Lars Kroijer is an occasional contributor to Monevator. His book, Investing Demystified, makes the case for index fund investing. Given the woeful performance of value funds over the past decade we thought we’d resurrect this classic post to give Lars a victory lap.
Most Monevator readers will know that I think passive investing in index funds is the rational choice for nearly everyone. A global tracker fund is the only fund most people need.
That’s because I believe most people have no edge when it comes to the extremely competitive investment markets.
I don’t even think many of us can judge whether one entire country’s stock market is better value than another, let alone pick individual stocks that will outperform.
For that reason, I think the most investors are best off using world equity index tracker funds to get their entire exposure to shares.
A world index tracker enables you to let the global capital markets do the hard work of figuring out where your money will earn the best return – because that is what is reflected in the various regional weightings in a world tracker fund.
International capital has spoken. You can just enjoy the ride.
Cheap and cheerful
Investing in a world tracker is the ultimate admission that you don’t know any better than the market.
By understanding your limitations as ‘dumb’ money and just ‘dumbly’ following the market, you actually make a very smart investing decision.
However many firms and pundits have tried to take passive investing in a different direction.
Whether it goes under the name of Smart Beta, fundamental indexing, alternative weighted indexing, or anything else, fans of these methods claim they can deliver superior returns to vanilla market weighted index funds.
The alternative-weighted funds aim to exploit various return premiums that have outperformed in the past.
For instance, there is much research that suggests that value (i.e. companies with low price-to-book or price-to-earnings ratios) and smaller companies both outperform the general market over the long-term.
Various indices and products to track them have been created to reflect this line of thinking.
Let’s put aside the poor performance of some of these strategies in recent years.
Is it rational to invest in them at all?
Dumber and dumberer
In short, I don’t think my definition of a Rational Investor – that is somebody who knows they have no edge – should buy alternative weighted investments as proxies for their market exposure.
By actively deselecting a portion of the market (that is to say buying alternatively weighted index funds with lower exposure to higher growth or larger companies, as in the example above), anyone who does so is implicitly claiming that the money invested in these deselected companies is somehow less informed than they are.
That is a pretty grand statement, and inconsistent with Rational Investing.
In contrast, I think it is probably fair to assume that those investors in high growth or large companies are highly experienced and informed, have read all the relevant books on investing, and are well aware of all aspects of the historical outperformance of various sub-sectors of the markets.
They are not stupid. In fact they are as much a part of the market as the value or smaller company investors are.
Do you really think that the trillions of dollars that follows companies like Google and Apple is somehow poorly informed?
Do you think that you know more about the markets than they do to the extent that you should deselect those stocks?
Expensive to implement
In my view anyone who suggests an alternative weighting to simply tracking the overall market looks a lot more like an active than a passive investor.
Likewise, the implicit cost of the part of the portfolio that diverges from the general index can easily approach the fee level of an actively managed fund.
Suppose an alternative weighted index has an overlap of two-thirds with the wider market, but it costs 0.3% more per year to implement than the market cap weighted tracker.
In this case you are effectively paying 1% per year on the one-third part of your investment that is different from the general market.
That is a fee level akin to some active managers.
An alternative universe
I think that many of these alternative weighted indices are created to match what has had the best historical performance and thus is easiest to sell.
If stocks with high P/E and growth rates had been the best performers over the past however many decades (as indeed they were over the last ten years) then I think the most popular alternative weighted indices would all consist of that market segment. We’d be marketed to with charts outlining all the reasons why the outperformance of expensive growth companies was expected to continue.
We would then be equally guilty of fitting the product to past returns and essentially saying that we had the insight that the future would be like the past.
And I don’t believe we can rationally say that.
Do you have edge or not?
As well as the active deselection of some parts of the market that it implies, my main issue with small company investing has to do with implementation.
Actively implementing a portfolio of smaller companies is very expensive. The trades required to build up the portfolio are subject to large bid/offer spreads and price movements if you trade in any size.
But even if you could pass the hurdle of costs, you are still left with the same question – do you really know enough about the markets to claim edge to the extent that you over-weight these stocks at the expense of other stocks in the market?
What is it that you know that the wider market doesn’t?
Whether you are picking a North American Biotech index, the Belgian index, or an index of commodities stocks, you are essentially claiming edge and an advantage in the market.
That’s no different from if you were tipping Microsoft shares to outperform.
Yet many passive investors who would scorn the ability of the average person to pick stocks will happily debate the pros and cons of these alternatively weighted indices.
I think that’s inconsistent.
Place your bets
Everyone wants a get rich quick scheme, so here is one for fans of alternative weightings.
Buy a fund tracking whatever alternative index you think is sure to outperform and sell short the broader index against it with as much money as you can borrow.
Now wait for the world to prove you right.
This will guarantee you riches, and a constant stream of lackeys from the financial media turning up to write articles about your investing brilliance!
Sounds unlikely?
I agree.
Instead: stick with the broadest and cheapest market.
Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.
So if I am reading this correctly then Lars is suggesting that what has recently been done to the Slow and Steady Portfolio is not Rational?
At the end of year Global Tracker ETF IWRD showed following top country allocations :-
Dec 2014 (PE) [Dec 2009]
USA 58.34% (18.21) [47.77%]
Japan 7.90% (21.35) [9.72%]
UK 7.87% (15.70) [10.30%]
Canada 3.93% [4.83%]
Eurofirst 300 (20.02)
France 3.63% (25.66) [5.24%]
Switzerland 3.52% [3.70%]
Germany 3.45% (17.34) [3.86%]
Australia 2.75% (19.82) [3.97%]
As investors put up the valuations in any particular region the weightings in the global trackers then increase.
Is this logical or do regions mean revert?
Has Lars at some point addressed the issue of overweight Japan 1989 in a global tracker?
Maybe we have to compromise, and just accept weightings whether reasonable or not? and just carry on with IWRD/VWRL as the only sensible option?
Just get this feeling we are following the lemmings.
I agree with the logic of this article but cant bring myself to invest in the US at the moment.
Is it possible to buy a World Tracker excluding just the US?
Three points are relevant here.
In no other walk of life do we allocate resources simply by price using no other measure.
As the Barclays Equity Gilt Study shows us every year dividends are far more important to returns than capital growth. So allocating capital by capital will be sub-optimal. £100 invested in the UK stock market in 1945 would have risen in terms of capital only, i.e. ignoring dividends, to £9,148 by the end of 2014.l With dividends reinvested it would have increased to £179,695.
Finally, the bet. Keynes told us that markets can remains irrational far longer than you can remain solvent.
“Do you really think that the trillions of dollars that follows companies like Google and Apple is somehow poorly informed?” No, but it could be poorly motivated. I can imagine a world where fund managers are scared of not being one of the crowd, of not holding Google and Apple, so that their investment is not a triumph of reason, but a result of abject fear of stepping out of line: dedicated followers of fashion, eh? But if that’s so (if!) does it not make sense to find some alternative tracking technique that is also diversified, also cheap, but less irrational? Why follow the herd over the cliff?
I’m all for people trying out new tracking models: let’s see how they perform. Meantime, I want more income than a global tracker will pay, and I’m frightened of all but short-dated bonds, so what shall I do?
An interesting and pertinent article Lars. I personally, like many here I imagine, am a fan of Vanguard lifestrategy – as lazy as possible. However, I do not like the home bias of their funds. Everytime, I read an article about the Japan crash I shudder.
I know this has occasionally been mentioned on monevator and there are some good articles online explaining the principle. However, I wondered what your personal view would be? Would you tar it with the same brush as other biases, e.g. smart beta?
Open to opinions from others too.
What about bonds? What’s a sensible weighting methodology there? Weighting by total amount of debt doesn’t seem very sound to me…
Hi
I am glad this discussion continues because I find it interesting and relevant. It provides a basis for investing globally and the country proportions using a market capitalisation model.
It sort of implies that the “crowds” know best.
But these “crowds” didn’t see the financial crash of 2008 coming, or plan for the collapse of oil prices. Clever bankers, experts, investors…
Does this alter the argument?
What about risk? Fama said that the premium on small cap stocks was due to the higher levels of risk associated with investing in these companies. So I think one is not claiming ‘edge’ by investing in small caps, but taking more risk which should lead to higher returns. This point seems to be missing from the article.
Don’t really care about trying to be smart enough to beat the world index, and VWRL is after all my largest single ETF holding. But for someone planning to live off the natural yield of my SIPP eventually I echo dearieme. The VWRL dividend yield isn’t high enough, and makes the FTSE 100 and All Share look better, maybe combined with Vanguard’s World High Yield ETF.
Thank you for a great article. I have been a committed passive investor for 20 years so I am broadly in agreement with the article. For what it’s worth I take a home tilt though and a slight smaller company tilt (mainly because of the over concentration of the ftse 100 and s & p 500 indexes).
I would be interested though if Lars could clarify what he thinks about sll the evidence for the value factor though. Do you think it is ‘incorrect’ or just that the costs of trying to access it are prohibitive?
Philip Weston – yes, you can buy world trackers that exclude the U.S. They are generally listed in the U.S. (which has its advantages and disadvantages). Try VXUS on Vanguard’s US Website for starters:
https://personal.vanguard.com/us/funds/snapshot?FundId=3369&FundIntExt=INT#tab=0
Good morning guys,
I wonder why the most favourite world tracker from iShares here is
IWRD (0,5% TER, distributing, only developed countries)
and not one of these two:
SWDA (0,2% TER, accumulating, only developed countries)
SSAC (0,6% TER, accumulating, developed and emerging countries)
SWDA has lowest TER, SSAC covers emerging markets as well.
I want to split my savings between 2 world tracker, from which one is VWRL, and I wonder what to choose from iShares for long terms (on the taxable account, so that’s why I’d prefer accumulating ETF).
Premiums work in the long run. In the very long run and there is no guarantee. I strongly believe Mr. Fama deserved the Nobel prize. There is another Nobel prize winner as an example: Mr. Schiller doesn’t prefer US stocks now. And Mr. Schiller has a very famous friend: Mr. Siegel who…
“anyone who does so is implicitly claiming that the money invested in these deselected companies is somehow less informed than they are.”
I don’t agree with the repeated theme in this article that a tilt strategy or smart beta or whatever implies that you think you are smarter than the market.
The golden rule is more return means more risk. If you tilt to small or value you take more risk (by investing in small unproven companies or in value companies – where value turns out to mean knackered). You would expect to be compensated for that risk by getting more return. Your selection of value stocks from the market universe increases your risk relative to the cap-weighted market. The other investors are not “dumber” than you, they have just implicitly selected less risk. You are not “smarter” you have just taken more risk.
Of course, some would have you believe that some of these tilts are a free lunch and you get more return than the extra risk you are actually taking justifies e.g. that the market consistently under-values value stocks. While that may have been true before Fama/French published their theories, I feel sure that market advantage must have long time disappeared.
The point on cost is the key. I used to have Dimensional Funds through an IFA and while the 0.3% TER was not too bad, the 1% IFA fee made accessing this strategy not cost-effective. At the end of the day, if I want more return I will increase my equity/bond ratio and accept that I am taking more risk.
&helfordpirate. That makes a lot of sense to me. I don’t tilt to value partly because of costs as you say partly because I don’t think I could stay steady during periods of underperformance and partl because the new ishares offering is concentrated in big companies and Japan (from memory)
Helfordpirate said:
if you tilt to small or value you take more risk (by investing in small unproven companies or in value companies – where value turns out to mean knackered)
But the bull market of the last 6 years has rewarded risk as evidenced by the outperformance of the FTSE 250 over the FTSE 100 by 50%. That is partly due to earnings recovery but also because of a revaluation that has resulted in mid caps now being valued at 10 to 25% more highly than the large caps.
A value tilt now means a tilt to large caps, which are less risky.
To return to the question of an “edge”. Maybe I have two. Let me start from the proposition that passive investing is a cheap way of mimicking the weighted-average active investor. My minor “edge” is that I have no need to bust a gut to try to get first quartile performance every quarter – nor to avoid fourth quartile performance. Yet it’s such people’s decisions that the passive investor is eventually mimicking, is it not?
My major “edge” is that I have a better chance than those active managers have – and therefore than the passive manager’s computer has – of understanding the purposes for which I am investing. Not the average global investor – me. Certainly I might be happy to use a global tracker as part of my portfolio – yippee, it’s cheap – but I’m damned if I can see why it would be irrational of me to use other equity assets too.
To show my even-handedness let me add that I don’t currently hold a global tracker but am actively contemplating buying one in one of my pensions – which, unlike my ISAs, is pretty indifferent to dividend yield.
@dearieme. I don’t see why your minor edge is much of an edge? . It enables you to take a longer view than a fund manager and keep down costs but it doesn’t answer the question “why do I have greater knowledge / better judgement than the person selling the stock I am just about to buy”. I can’t see why you major edge is an edge either? Have I misunderstood some subtlety in your point in which case would be interested to understand more.
Hi
Do active fund mangers have or believe they have an edge?
I can’t help but feel that there is a circular argument to this piece. Yes, passive investment is about accepting you have no edge and you shouldn’t try to second guess or beat the market. However, you’ve (presumably) come from a position that the whole market ultimately moves upwards. I don’t invest in the whole of the market on the basis of returning whatever the market does – I invest in it because history has shown (with a LOT of evidence) that investing in whole of market has yielded a reasonable rate of return in the long run.
Hypothetically, what if history had shown that the whole market had proven to remain stagnant overall, and that the returns lay in small cap or value (with the research to back it up)?
I’m not disputing that investing in whole of market is a good idea (given the evidence), simply that we do so because we have history on our side. So if the evidence exists for value or small cap yielding additional risk/return premium, why would you not tilt towards it? Are you saying you know better than the people who have done all the research?
Or put another way: if history and research had proven that investing in the whole market yielded no return, would you still do it?
@moongrazer. For me it would depend what time period you meant by ‘history’. If you mean only 10-2o years I wouldn’t think that was long enough. It isn’t really plausible to me that you would get a consistent segment of the market that had zero returns over the very long-term. The market may not be completely efficient but there it has a certain wisdom over the very long-term, surely? (Ie investors would leave that segment until prices dropped enough to give a return going forward)
I do see secular currency trends as a reason for some home bias in a portfolio by the way. But this doesn’t negate the main point of the article for me at least.
@Passive Investor
I’m talking 200 years of history rather than 10-20, but certainly I feel that the reason we even have this discussion is because history has borne out that the market ultimately moves upwards.
@ Passive Investor
“I do see secular currency trends as a reason for some home bias in a portfolio by the way.”
The currency issue bothers me too and I have no ready answer
Would you kindly expand on your thinking.
All Best
@magneto. Over the long-term currency movements balance out. So the (bad) times when you buy foreign stock when the pound is low are balanced out by two things: good times when you are buying with a high pound and the fact that if the pound is low, dividends denominated in foreign currency are worth more (assuming they aren’t being used to re-invest in foreign stocks) . This means that generally it isn’t worth the expense of hedging currency exposure to equities (this isn’t the case for foreign bond exposure which according to Vanguard at least is better hedged).
My concern about this is that the long-term isnt entirely relevant in the 5-10 years before and at the beginning of the retirement draw down period. It would be a serious problem if the pound was significantly higher during this period than it had been during the previous period of investment accumulation. I see it as a source of risk that I want to manage by having a significant home bias to my equity investments.
@Passive Investor
Many thanks for the response.
We are in mid retirement with 1/3rd stocks domestic.
Constantly re-thinking this aspect in regard to Lars’ and other opinions.
Maybe after all we are not distorting allocations unduly but aiming for a sensible compromise.
Fully realise that there can never be an optimum domestic allocation determined in advance.
Humility in the face of Uncertainty
Thanks again, something to chew on.
@magneto. As you say humility in the face of uncertainty. In the scheme of things the fine tuning between domestic / foreign / emerging / small / value doesn’t really matter at all. What does really really matter is keeping costs down, managing risk (ie having a significant allocation to bonds / cash), and managing your own psychology so as not to panic in a down turn. Like so many things in life, easy to say and difficult to do…..
A very persuasive post, thanks.
Although Keynes may have said that the market can remain irrational for longer than you can remain solvent, I would suggest that markets can remain irrational far longer than you can remain rational.
It is all about the rational/irrational relationship, maybe even inversely so. We are living with an unknowable, unpredictable and volatile beast that is the market. That would seemingly be the irrational party. But we know that individuals (even in Hounslow) can and do manipulate it. That demands a degree of predictability. Maybe we are the irrational ones living and loving this great ‘beast’, pouring our hard earned money into its greedy jaws hoping for a golden egg to appear from its rear end in time. How rational is that?
In one of Kipling’s Plain Tales from the Hills there is a line that
“any woman can manage a clever man, but it takes a very clever woman to manage a fool”. We have to be rational to manage this crazy relationship, or are we the fools being managed by our own monstrous creation?
Morning Mk
The actual RK words are, “Take my word for it, the silliest woman can manage a clever man; but it needs a very clever woman to manage a fool”. – Wikisource
My old English teacher would have winced at what he would have felt was an unnecessary semi-colon, and I wonder what kind of woman would be able to manage a motley fool?!
I hold Vanguard All World in combination with Vanguard All World High Yield in a ratio of roughly 2 parts to 1. My thinking is along the lines that the High Yield ( the index methodology is a blend of yield and market cap) has a value bias but holds back on companies and thus markets with below average yield and looking back to a 1989 situation of the tech crash when we had 100+ P/E companies and markets it would have eliminated them from one third of the portfolio.
I don’t have any edge to call the irrational markets but we may well have an inkling and this method at least caps any such problems and I can resist the temptation to “do something” knowing I have a method that limits the perceived market irrationality.
A mild home bias to the UK can be justified that the currency represents my liabilities, it’s much cheaper the uk trackers are around 15+ bps cheaper on management ( VWRL vs VMID and ISF) and one avoids the 25 bps withholding taxes on VWRL on the income side and of course as individuals we can do what we like if we are happy that the combination works and it avoids tinkering, over trading and related costs.
@ Lars – there’s a large body of research that shows that tilting towards certain companies has beaten the broader market over time, geography and asset classes.
Explanations for the higher expected returns include a bigger risk premium for accepting the perils of investing in riskier companies and ongoing biases in human behaviour that cause investors to overpay for certain glamorous companies.
It’s not irrational or arrogant to acknowledge this research. As Helford Pirate says you’re accepting greater risk in order to achieve greater return.
It does seem irrational to me to believe that these styles of investing will outperform in the future just because they have in the past. Or that they won’t nose dive for a hideously long time and break your commitment to them. Or that heavily marketed Smart Beta products are the best way to capture these returns.
Like a chainsaw or a Hobbit’s ring these are tools best wielded with care.
@Topman Yes it’s been a while since I dusted off my old Kipling books, thanks! Although Kipling wasn’t all that popular when I was at school, my dad always read me his stories and then I happened to spend a couple of years at an old Raj hill station, so I had a bit more local understanding and plenty more time to read!
As for managing a motley fool, I should think Lady Fortune would do a good job : )
@Minikins
Just so!
@kamil. Unfortunately the tax treatment of accumulation and income units is identical. The income from accumulation units has to declared as such despite the fact it is rolled up in the fund. There is a clear explanation on the HMRC website. I thought the same as you until my accountant brought me up to speed a few years ago. The one useful thing you can do of course is to have higher income generating assets in the tax shelter and more growth orientated assets outside the shelter.
I’m just learning about investment and have a very new and ‘modest’ portfolio put together over the last year. I started off, and am still drawn to passive investing becuase I don’t think I can beat the market and the costs of active funds seem to outweight possible beneifts. I have passive as a core with some actively managed funds where I believe there is value to them (i.e. not excesivly priced and with good track record of above index returns over 5 years).
But the more research I do and the more I educate myself, the more I am finding myself questioning the whole thing at a very fundemental level.
Perhaps you will all smile at my naievity but if passive products are tracking the market then are they not following what active investors decide to invest in? And in my year of getting to grips with equity markets it seems to me a lot of investment is based on an assumption that the value of markets will go up (doh – of course I hear you say!).
Deep down this seems dangerous to me and is akin to basing wealth generation on the assumption that people in the future will just value equities higher than we do now. Surely the basis for investing in a business is that it offers physical growth, sustainability, real returns for investors in the form of dividends from profit, and not just that its share price will go up. It offers something tangible.
Sorry not even sure what the point of my rambling post is other than to say funds allow me to diversify risk which I could not do if I invested in individual shares. However I worry that my future pension is based on an an idea that ‘markets just go up over time’. From what I can see in hsitoric data of FTSE all-share thats only really true since the 1980’s. I for one would feel much more comfortable investing in something more tangible.
@Kris — These are very sensible questions that a new investor should be asking. Your reading of the data is a bit off, however — the long-term (100 years or so) *real* return (i.e. after inflation return) from the UK stock market is about 5%, so it’s not just a post-1980s return. A few countries have done better, more have done worse, and we can’t know which will do better/worse in the future, hence most think it prudent to diversify internationally.
Regarding your fundamental questions you raise, try reading these two pieces, in this order:
http://monevator.com/is-investing-a-zero-sum-game/
http://monevator.com/is-active-investing-a-zero-sum-game/
Hope this helps! 🙂
Kris the basis for people paying more for buisnesses in the future is indeed based on growth and profits increasing in the future. The amount people value those profits fluctuates over time and is somewhat higher now than in the early eighties.
However the basis for hoping that equity prices will go up over the long term is based on the rationale and historically observed experience that businesses pay out part of their profits in dividends but the rest they reinvest in the buisness so that the business can grow and increase its profits in the future. Whereas there are many hiccoughs on an individual company basis this has been the broad experience for equity markets as a whole.
I would by the way ignore the observation that the majority of equity returns come from dividends, this is a linguistic distortion of the genuine finding that without reinvesting your dividends you lose most of the potential total return. The return historically has come roughly equally from dividends and growth. You need the growth both to increase the dividends and to make the reinvested dividends worth more than they were when issued.
@kris. Others can probably answer your questions better than me. Very briefly though, it isn’t investing in the market as a whole that is the zero sum game but trying to beat the market that is zero sum. For every investor who buys a stock there has to be seller. The market is just the sum total of millions of transactions. You are certainly right to believe that as a private investor you can’t (except by luck) expect to beat the market. If you think you can, ask yourself why your judgement / knowledge is superior to that of professional investors who spend their lives analysing companies. (And half of them won’t beat the market either of course).
There is loads out there about the source of returns from equities. The best analysis draws a distinction between speculative returns (the bit you are worried about that comes from short-term investor confidence) and investment returns (dividends and earnings growth). In the short-term speculative returns can dominate but over longer and longer terms they get cancelled out and it is investment returns which matter. Investment returns arise from companies creating wealth and this fundamental source of return is the reason for investing (rather than gambling). This idea is described in a well known quote from legendary value investor Ben Graham who said that “over the short-term the stock market is a voting machine but in the long-term it is a weighing machine”.
There is probably lots of good stuff on Monevator but I also learnt a lot from “The little book of commonsense investing” by John Bogle and the Vanguard website (both US and UK sites have excellent stuff on this and historical returns). Other tips are Tim Hale “Smarter Investing” and anything by Rick Ferri or William Bernstein.
PS I get quite evangelical about this as for the first five years of my investing career I was sucked in by tips from newspapers and I always bought “last year’s best fund”. I could never understand why this didn’t produce the excess returns I expected. By chance I was then lucky enough to come across passive investing around the time that Virgin introduced the first (as it happens now very expensive) index fund to the UK in 1995.
What brilliant comments 😀
@Grand “What brilliant comments :D”
I agree!
Is there any way of subscribing to the comments even when you haven’t made one? I often don’t have anything to add personally but like to see what other people are saying.
@passive, Virgin were not the first to launch a tracker in the UK. I was invested in L&G trackers before Virgin came along. Virgin were always more expensive than others as well. Someone once said that no-one ever lost money by underestimating the intelligence of the general public…
@Uncertain, I totally agree with your comment about spurious claims that the majority of equity returns come from dividends. Such claims are either based on a misunderstanding of the historical record or pure marketing spin trying to persuade investors to put their money into active or “smart” beta funds.
Regarding value/small caps or whatever else has historically beaten the market – these historical facts are now known by active investors and so it is not unreasonable to assume that this information will be taken into consideration in setting current market prices. In future small caps, which may be more risky overall than large caps may beat the overall market. But that cannot be guaranteed, otherwise it would not be a risk and buying small caps whilst shorting large caps would be a source of risk free returns.
@ The Investor / Uncertain / Passive Investor
Thanks for your thoughts and the extra material to read. I’ve read the links to the zero game posts and its very enlightening. I’ll look over some of the other mentioned reading.
My biggest concern in my short investing career is that the market turns out to be made up of speculation, hype and overconfidence like some giant bubble waiting to burst over 20 years. And of course I guess this does happen hence ‘market corrections’?
Nice to be reminded there is some substance behind it all and wealth is being generated by something tangible!
My first 6 months of investing I bought active funds before I discovered ETF’s and passive investing. Cant ditch the actives just yet because of trading costs and they are doing well. However for the last 6 months its been passives all the way and am slowly rebalancing.
Oh well onwards with the learning 🙂
Kris I am not against all active funds and have a few myself (mainly IT’s)
However I would point out that if you are planning for the long term trading costs will be swamped by ongoing fees and if you are thinking of changing from active to passive the sooner the better from an overall cost point of view. (Assuming you haven’t got either big capital gains or a lock in period with higher withdrawal costs)
@ naeclue. My mistake as you say L&G, HSBC and others introduced tracker funds in 1989 – early 90’s ahead of Virgin by 5 years or so.
http://www.moneymarketing.co.uk/journals/2012/08/03/w/q/w/defaqtopassiveinvestingguide_july2012.pdf
@Naeclue – “….. no-one ever lost money by underestimating the intelligence of the general public…”
Often wrongly paraphrased, it was in fact H. L. Mencken, writing in the Chicago Tribune on 19 September 1926, who said, “No one in this world, so far as I know – and I have researched the records for years, and employed agents to help me – has ever lost money by underestimating the intelligence of the great masses of the plain people”. – Wikiquote.
Without wishing to stray OT, suffice it to say that there many other superb Mencken quotes there, of which one of my favourites is, “Shave a gorilla and it would be almost impossible, at twenty paces, to distinguish him from a heavyweight champion of the world. Skin a chimpanzee, and it would take an autopsy to prove he was not a theologian”.
By coincidence, I was thinking of investing this year’s ISA in a smaller company ETF, on the basis that all my existing ETFs track large/mid sized companies. I also wanted to use a different broker to my current ISA, and a different ETF provider, in order to spread risk around FSCS limits.
So I looked at my bank’s stocks & shares ISA and asked them why they don’t trade the ETF I was considering. Their response is ‘some ETFs have been classified as complicated and … resulted in us no longer offering them’. They also no longer trade any ETCs, as they are all classified as complex.
Perhaps they’ve been reading Lars’ book.
My current ISA platform and my SIPP platform will happily let me trade in the ETCs and ETFs that my bank won’t. Not sure what message to take from this, other than that I should re-read Lars’ post and book and remember that I don’t have an edge.
sorry it has taken me so long to respond (I’ve been away). I generally agree with the comments. Just to respond to one from @Passive Investor re risk premium, I’ve not explained myself well enough; there is no doubt that certain segments of the market (small cap, etc.) have performed better over the past while, and they were part of the reason for the article. I’d also agree that some of those sectors you would ascribe a higher expected return to than the overall market (small caps an obvious example), albeit at a higher expected level of risk. It is of course no surprise when those segments then often do worse than the overall market in a 2008 scenario (side note: remember the endless number of hedge funds who claimed to be market neutral (i.e. dollar neutral), but still performed extremely poorly because they were long a bunch of small cap names and short an index of large caps against it).
My point is more that on a risk adjusted basis there is no expected out-performance from the smaller stocks as you can expect the market to re-allocate to the small cap (or other segments) if there was. So unless you want more risk in your equity portfolio than that offered by the overall market (and you can’t/won’t/shouldn’t do it via gearing) you are still better off getting your equity exposure via the overall market, instead of trying to do a mix of various segments other than what is already implied by the market. Part of the reason for this is add’l trading and admin costs, but expenses are also likely to be higher (part of the point of the article) which will matter in the long run. So instead of doing a mix of say 50% bonds / 40% overall equity market / 10% risky equity market I would argue you are better off doing say 45% bond / 55% overall equity market (or whatever that ratio will be in the specific case).
In the case where you want more risk from equities (for whatever reason really) than implied by the equity market, and can’t get it via gearing it could make sense to invest part of your portfolio in these high beta segments (like small caps, etc.). But in my view it is really in lieu of getting gearing (and perhaps cheaper), and not because you believe that those segments will perform better on a risk adjusted basis. If you thought you could consistently predict that they could you should start a hedge fund:
1. Buy those segments
2. Shot the overall market
3. Adjust sizing to be risk neutral
4. Get all the gearing you can get your hands on, and get rich.
I know this is not what you are saying obviously, and actually think we fully agree with each other.
Sorry I’m being long winded. This is probably as clear as mud.
On another note I’ve decided to be better about Twitter. Does anyone on this forum know a lot about it and have 5 minutes to spare? Thanks in advance.
@Lars That mainly makes good sense. A couple of quick points:
You write :
My point is more that on a risk adjusted basis there is no expected out-performance from the smaller stocks as you can expect the market to re-allocate to the small cap (or other segments) if there was.
Are you making the stronger statement that the empirical data show no risk-adjusted out-performance (which is contrary to my previous understanding)? Or are you just saying that there shouldn’t be any risk-adjusted out performance because markets are efficient enough to erode it over time?
The point about taking more (or less) risk by adjusting bond:equity allocation was very interesting and makes a lot of sense. This is approach is certainly a cost effective way of managing a portfolio.
I still worry about over-concentration of ultra large cap companies in the FTSE All-share (and to a lesser extent in S & P 500) and see that as a reason to tilt a little to mid and small caps. I suppose it doesn’t make sense in term of managing risk as assessed by volatility but perhaps it does against tail-risks (eg significant underperformance of HSBC or Shell).
Thanks anyway for an interesting article and comment
I still worry about over-concentration of ultra large cap companies in the FTSE All-share (and to a lesser extent in S & P 500) and see that as a reason to tilt a little to mid and small caps.
That is what everyone else does too which is why the big caps are chepaer than the others.
I know nobody here but I’m sure most of us will regret to be too bold, “smart” and not follow the brutal simple advice of Lars. I hope I will be the exception that proves the rule:)
Hi @Passive Investor
Agree with you that there is overwhelming evidence that this (like many other) sector has outperformed in the past. But in my view that we can’t conclude from that that this would be the case going forward. If life was only that easy – we could buy what has outperformed in the past. But many, many things have systematically outperformed since the start of stock markets, and many billions of dollars with huge and complex computer systems look to see if those anomalies can drive performance going forward. Perhaps they can, but it is a massive claim of having an edge over the markets which I think is unrealistic for most people. I think we as individuals are hugely guilty of recency and finding patterns where none necessarily exist, but that is another issue.
I agree with you that sometimes this almost blindly following the market means that you do things that sit oddly with you, like weighting companies/sectors/countries that you are not crazy about highly (yes – you would indirectly buy more Apple after it has gone up massively). But besides being an expensive headache to de-select those things it also implies an edge over the market.
Sorry to be long-winded again. It’s funny that less than 5 minutes ago I was asked to comment on the relative merits of two different hedge fund strategies. I’m feeling slightly bipolar…
@Lars. Thanks I basically agree with you. Although it’s interesting to discuss fine tuning an investment strategy / portfolio construction it isn’t the main point. Keeping costs right down with a cheap broad-based tracker, avoiding market timing and having an appropriate proportion of bonds is pretty much all its about.
It is interesting to compare the ‘average’ investment trust to a global index and this can be done here http://www.theaic.co.uk/aic/statistics/aic-stats
Select the relevant month and there is a set of size weighted average performance figures of different sectors, I believe the NAV performance is most useful and the gearing is shown and also the overall average performance.
A set of indices are shown below the Investment Trust performance table including The FTSE All World tracker, whilst the trust performance figures are net of charges, the 10% or so typical level of gearing will roughly equal the low charges of a good ETF.
Whilst at a sector level there are always some examples of exceptionally good and poor performance, the overall average is pretty similar to a Global Tracker by and large which supports the hypothesis that the Global Index approach is going to be good enough for most investors.
@hariseldon. I hadn’t seen the AIC website before. It looks like a great resource for IT enthusiasts. . I am much more sceptical of the benefits of Investment Trusts than some of the people who comment here though.
In some respects certainly they are better than open-ended funds (eg lower ocr, very long history of consistent dividends in some cases).
Negatives are gearing and discounts to nav which add volatility. The OCR doesn’t include quite a lot of expenses involved in trading. So even a fund with an OCR figure of say 0.7 % is likely to have an additional o.5% of hidden costs which drag on performance. It is virtually impossible to compare risk adjusted performance with any particular index. On an individual fund level the fact that managers will inevitably vary the proportion of their holdings in different sectors makes a fair comparison impossible. On a group level (ie comparing all the funds in a sector with an index) there is no practicable way to take account of survivorship bias.
Could we argue that, adding a global small cap index fund alongside our world equity index fund would be a worthy addition.
After all the market capped index is very heavily weighted towards the biggest companies (even if there share prices drop somewhat). We cant know small caps will under perform large caps. Would the ultimate passive fund be an equally weighted index?
@newbie — Well, that’s the essence of the debate as outlined above. Lars believes you should just hold global market cap weighted index — that is the ultimate expression of how people have bet their dollars/pounds/rubles, whatever, and he argues that as you have no reason to believe you’re smarter than them you should not deviate from that.
In contrast, those who overweight say small caps or value shares or quality shares or what not point to historical evidence that (for some reason) these tranches have outperformed in the past as suggesting they might in the future. Lars argues that you can’t make that leap. It’s up to you to make your own mind up — you’ll find people who call themselves passive investors on both sides of the fence (and sitting on it!)
Equal weight isn’t ultimately passive because you’re asserting that you know that, say, the market cap of a giant like Apple is too large versus a smaller company that you are allocating more money towards.
Note that equal weight has done better than market weight in recent history. That’s said to be down to the small cap effect mentioned above.
Hope that clears up some of the confusion. 🙂 The best I can suggest is that you keep reading around the site, as we can’t really restate all these things every time someone asks unfortunately, just for sheer workload reasons. 🙂 It’s all here though.
@The Investor & newbie — “I was actually going to call the book The EDGELESS INVESTOR, because that’s what I really think the book is about, but the publisher disagreed and thought that has negative connotations — the idea that you’re without something — so this was our compromise.r” Lars Kroijer http://www.fool.co.uk/investing/company-comment/2013/11/05/trancript-the-edge-less-investor/
A knowledge edge is very rare, but you might well have an edge over the market in regards to risk tolerance, tax treatment, being allowed to not act in a crash. Even humility is an edge in itself, as is flexibility over retirement and even enjoying the job you do
I think the lifestrategy approach is right – only bias to home and only within limits just to control risk more than anything, to control behaviour even if it is at a cost to returns. Bear in mind that Americans use home bias too and we’re not partially American – the market is skewing because the American market is big and they want a home bias, not entirely on the basis of profitability
It was almost a religious epiphany when I first read Monevator and also Lars book and articles. Not only is it blindingly obvious and rational, once the logic and evidence is read and understood, it chimes with most individual investors’ experience. Most active managers don’t beat their index, how can someone with even less advantage? There’s some good articles on theitnvestor.co.uk analysing whether ITs do any better. That the vast majority of money in markets is that of active fund management, what do we know they don’t. Looking at my past failed investing gambling, I was a ready convert. Even when I moved into top-tipped/recommended funds, whatever their sector, I found many underperformed a world tracker. And we can’t predict the future outperformers and for how long/when to market time a jump ship. I’m happy to get the world market return, rather than paying a fund manager for a c.1/3 chance they’ll beat their index, at a higher cost. Still have some active choices but in full knowledge it’s an additional gamble beyond the risk inherent in long term equity investment. Eg who knows whether the Nasdaq and SMT will continue their incredible market performance and for how long.
A global equities index tracker and a global bond index tracker hedged to the Pound did it for me
75-17 years retd
xxd09
@Tony – yes I would say I’m in a similar position – I buy the arguments in favour of passive trackers – and maybe a little home bias, although in the UK that doesnt feel vital at the moment. So a lot of my retirement money is in trackers.
But with some of it I do dabble with individual equities (some of which are as simple buy and hold quasi index trackers) and also with trying to pick investment managers who I think have some enduring actual repeatable skill, reflected in outperformance relative to benchmarks and risk. I know I have little or no edge as a stick picker, beyond a simple aversion to two or three sectors that I think have a long history of offering poor odds, but I might do ok as a longterm fund manager picker.
The catch is that my picking needs to be bold and good to move the needle. if the chosen funds get 30% of the portfolio, and they average a 10% pa outperformance before fees (say 0.75%) declared costs (0.2%), spreads and other hidden costs (0.3%), and my platform and dealing etc costs (0.1% pa), then that bumps up the annual rate of return by 2.5%pa (eg up from 5%pa to 7.5%pa). And that is about as good as it can get. if the chosen funds underperform by 10%, then my returns drop by 3.5% (from 5% to 1.5%).
So even with this quite high level of prospective deviation from the index, I need odds of about two to one in my favour in order for this to be a good bet. Not many funds or managers measure up.
Doesnt stop me trying…
I have a bunch of regional trackers that approximate the FTSE World index by weight, as historically that has been cheaper than buying a world tracker. I did buy the Vanguard Developed World markets ETF earlier this year though as its TER has dropped to only 0.12% and if I was starting from scratch now I think I would go for a world tracker as suggested (or probably a developed world fund and an EM fund). It is just much simpler to deal with and for some inexplicable reason, I have noticed that a bunch of regional trackers gradually drift from World Index weightings over time.
I also hold some US listed small cap ETFs, a US low volatility ETF and a US REITs ETF. Thankfully all US listed with low TERs, but again, I don’t think I would bother with any of them if I was starting now. Retail investors are not allowed to buy US listed ETFs any more anyway. Lars is right. Keep it simple and buy a world tracker.
@David R, Reading your post, I thought you were almost talking yourself out of gambling towards the end!
All the evidence suggest that over the long haul you are highly unlikely to be able to add any value by picking actively managed funds, so why take on bets when the odds are so heavily stacked against you?
My bets on small caps and US REITs didn’t pay off (have not up until now anyway), although I could not quantify the underperformance of my portfolio as a result. The low vol ETF bet has worked in terms of risk adjusted return, but not outright return.
Does this mean one shouldnt invest in a global smaller companies tracker? At the moment my split is al vanguard -60% global all caps, 20% global smaller companies, 20% Emerging markets (though Im thinking of going with L&G emerging markets index tracker on this one)
In my mind it is wrong to characterise an investment strategy as either passive or active. Even the most passive of strategies requires some (pro)activity. Take the suggestion above that all you need is one global tracker. Yes but which one? SWWA which tracks MSCI World has a 67% weighting to the US. Another very popular tracker, VWRL which tracks FTSE All World has 57%. The former has a 0% weighting to China, the latter 6%. Immediately our passive investor is faced with what could be considered an important choice and arguably needs an edge to decide which is the best index.
Take another passive investors favourite, LifeStrategy funds. In its blurb Vanguard states: “The Fund is actively managed in that the Investment Adviser has discretion in respect of the Associated Schemes in which the Fund may invest and the allocations to them”. So passive for the investor maybe but active management nevertheless.
Possibly none of these above examples of the choices facing the ‘passive’ investor are going to make a massive difference in the long run and are almost certainly going to matter less than the equity/bond mix. Therefore I personally don’t see that allocating part of ones portfolio towards small cap/ value / income / property etc does represent a drift away from passive investing methodology. For me passive investing is all about following a few basic rules which this website has taught us:
1 Understand that investing is for the long term
2 Decide on your asset split and stick with it
3 Rebalance annually (or quarterly if you must)
4 Keep costs low
My question to Lars would be, do you still hold to the view that the low risk part of the investment should be a government bond fund? As opposed to cash, for example?
Is the Vanguard FTSE Global All Cap Index Fund better than the Lifestrategy Funds?
Is the Vanguard Global Bond Index Fund Hedged, better than a UK only bond index fund?
Any views would be welcomed.
Thanks
Metro
@metro. Firstly I’m no expert (who really is). Some thoughts.
I personally prefer (and hold) the All Cap fund. It will always follow the FTSE world index by country weight. I can’t and won’t make micro calls on country weighting. Completely agree with Lars.
As for LifeStrategy, there’s an argument that says the equity is too UK focused even though 78% of the FTSE 100 revenues (which make up most the UK All Share index) come from outside the UK. Personally I don’t see the UK index as a growth area and wouldn’t want to hold more than it’s FTSE weighting. Historically it’s been more dividend paying. Until recently this has been OK – but look what’s happened this year.
With respect to the Bond fund, going global can help diversify risk but you will hold corporate bonds in the Vanguard fund highlighted. This will help the return but also import risk. Worth remembering that bonds and equities haven’t always been negatively correlated….
When you next go to Vanguard’s website, click on the drop down menu top right where it says ‘Personal Investors’ and select ‘Financial Advisers’. There’s an abundance of information in there about the benefits of going global, hedging currency, etc.
Hope this helps.
@Naeclue
I also started with L&G trackers back in the mid-1990s; 2-3% annual fee as I recall – cheap at the time – and no initial charge either… :-O
Passive investors today don’t realise how lucky they are!
@David Kennedy, I never paid 2-3% for a tracker fund. The L&G tracker funds cost me between 0.25-1.0%, depending on the region. There was also an up-front fee of 5%, but there were ways of avoiding this. For example, if you bought direct from L&G they often discounted this charge, only charging if you sold within 5 years. You could also get cashbacks from brokers, which were banned in the RDR. If you went direct, sometimes L&G would even not charge the first year’s fees either, even for ISAs/PEPs. It was of course perfectly possible to pay 2-3% by choosing a shark for a broker.
Hello,
Firstly thank you for your newsletter. It has really been a source of valuable information to me.
I was wondering, when buying index fund I know that it is better to do dividend reinvested. But since it is important to rebalance your portfolio regularly, then wouldn’t it make sense to use the dividends of a passive income to do that?
Don’t let perfect be the enemy of good enough. VWRL is good enough.
The issue here is quite simple.
Once you have decided to remove specific, i.e. stock, risk by buying the whole index and thus only having systematic, i.e. market, risk the question is how do you weight the portfolio.
Conventional trackers simply use mkt cap; in other words how popular is that company. Nothing to do with its profitability.
The problem we have today is that we have free money from the central banks being allocated on the basis of not much more than mass voting by the uninformed that makes TV talent shows look intelligent.
@Marco yes there’s VWRL (inc) but also VWRP (acc). Latter saves the bother or investor default in (not) reinvesting the dividends. I think the only reason accumulating phase investors would prefer the former is surely not knowing about the latter and/or the former being much bigger and so probably attracting more trading volume.
@Sybille — We’ve done a big series on rebalancing, which touches on these issues:
https://monevator.com/series/how-to-rebalance-your-portfolio/
(Click ‘previous posts’ at the bottom of that list to see more in the series)
Actually, it’s not important to rebalance ‘regularly’, or at least not often if that’s what you’re implying. Studies show some rebalancing is important, but it doesn’t make a huge difference how often you do it (monthly, quarterly, annually, every two years etc). Yes, one study will show one is better than another but it’s all much of a muchness, especially after costs.
Rationally I agree with Lars, and have bought two copies of his book to prove my credentials ( gave one away). While I have a fair chunk of global trackers, bond and equity, my transactions this year have been to buy Brunner, Emerging market tracker, china growth fund ( not bg), emerging market bond fund, Japanese smaller company fund.
Bit of a gap between theory and practice.
Having read this article I wondered about my behaviour and reckon it’s partly a device to give me a feeling of active participation in my own future, and partly a go at market timing in disguise.
After all, adding weight to Japanese smaller companies now doesn’t really mean I believe they will always confer an advantage over neutral market weight, but it must mean I think there may be an advantage in the shorter term.
Since I am slack at monitoring performance, and don’t baseline, I will never be forced to face up to my mistakes .
@MrOptimistic, surrounded by temptation it is difficult to remain pure and rational, as we are not rational beings. I have been looking at value factor ETFs recently…
@A Betta Investor, the market is cap weighted. If you don’t weight by market cap, you would have to make an active choice as to how to weight. How could someone without an edge, or a recognition that they have no edge, go about choosing a better weight than the market?
In addition to the how to choose the weights problem, any weighting scheme other than market weight costs more in management charges and more in rebalancing. These additional costs put any non-market cap weighting at an immediate disadvantage. I have been looking at value ETFs, but I have this issue constantly at the back of my mind.
Some insight into the additional costs can be obtained from this Vanguard document https://www.vanguardinvestor.co.uk/content/documents/legal/vanguard-full-fund-costs-and-charges.pdf
Comparing Vanguard Global Value Factor ETF to Vanguard FTSE Developed World ETF (a cap weighted tracker), shows a 0.11% higher ongoing cost and 0.09% higher transaction costs. Other weighting schemes, such as momentum and low volatility have even higher transaction costs. So the Value ETF would need to generate at least 0.2% more than cap weighting over the long term just to keep up. The Vanguard Global Value Factor ETF is the lowest cost value ETF I could find, but I found out today that Vanguard are going to wind it up because it failed to achieve sufficient scale!. The next viable alternative is iShares Edge MSCI World Value Factor. It is a large fund so hopefully would have lower risk of being wound up, but it has an even higher ongoing charge of 0.30%, so would need to generate 0.27% more than the basic Vanguard tracker just to keep up, assuming the iShares ETF has similar transaction costs to the Vanguard Value ETF.
Sorry, the transaction charges of the Vanguard Global Value Factor ETF are 0.07% more than those of the Vanguard FTSE Developed World ETF, not 0.09% as I stated above.
Nae clue,
Weighting by mkt cap is just as much an active choice as any other measure. You are simply using price rather than say, revenue, profits, book value or whatever other measure of a company you might prefer. Selecting that measure is a conscious decision.
Bogle only used it to start with because he was not allowed to do anything else with the funds he managed to hang on to after he was fired by Wellington. He did not select that measure after an exhaustive analysis of all the alternatives.
We are all familiar with the phrase that someone knows the price of everything and the value of nothing. In some ways that sums up what cap weighted trackers represent, the price of everything but no concept of value.
Yet in every other path of life price is only one factor used when we make buying decisions. Why are other measures not relevant when we buy companies?
What happens in practice is that allocating capital by price means that more and more capital is assigned to the assets that command the highest price which surely makes no sense.
In practice we look for what bang we get for our buck when buying houses, car or groceries, price is never the sole determinant. Companies are no different.
A betta investor
JB on market cap-weighted indexing: “Since such an index beats the heck out of money managers, what kind of trouble would it be if there were a perfect index?” He continues: ” . . . will a value-weighted index do better? will dividend-weighted index do better? Probably it will do better some of the times. I do not believe it will do better in the long-run. That remains to be seen. But when you think about it, if let’s say fundamental-indexing—whatever that means exactly, but a weighting by some company corporation data rather than by market price—still owns essentially all the stocks that the S&P 500 owns but with somewhat different weights—not huge, but somewhat different weights—so they may do better, they may do worse. But if they continue to do better, well what will happen? Everybody will take their money out of the market-weighted index and put it into the value-weighted index and then the opportunity will vanish. That’s the way the markets work. I don’t think it’s going to work. And I don’t think that it’s worthwhile to add that risk.”
@A Betta Investor. “Weighting by mkt cap is just as much an active choice as any other measure.”
No it isn’t. Weighting by market cap is what the market does. Market cap weighting is not an active choice it is THE passive choice. Any movement away from market weighting is an active choice.
We could get into a detailed epistomoligical argument about that, but a decision not to take a decision is, in fact, a decision.
@Robert Davies, I am not saying investing passively in a cap weighted tracker is an absence of a decision. It absolutely is a decision to do that.
What I am saying is that investing in a cap weighted tracker is not an ACTIVE choice. It is a PASSIVE one. Investing in a cap weighted tracker is the one and only passive choice.
I’m a relatively new investor. Given the current situation in markets, the US in particular with some current valuations, I think it makes perfect sense to have at least a small tilt away from market cap weightings. My only investments have been global trackers across my workplace pension, my SIPP and also my ISA for spare change but I feel very uneasy at the moment so have given my new payments a 10% tilt away from the US across all other geographical areas. I’m also keeping a larger portion of cash instead of all bonds for the same reason.
I agree with some of the comments above that it doesn’t seem to make much sense to keep ploughing the majority of my monthly payments into the already very expensive companies at the top of the market caps. I don’t feel I’m claiming an edge here, I may achieve less than market average and I accept that but it is what makes sense in my gut and it is helping me sleep better.
I guess I just don’t see the point of paying the current prices which are taking into account the next what, 20 years of growth already?