Re: index tracker funds
We have two distinct themes here:
1)Market timing and past performance
2)Fees and charges for investments
1)My answer to market timing as an investment strategy is simple. I have never met anyone with a crystal ball! To benefit from attempting to time the market, you need to be correct three times – getting in, getting out and getting back in again. I’ve never met anyone who can do this and even if I did, I would have no way of knowing if their view was luck or skill.
An easier way to look at it is like this; all investors in aggregate make up the market and therefore the rational position for any investor is to aim for the average market return. Why would anyone believe that they possess skill, information or insights in excess of the sum of all other investors in the market and are therefore entitled to obtain a higher return than the average?
Obviously some investors, by definition, will obtain an above average return but no more than we would expect to occur by chance and there is no evidence in the academic literature to support persistence in this performance, supporting the widely held view that luck has more of a part to play than skill. Equally, even if there was an element of skill, we have no idea how we would identify in advance who these people might be i.e. how would you decide to back Peter Lynch at Fidelity in the year 1977?
Past performance as a guide to the future
Again there are two distinct issues to consider here:
Is past performance a guide to the future? If we relate this back to my point about persistency of fund manager performance then the answer is clearly no.
However, when we are talking about the structural relationship between risk and return then the answer is yes, history does offer important insights into the relationship between risk and return over time.
For example as an investor I can expect to be rewarded over time with a higher return from an investment in the stock market compared to an investment in government bonds. The explanation for this is to do with the expected return on capital. Shares are more risky and therefore I expect a higher return for an investment in shares – otherwise why would I take the risk? This is true at anytime, today, yesterday and tomorrow.
Again, all shares have to be held in aggregate and therefore for every seller there is a buyer. If you think shares are going down and you sell, somebody must be taking the other side of the trade. Recent falls in the prices of stocks around the world fully reflect the additional risks associated with the credit crunch and global slowdown. The current price of stocks right now is the fair market price as set by the interaction of all these opinions in the world and all the independent buying and selling decisions.
If I buy today, the price I pay to own stocks today is the compensation for taking on the risk of owning stocks. However, I still expect a positive return over the long term. There is nothing special about current market conditions that would lead me to any other conclusion since all the information is available to everyone and the sum of all opinions is the current market price for the stocks I buy.
As an example let’s consider an investment in the US stock market around the time of the Great Crash of 1929. Logically, if market timing works and given the benefit of hindsight we have from our vantage point in history, one might rationally conclude that an investment made after the Crash should offer the best returns – surely that is the point of attempting to time the market.
The total return of the US Stock market up to end December 1950 was as follows:
January 1928 – December 1950 280.62%
January 1929 – December 1950 174.11%
January 1930 – December 1950 220.79%
January 1937 – December 1950 178.46%
Source: Data provided by the Centre for Research in Securities Prices, University of Chicago
Who would have thought to make an investment ahead of the Crash for the highest overall return? My conclusion is that a market timer is much more likely to be sat on the sidelines waiting for a “clear” signal that the market has turned. Some might even wait for years in our example perhaps until 1937 and still end up with an overall return only marginally better than if they had just bought and held in January 1929 the year of the Crash itself.
Where we use empirical evidence to increase our understanding of the relationship between risk and reward in markets, then past performance can be a useful guide.
2)Fees and charges
My original post was to do with the hidden costs associated with active fund managers. The vast majority of retail financial services products sold to the unsuspecting public are of this type and consequently I feel that a discussion of this subject is long overdue on askaboutmoney.com
However, there are some posters who clearly have a more detailed grasp of these issues and have already worked out for themselves that an investment via an ETF represents a huge leap forward.
My final point is therefore this, in answer to the question why would someone already buying ETFs through a discount broker wish to consider taking investment advice?
The original school of thought around index tracking was that a market capitalisation weighted portfolio is the only legitimate stock investment.
I don't agree that the only legitimate indexing approach is holding the market portfolio. That view persists by the intellectual equivalent of squatters' rights. Since the earliest passive portfolios were based on the broad US market, traditional indexers tend to think any approach besides the market portfolio is closet stock picking
The reality is that most of the indexing approaches fall short of replicating the market by making a concession here or there to accommodate consumer preferences and costs.
Don't get me wrong: it's hard to fault a market index approach. It's better than the vast majority of managed funds, and most investors should require a good reason to invest in something other than the broad market. But if there's more than one type of risk driving returns, it's possible for investors to use a wider range of strategies to gain greater expected returns—all within the bounds of indexing.
Many studies have highlighted that the single most important factor driving returns in a portfolio is asset allocation. The key issue for an investor should therefore be this: what represents an asset class and what is the anticipated or expected relationship between asset classes: i.e. correlations, covariance, risk premium above Treasury Bills etc?
Defining what represents an asset class is important because investors use asset classes as key components of diversified portfolios. For this purpose each asset class needs to have a specific risk-return function.
Sorting stocks on anything other than factors of expected returns can fudge the clarity of the investment process and undermine portfolio diversification. When investors mistake where returns come from, the asset classes they assemble become arbitrary. This can lead to inadvertent tilts on the underlying factors that actually determine returns.
For example, investors sometimes manage industry exposure, as if sectors such as Technology, New Energy or Infrastructure constitute asset classes and ETF providers are happy to oblige with funds available for almost any subset of the market.
By way of validation, analysts talk about what companies produce and how it affects the prospects for their stock prices. However, as Adam Smith pointed out over 200 years ago, a company's industry bears no direct relation to the flow of capital. In other words sorting stocks by sector or industry does not add anything to an investor's portfolio. The reason for this is that I cannot expect to be rewarded at a rate greater than the market rate of return for any risk I can diversify away. So, taking a bet on renewable energy companies does not offer investors a higher expected return than the wider market but it does expose the investor to more risk. The investor can capture exactly the same market rate of return but with less risk, by holding the wider market.
Equally, an investor might seek to diversify their portfolio by including various investments in different countries. Again, the reality of modern global capital flows is that the expected return on any developed economy is exactly the same and there is little to be gained by betting on any particular developed economy. The most sensible starting position for an investor would therefore be a highly diversified global portfolio. By contrast, Emerging Markets do offer a premium expected return above developed economies. The geopolitical issues create additional risks for which investors expect to be rewarded for taking compared to an investment in developed markets.
Using ETFs we might therefore select the MSCI World Index Total Expense Ratio 0.5%pa. Job done.
Sadly not, this is an index of just 691 Stocks with the majority being Large Capitalisation, Growth Stocks,
Research by Fama and French (1992) found that risk factors of market, size, and book-to-market seem to account for virtually all the differences in returns across industry groups (except real estate stocks, which for that reason probably constitute their own asset class).
Therefore for higher expected returns, an investor should hold amongst other things more small companies. Yet, there aren't many publicly available funds that actually hold every stock. There are thousands of tiny stocks at the smaller end of the spectrum that are costly to trade. Retail funds tend to sample from these stocks, buying only some of the names until they have a portfolio that looks and hopefully behaves like that segment of the stock universe. Since the universe of these tiny stocks totals less than 2% of the market, such a practice is hardly egregious, but it can cause portfolio performance to deviate from the index during small-stock bull markets. It also demonstrates that even pure indexers don't mimic the market regardless of costs.
Investments such as ETFs have the inherent limitation that they are based on commercial indexes. Success is measured by tracking error, i.e. how well the index is followed. What if the investor is following the wrong index?
I might use selective ETFs in a portfolio but investors need to be aware of some of the pitfalls. An example might be the negative roll yield on a commodity ETF. This is another hidden cost that many ETF investors are simply unaware off and which can cost a fortune to hold a long position in a commodity compared to the spot price. An analysis of the spot price of sugar compared to a rolling futures contract over 4 years highlighted a 126% difference in return.
So, in addition to a limited selection of ETFs I recommend to my clients a range of Institutional Class index funds which allow investors to capture the market return at very low cost (for example a Global Equity fund with around 12,000 stocks in it for 0.5%pa TER) and to tilt their portfolios towards Global Smaller Companies and Global Value companies or European Smaller Companies or European Value Companies or Emerging Markets or Emerging Market Small Companies or Emerging Market Value Companies.
Since these are all specific positions of additional risk, and since risk and reward are related, over time, these are investments that investors would expect to offer a higher return than the common commercial indexes such as the MSCI World and indeed this is what they have consistently delivered.