change of reasoning about the benefit of long bonds to balance a high equity allocation?
> Hale has also downgraded the return expectations for his range of model portfolios.
Is this purely due to the downgrading the expected returns from bonds or has he reduced the expected equity returns too? What sort of return is he suggesting now?
Andy – he seems to be saying 6% for equities and 1% for bonds, both after inflation. That is my reading of his tables. Not sure what the previous version had?
Also, leaving aside the counterparty risk, what did he previously recommend for commodity exposure?
David – In issue 2,
Smarter Portfolio 1 – 100% UK Index Linked Gilts (short dated) – expected real return of 2%
Smarter Portfolio 6 – 100% Growth Assets – expected real return of 6.3%
Commodities exposure in the Smarter Portfolios was 0% for Portfolio 1, 2% for Portfolio 2 and so on up to 10% for Portfolio 6.
The defensive asset mix of the Smarter Portfolios only uses short dated UK index linked gilts, or conventional long dated gilts. Never conventional short dated gilts.
I must say I had forgotten that he recommended the short dated UK index linked gilts for the more conservative portfolios.
He does make the point that in the absence of suitable products for short dated UK index linked gilts, a combination of cash and longer dated index linked gilts could be used.
Thanks Mr A for letting us in on whats new in this edition. Tim Hale is recommend for anyone who needs conviction about passive investing although its a hard and technical in places i feel and could make you think – whats the point of most asset classes – including bonds (and now its seem more so property and commodities).
Using vanguard life strategy is I feel the best (for me) approach to bonds. I aim to very slowly build exposure to the 20% equity version, which if you delve deeper only has approx 15% exposure to longer dated gilts (over 10 years), although its seems longer duration index linkers are more prevalent (75% of this asset class and total approx 15%).
As always its best to understand that, as said time and again, bonds are there to reduce risk. And also that re-balancing asset classes is key. I think if we try to be too clever about bond exposure most of us will fail.
I think I’m still a little confused about bonds.
‘If a gilt fund has an average duration of say 10 years then it will lose (or gain) approximately 10% of its net asset value (NAV) for every 1% rise (or fall) in interest rates.
Also a duration of 10 also means that the fund will recover its original value within ten years as higher interest payments compensate for falls in price (though the recovery can be faster in practice).
In addition as the price declines, yields rise, so as the bonds mature they can be reinvested for a lower price into new gilts that pay higher levels of interest.’
So, if I’ve got a 15/20 year timescale then maybe I’m looking at intermediate bonds and then buy short or sell into cash for the remaining 5 years ?
The aggressive equity portfolio has an expected return of 6% pa with a 20yr chance of loss of 1 in 10 (10%).
The defensive bond portfolio has an expected return of 1% pa with a 20yr chance of loss of 1 in 5 (20%!!!!!).
Sort of redefines the meaning of “safe”, doesn’t it?
As an aside, I think the 10% chance of loss is far too high. This is because Mr Hale has used a Monte Carlo simulation which will simulate long-term risks mathematically from the short-term risks. As Prof Jeremy Siegel showed, this is not valid for equities due to the strong mean revision of equity returns. (Chapter 2, Stocks for the Long Run). This effect is also dealt with by Andrew Smithers (Chapter 17, Valuing Wall Street).
@ Andy – the change of heart on long bonds is due to the current environment. Long bonds would still be your friend in a deflationary / inflation below expectations scenario.
Lots of commentators are downgrading equity return expectations on the basis that lower bond returns plus the equity risk premium equals lower equity returns.
@ Paul S – I haven’t read either of those books, but am interested. What do you think the chance of loss is? I don’t have my Hale books to hand, but I think I’m right in remembering that the UK market has never lost over 20 years. Although that doesn’t mean it can’t happen as is amply demonstrated by other developed markets.
TA,
From eye-balling the charts in “Stocks for the Long Run” (this is all US data, of course) the average annual real return is 6.7% for 20 year periods with a standard deviation of 2.8%. That gives 2.4 SDs to zero return which equates to 1% chance of loss.
Andrew Smithers states that chance of loss (US data again) reduces to <5% at 14 years which is very close to 1% at 20 yr.
I strongly recommend you get a copy of Siegel's book. It really is the definitive work.
Thanks, Paul, I must get around to reading Siegel. There is a danger with relying on US historical returns though, which is that the US has enjoyed a particularly benign 100 years.
That average annualised real return for the States compares to approx 5% in the UK, 4% in Switzerland, 3.17% France, 2.8% Germany, 1.86% Belgium. Which means they went through some pretty brutal periods over decades. Obviously two world wars were a headline factor, but a broader view of developed world returns has some US commentators questioning whether US investors should bank on the same happening again in the 21st Century.
Hale has a graph showing the disparity of returns in the worst 10 years: US -40%, UK -61% – actually we’re the worst – and only Australia beats the US. Would be interesting to see the same thing again but over 20 years.
In the early days (1900s etc) the US was arguably an emerging market, which probably didn’t hurt returns. Of course all global markets were very narrow at the turn of the century, too, but certainly the US economy was much like an emerging one today.
In terms of looking at both historical returns, and supply based models that use the discounted dividend model to calculate likely future real returns on equities, I would thoroughly recommend ‘Rethinking the Equity Risk Premium’ which is a series of academic type papers from 2011 which has been edited by Laurence Siegel. I got it for free but it is currently selling on amazon as an ebook for just 77p!!!
http://www.amazon.co.uk/Rethinking-Equity-Premium-Laurence-Siegel-ebook/dp/B006ZOVU4U/ref=sr_1_1?s=digital-text&ie=UTF8&qid=1384977645&sr=1-1&keywords=Rethinking+equity+risk+premium
It includes a superb paper ‘Equity premiums around the world’ by Dimson, Marsh and Staunton which amongst other things shows real returns historically across 19 countries, breaks down the returns into their component parts, illustrates numerically the affect of purchasing power parity to historically eliminate currency risk for very long term investors to within 1%pa, and looks at survivorship bias by looking at the effect of stock markets that have collapsed such as Russia in the 1917 and China in 1949.
I cannot rate that book of papers highly enough. Not for beginners but for experienced investors looking to get insight into what future returns might be it is totally brilliant.
By the way interesting to read that Tim Hale’s focus on going short-dated is a feature of the current (third edition). Thanks as always Accumulator for a great article.
Been re-reading my Second Edition copy, even if there was a short dated (0-5 year) index linked gilt tracker wouldn’t the real yield be even worse than a mixed date one? Using the Vanguard one myself.
As to expected real returns I’d be happy with 2-3% over the next decade given how skewed the markets are. Having to release a new edition of a very well thought out book, that was already based on over 100 years of data, is proof of how extreme market conditions are.
P.S. There is a piece on Fidelity’s website about Bond Strategies for today’s markets, worth a read even though its essentially flogging their Total Bond fund.
I think the main aim of reducing duration in your bonds is to reduce drawdown risk / volatility, especially in this weirdly extreme climate, not to try to eek out an extra 0.5% of return. In a properly diversified portfolio you’ll be getting most of your returns elsewhere…
The main problem I can see is that historically, bonds are meant to spike up when equities tank, significantly reducing volatility. However, they just can’t do this any more as they are so highly valued already, particularly if the duration of bonds held is lower.
Therefore, either one just accepts higher volatility by having minimal bonds, accepts low returns by having even more bonds, or finds some other way of diversifying by looking into more esoteric classes. None of which are particularly appealing… I’m young enough for the first option, but not everyone is!
Obviously the US has had a good run but as far as anyone can see it always has had. The US as emerging market idea does not really hold up as the returns have been incredible consistent over any reasonable long period. Siegel tracks it from 1802 and Shiller from 1870. I do not have the details of the European markets you quote but getting bombed to rubble and occupied by invaders has to tell on performance……socialist politicians too.
Snowman…thanks for that link, I will follow it up.
Many thanks indeed TA, very helpful article. Looks like I need to pop down to Peckham library and see if I can get my hands on the 3rd edition for a peruse.
http://www.efficientfrontier.com/ef/997/maturity.htm
Two points – William Bernsteins piece above gives his rationale for staying away from long-bonds (and this was before the current environment of QE). As he pithily writes “long-bonds aren’t an investment – they’re a wager against interest rates”
Separately (and I’d be grateful for Accumulators comment). The duration of index linked gilts may not be such a worry as prices are more sensitive to changes in inflation expectations than they are to interest rate rises. In other words if interest rates go up a 15 year plain gilt and a 15 year index linked gilt won’t show the same price fall. The index linked gilt price will be protected a little by the fact that inflation expectations are likely to have risen and so will the price of the index linked gilt.
I can’t find a simple reference for the above comment so would be interested in comments for anyone who knows more about this.
I’m a bit late to this but is anyone aware of any practical books about decumulation strategies with a UK focus? I.e. how to live off a portfolio rather than build up a nest egg?
Or would TA like to take up the challenge himself?
@ PI – Thanks for the Bernstein link. I enjoyed the piece. Bernstein always has advocated the use of short-dated bonds for as long as I can remember.
On index-linked gilts, you’re right, that linkers should be less vulnerable to interest rate risk than conventional bonds because real interest rates are less volatile than nominal interest rates. Still, the durations of linker funds are very long which will amplify volatility and that may not be comfortable for a retiree who craves stability from their portfolio.
Andy – thanks that’s useful, and sorry for the delay in responding.
Shows how much things have changed, I think you’d struggle to get 2% real in short term ILG’s. The last graph I saw had -2% real for short term ILGs trending up to about 0% real long term.
The good thing about index linked gilts is their inflation protection, but you really are paying for it. I’m sure I can find a gilt yield curve but thinking about it though how does this work in a fund? Do they only roll over maturities into longer term gilts, or is there some other trading going to keep the duration at a certain amount – just confused.
Now off to download that book on the equity risk premium. It may brighten a dull commute!
I am passive investor who uses the Tim Hale Home bias global style tilts 5 portfolio I am unable to find passive short dated linker funds for Government and Corporate bonds which are either UK based or global. I am willing to take Tim’s advice and use active managers who offer short-dated linker funds. Does anyone have any advice on funds that could be useful?
This site is a breath of fresh air for the UK investor!
An excellent question, Chris. I haven’t looked into it yet myself. I think Hale did make a suggestion though in his practical application section. I can’t remember what he said though and don’t have the book to hand.
Glad you like the site.
@ The Accumulator – apologies to be picking your brains so much at the moment! Thanks very much for this article – very useful to have an update based on the current climate.
I was just wondering if you happened to have looked into the short-term index linked funds yet, and if so, whether you have any recommendations?Currently I am thinking of holding a mixture of cash and short-datedbonds in my defensive mix
Hi Emma, there are no short-dated index linked tracker funds. Hale mentions the actively managed Fidelity Global Inflation-Linked Bond fund but note, that’s a global fund, and I personally haven’t looked at it. On the UK gilt side, he’s only able to come up with an intermediate Dimensional Fund Advisor’s index-linked fund i.e. it’s not available as a DIY option and it’s not a short-dated fund.
I only recently heard of this book. Are there any rumblings of a 4th Edition now since it has been a few years?
Patrick – yes a fourth edition is due for release in August 2023.