Good reads from around the Web.

I have a soft spot for Hetty Green, and a bit of sympathy. There’s no doubt this super-investor of a century ago was a craven asset accumulator who put amassing a fortune above all else, but then so has been Warren Buffett for most of his life.

Yet whereas “Uncle” Warren is lovingly known as the Sage of Omaha, Hetty Green has gone down in history as “The Witch of Wall Street”.

Her black dress and hat didn’t help, but I think it was her ruthless and successful market raids in times of strife that got up people’s backs (or let’s face it: men’s backs).

Like Buffett, Green was greedy when others were fearful, amassing vast quantities of assets during downturns and then selling them at her leisure when the good times rolled.

This was back when cartels of wealthy speculators really did gang up to break each other and Green stared down more than her fair share.

She ended up insanely wealthy.

The only way is not up

I’ve been thinking about Hetty Green because for the first time since 2009 I’ve been a net withdrawer of money from the market this month.

Only a per cent or two here and there. Nevertheless it feels odd.

This year I’m not only doing it to defuse capital gains tax. I’m selecting the option to “transfer money back out to your nominated bank account”. In metaphorical Lord of the Rings terms, this is a dusty, cobwebbed path that has only been whispered about in myths and legends in my house.

I’m obviously not calling a top, nor claiming an ability to. As it happens I don’t share the doomy prognosis that this whole rally is built on phantasmagorical easy money. And for what it’s worth, I think the market is far more likely to be 100% higher than 25% down in five years time.

But there’s no denying these are “good times”. In contrast I remember ransacking my loft for semi-valuable junk that I could flog on eBay to keep buying even more shares during the darkest days of 2009.

I was lucky, but I might not have been rewarded so quickly for my boldness. The fact is I became massively overweight in equities, and I was very conscious of this when I welcomed my more level-headed co-blogger The Accumulator to the Monevator fold the following year.

My Colonel Kurtz style expedition to the limit of stock market exposure was not what I’d created this blog to be about. The Accumulator practices what he preaches.

Back to reality

That was then and this is now. Things turned out okay, and it’s just as important to be fearful when others are greedy as the more oft-cited opposite.

Having run with far higher equity exposure than is prudent for anyone who still hopes (/needs) to use a fair slug to buy a house, I’ve started dialling it back. I’ve been withdrawing cash, and also shifting some money into safer stocks and preference shares.¹

Hopefully I’ll finally buy a house or flat soon (I really do want that big, cheap mortgage). But if I don’t buy then cash is an amazing asset over the short-term, even at a time of diabolically low rates, thanks to its great optionality.

Moody blues

As of Friday I’ve pretty much tripled my net worth since those 2009 lows (not entirely due my investments rising, but they did most of the heavy lifting) and if I’m honest I feel myself getting impatient if my portfolio doesn’t end the day or the week higher.

I’m taking for granted daily moves in my net worth that surpass my monthly earnings. A terrible sign!

This is a dangerous mood, and I’ve known it before — from before the crisis of course. Yet I probably wouldn’t be taking out anything if I already had the house. I would probably just tune the active portion of my portfolio to a more passive auto-pilot setting and take the summer off to refresh.

As it is I will definitely need some of this money within the next five years (perhaps the next few months) so I’ve returned to Personal Finance 101.

Or as The Accumulator might call it, sanity!

Hetty Green became super wealthy. Colonel Kurtz developed a death wish and got hacked to death in the jungle.

I hope to end up somewhere in between.

From the blogs

Making good use of the things that we find…

Passive investing

• The opposite would have to be right – Abnormal Returns
• Markets can predict people – Rick Ferri
• Resources to compare brokers and platforms – DIY Investor (UK)
• Even indexing takes work [US funds, but relevant] – Chicago Planner

Active investing

• Has dividend investing become too popular? – UK Value Investor
• A simple guide to selling stocks – Clear Eyes Investing
• Buffett isn’t worried about record corporate profits – Brooklyn Investor
• Where to invest now dividends are de rigueur? – Simple Living in Suffolk
• Who is in control of your company? – iii blog
• Write-ups on Stockopedia from the London Investor conference – Part 1, 2 & 3

Other articles

• Remember this moment – The Reformed Broker
• Practice constant optimisation – Mr Money Mustache
• The Cherry Coke effect – The Psy-Fi blog
• Five lessons in contentment from Buffett and Munger – Zen Habits

Product of the week: The Nuffield Health Bond is paying 6%, but there are tax complications. The Guardian wonders if it’s worth the risk.

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site.

Passive investing

• There is no global bond index tracking fund² – Index Universe
• New US ETF to target total ‘shareholder yield’ – ETF Trends

Active investing

• Nick Train: Valuing quality shares [Search result] – FT
• Hedge funds set to reach for mass market cash – Guardian
• Preference shares for income – Money Observer (via iii)
• Cambridge-based hedge fund tries cheaper approach - Dealbook

Other stuff worth reading

• A different way to invest in life – Wall Street Journal
• Markets and memory banks – Wall Street Journal
• Could self-building go mainstream? [Search result] – FT
• The art market has gone bananas – FT
• Retirement is bad for your health – BBC
• Demand for fixed rate mortgages hits record high – Telegraph
• The future of capitalism: The Chicago Mercantile Exchange – Economist

Book of the week: I recently met one of the 12 investors profile in Free Capital and he was just as enthusiastic about investing in real-life. Please note: This one is for active investors only!

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1. Note I say “some”. I’m one of those nutters who owns a handful of Tesla shares, for example!
2. The Investor notes: Good thing too IMHO, you don’t want to track debt by market weighting!

I have long been a fan of income-orientated strategies. Not because the returns from income are necessarily always superior to total market approaches – though at times they can be – but rather because a focus on chasing capital gains can be so ruinous.

Not every decision in investing needs to be about maximising your theoretical return – there are other risks and rewards to think about, such as the risk of getting carried away, or the reward of being better motivated to reach your goal.

Accordingly, I believe in normal times many people would do better focusing on investment income rather than their net worth when calibrating their financial freedom plans.

But these are not normal times. Now it is expensive to have a taste for income:

• Cash was yielding 5-6% half a decade ago, provided you were happy to chase the best rates. Now it pays 2% at best.

• Long-dated UK government bonds will get you less than 2% a year. Gilt yields above 6% were the norm in the 1990s, and 5% was still possible before the financial crash.

• The only shares the market truly loves are dividend paying shares, which has brought the yields down on many of the HYP favourites

Today’s low yields may prove to be rational, and we’ve warned before you may come a-cropper if you eschew cash or bonds in disgust at their miserly yields.

Personally I’m happy to take the risk of holding zero bonds (I’m a more than semi-active investor, remember, unlike my nobler purely passive co-blogger).

I do maintain a larger cash war chest than I otherwise would though (and indeed am about to add more to Zopa).

Coke is it

As yields have been pushed down across the fixed income classes, some safety-first investors have tiptoed into equities.

I suspect this is what has led to the most defensive-looking shares – utilities and the big consumer staples companies, as well as healthcare – doing so well.

You can also see the popularity of dividends in investment trust premiums and discounts. The equity income investment trusts long ago moved to a premium, whereas many global growth trusts still sit on big discounts. I’m just working through the update of my demo high-yield portfolio for next week, and I’ve already noticed my comparison basket of income trusts has truly been on a tear.

When a supposedly safer investment gets more popular, the price appreciation means it’s probably become more risky.

Sure, companies like Diageo and Coke will always be more predictable than miners or metal bashers.

Whether the shares are a safer investment comes down to the price you pay. If people are paying too much for boring dividend stocks, then they will get lower returns than usual in the future.

Hunting high and low

Active investor David Schwartz touches on this theme in his article in the Financial Times. (The link leads to a search list, the article should be up top).

Schwartz writes:

At first glance, a high-yield strategy looks to be worth pursuing. Profits from a steady investment within the high-dividend universe rose by 123 per cent in the past 15 years, assuming dividends were quickly reinvested.

In contrast, a low-yield investment approach resulted in a gain of just 41 per cent.

But the trend was reversed when a 10-year timeframe was used. Low-dividend shares gained 179 per cent since May 2003, against just 135 per cent for higher yielding shares.

Low yield shares did particularly poorly around the time of the dotcom crash, because so many tech firms blew up. In addition, steady ‘old economy’ companies had been shunned for years, which meant they were relatively cheap and sported high yields in 2000.

But very different conditions prevail today.

I’m not suggesting you should now blindly buy low yield companies instead of high yield ones. Passive investors should as always follow the principles of strategic ignorance and simply stick to their asset allocations. Active investors should be wary of any cut-and-dried ‘rules’ at all.

However the steady media and adviser commentary that’s pushing investors towards dividend-paying stocks does seem like an accident waiting to happen:

• Firstly, all share prices decline from time to time. How will bond investors turned reluctant dividend-chasers cope when this bull market finally ends and their portfolios wobble?

• Secondly, according to Schwarz low-yield shares are actually outperforming since 2009, despite the fad for income.

The dividend-chasing I’m discussing here has been most evident over the past 6-12 months, and is mainly a blue chip phenomenon, rather than a market wide one. I don’t think high yielding cyclicals are being targeted, for instance, which may explain that post-2009 result.

I also suspect Schwartz’ short-run data may be skewed by BP’s problems, and by the scrapping of bank dividends during the crisis.

As banks like Lloyds and RBS start paying dividends again, these low-yielders may deliver strong returns as they move back to being the higher yielders of tomorrow.

Consensus is costly

Let’s not get carried away with any of this. Schwartz’ analysis only covers 15 years – a blink of an eye in market terms. It doesn’t prove anything in particular.

Also, a big bonus of income-focused strategies is they substitute trying to trade for profits or even going for total return for simply building up your income streams. When you’re ready to spend the income instead of reinvesting, you just start to spend it.

In my experience income strategies also tend to be less volatile, with reinvesting the higher income helping to further cushion the downside.

All this has advantages (mainly psychological) that may even outweigh the pursuit of the greatest total return that is theoretically available from buying the entire market. Some people may therefore still rationally choose to buy equity income trusts on a premium, for instance, or income-orientated ETFs that may contain relatively overvalued dividend paying shares, even if returns prove to be a bit lower than from racier alternatives – especially if they’re refugees from the bond market.¹

Tastes wax and wane. Back when I first got seriously interested in investing, a company’s shares sometimes got dumped for initiating a dividend payout! Growth was everything to a lot of people. Today the opposite seems to be true.

I don’t think even the blue chip consumer-focused dividend payers that are now so popular are in a bubble, exactly, although their multiples look quite stretched in many cases.

But if you’re buying higher-yielding stocks in this market – especially the so-called ‘aristocratic’ dividend payers – because you expect them to deliver higher returns than equities overall, well watch out.

Being in with the popular crowd has never been a route to investing riches.

1. Personally I would prefer certain of the larger global trusts still on reasonable yields and discounts, but each to their own.

It’s never a good idea to invest in a product that you don’t understand or can’t get good data on.

And while the ideas behind the Powershares FTSE RAFI ETFs aren’t so hard to grasp, getting a handle on how they’ve performed is like a Soviet show trial in numbers – the truth is hard to find.

Why should you be bothered with the RAFI ETFs? Well, they could offer UK passive investors a chance to capture the value premium, via a so-called ‘smart beta’ strategy known as fundamental indexing.

• The value premium offers investors the chance to amp up returns.

• Fundamental indexing theoretically fixes some of the problems of market cap indexing, particularly the tendency to load up on overvalued equities.

• UK passive value funds are few and far between.

Better still, the RAFI ETFs have been available in the UK for over five years now, so we can pit the claims of fundamental indexing against some hard numbers.

However it turns out that getting Powershares, Bloomberg, Morningstar and Trustnet to agree on the performance data about these ETFs is like hoping for consensus at a UN Climate Change Conference.

Pick a number, any number

The following table shows the various returns quoted for the Powershares FTSE RAFI Developed 1000 ETF (PSRD).

Source as stated

So that’s about as clear as John Prescott then – lots of different numbers that would ideally be the same.

• The figures date from 3 May, except for Powershares which quotes from March 31.

• Bloomberg doesn’t say whether dividends are reinvested. The others all do.

• MorningStar and Trustnet clearly state the returns are annualised. The other two skip the details.

• Powershares’ performance data isn’t available on its retail site. You have to masquerade as a professional client to access such privileged information.

Trustnet’s numbers are clearly off as they’re lower than its figures without dividends reinvested. Trustnet’s net return figures match MorningStar’s total return numbers, bar rounding error, so we’ve at least got some kind of match.

Ultimately, it’s not good enough and I wish Invesco Powershares would present clear, updated, annualised figures on its own website, so that investors can see what these ETFs are really capable of.

Performance anxiety

Inconsistencies also bedevil the other three RAFI ETFs I checked out, namely:

• PSRU – UK equity
• PSRW – All-World including emerging markets
• PSRM – Emerging markets

In the case of PSRW and PSRM, Powershares doesn’t quote performance data for either fund, despite the fact they’ve been available for over five years. Instead it quotes the index performance.

That’s sneaky because the indexes don’t include the fund’s actual costs, which drags down performance like a lead weight.

The RAFI Emerging Markets ETF is known to have suffered significant tracking error due to costs. (Presumably that’s why PSRW and PSRM switched to a synthetic index replication strategy after a couple of years).

A lack of performance transparency is enough to make me give up on a fund there and then. There are already enough potential grey areas and grey hairs associated with investing, without creating extra room for doubt.

But as I said earlier, value funds are hard to come by in the UK. It would be great if I could find strong evidence that these ETFs work, so let’s persevere.

Battle of the value trackers

What I really want to know is that PSRD performs well against other value trackers. I know that value funds can lag the market for many years, so I need reassurance that my value pick isn’t a duffer.

The following index trackers all offer varying takes on the International¹ Large Value strategy. The exception is the L&G fund, which is a Large Blend international tracker that acts as a proxy for the market.

How does PSRD match up?

Source: As stated or Trustnet

On the whole, it hasn’t been a great five years for value equities, so if PSRD performed as per the Bloomberg numbers then I’m interested. Much less so if the MorningStar (and Trustnet) numbers prove true.

I can’t get a clear signal from the numbers though, and the same story repeats itself for the UK RAFI ETF – PSRU – which seems OK by some lights and slothful by others.

The All-World and Emerging Markets ETFs don’t look great by any yardstick over five years, and have clearly suffered at the hands of reality. Perhaps the synthetic approach will turn things around, but the lack of live data on the site is hardly reassuring.

Case not proven

Here’s the problem. Fundamental indexing is something of a novelty act in comparison to tried and tested market cap investing.

In theory, fundamental indexing is the superior strategy over time, but theoretical advantages can be overwhelmed by the costs and the practical difficulties of real-world application.

I need more reassurance, not less, to take the plunge. If I can’t tell whose numbers to trust – and the ETF providers aren’t making matters crystal – then I’m going to err on the side of caution and leave these funds alone.

I dare say that other funds are afflicted by inconsistent data, too. But bold claims have been made for fundamental indexing and so the supporting evidence should be placed squarely in the hands of investors – assuming the evidence is out there.

Take it steady,

The Accumulator

1. Developed world equities including the UK, but not emerging markets.

Good reads from around the Web.

I wrote a big introductory musing article about the state of the world as usual this morning, but it’s so long that I’ve decided to save it for a future post in its own right.

It was riffing on this post by David Schwartz in the Financial Times about high yield shares (that’s a search result – click the article near the top).

So you can go read that to get prepped up.

Look on the bright side – less homework for you before you get to dive into this week’s links!

Enjoy.

From the blogs

Making good use of the things that we find…

Passive investing

• When fund selection is done right – Rick Ferri
• Are investors really this clueless? – Canadian Couch Potato

Active investing

• Hindsight bias – Expecting Value
• Confirmation bias and perma-whatevers – Abnormal Returns
• Value traps that aren’t – The Value Perspective
• Tesla and growth investing – Ivanhoff Capital
• Intertek: Great growth, but expensive – iii blog

Other articles

• How to prosper in an economic boom – Mr Money Mustache
• You ever go totally crazy? – James Altucher Confidential
• Financial repression and UK wages – Retirement Investing Today

Product of the week: Credit Unions have often been touted as a post-crisis alternative to greedy Big Banking, but The Guardian reports one a month has been going bust. They’ve been smaller operations so far, and savers were compensated up to the £85,000 FSCS limit.

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site.

Passive investing

• Interview with passive investing legend Charles Ellis – CNN Money
• US investors increasing their reliance on ETFs – FT

Active investing

• Great write-up of the Berkshire annual meeting – Jeffrey Matthews
• Has Australia’s luck run out? [Search result] – Merryn/FT
• Lesson from Buffett: Doubt yourself – Wall Street Journal
• The oil and gold booms are over – Bloomberg
• Alternatives to ‘terrible’ bonds [Search result] – FT

Other stuff worth reading

• Co-op Bank downgrade: Is your money safe? – Guardian
• Time to buy a Euro property bargain? – Telegraph
• Where is property cheap but family friendly? [Interactive] – Telegraph
• Peston: Who should get our RBS and Lloyds shares? – BBC
• Wall Street is back – The Economist
• Why you’re right to fear the news – MarketWatch
• Soros debating Europe [Long!] – Project Syndicate (or Reuters’ recap)
• The biggest retirement myth ever told? [US, would love to see UK data] – Motley Fool

Book of the week: Early reports are that Baz Luhrmann’s movie version of The Great Gatsby isn’t so great. Read F. Scott Fitzgerald’s amazing account of the dark side of wealth and power on Kindle instead – it’s just 49p!

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The 5:2 fasting diet is all the rage. And as a fan of the occasional bout of nil by mouth, I’m not surprised.

Sensible fasting can throw the reset switch on conditions such as Hungry Hippo-itus, whereby a cheeky slice of cake in January has become a daily muffin ritual by May.

Fasting also delivers results quick, which is great provided you don’t let it become an eating disorder. If you want to stay slim and sexy on the cheap, you should try it.

What the 5:2 diet does is turn fasting into a routine for long-term weight loss.

According to the BBC documentary that popularized intermittent fasting, if you limit yourself to 500 to 600 calories for two days a week, you can eat whatever you like for the rest of the time and still lose weight.

Early scientific research suggests it might also be good for your immune system, your blood sugar levels – even your brain.

We’ll see about that, but books on the diet are already topping the bestseller lists, and more and more people at dinner parties are stuffing themselves with cake while telling me between mouthfuls that they only had a salad the night before.

I haven’t noticed many thinner people when squeezing onto London tubes, but I live in hope.

Lessons from the 5:2 diet

I think there are three main reasons why the 5:2 diet has struck a chord:

• You don’t have to go without anything you like.

• You don’t have to think about what you’re doing all the time.

• It can quickly deliver results.

It’s a very pragmatic diet. In an ideal world, none of us would put on an extra kilo or eat cheesecake. In reality we do, and the 5:2 diet offers a way of dealing with it.

Are there any lessons for us as investors?

You and I both know the best approach to investing is careful budgeting and saving into passive index products for 30 to 40 years – all within tax shelters such as ISAs and pensions.

But we also know most people don’t save enough, that they buy active funds and trade stocks, and that CNBC exists and so do the temptations of Apple products and foreign holidays.

So within that mindset – that is, making an imperfect world a little better – here’s how the strengths of the 5:2 diet might be applied by investors – or would-be investors – who stray from the path.

You don’t have to go without anything you like

5:2 investing would acknowledge a few truths about human beings and money.

These include the big one that we like spending money now, rather doing without to spend it in the future – whether because of the time value of money, or because we struggle to envisage our future selves.

A quick and dirty 5:2 style response might be these two rules:

1) You must automatically transfer a fixed amount of your salary into your long-term savings each month.

2) You must never go into debt.

Why is this helpful? Because it automates your long-term saving, and enables you to spend what’s left over however you like.

Let’s say you’re 30-years old and you bring home £3,000 a month. If you set up a direct debit to transfer £500 a month from your account into an ISA or pension, you could do what you like with the remaining £2,500.

An iPad? A weekend break to Amsterdam? No guilt trips, just so long as you follow rule one AND you don’t break rule two, and never go into debt. Just let the after-savings money accumulate in your current account, and spend it as you see fit.

5:2 diet and active investing

Here’s another truth. Many people prefer to invest in managed funds or to buy their own stocks, rather than purely passive invest – even some who know better.

Personally, I’m a sucker for a portfolio of shares, and even I buy the odd investment trust on a discount.

So what might 5:2 investing have to say about this?

Well, perhaps you could divide your savings pot into sevenths. You could run 5/7ths of it passively, and maybe put 2/7ths in active funds (I wouldn’t!) or individual shares (I do).

Better yet, you could divide your monthly contributions into sevenths, and pipe the larger portion to your passive strategies, and the rest to your stock picking account. This way you won’t subsidize bad stock picks with your growing pot of passive money.

I believe most people will do better investing entirely in passive index funds, but equally I admit investing would never have captured my imagination – let alone got me blogging – if I only bought index funds.

If you’re like me, this might put a limit on your dark side.

You don’t have to think about what you’re doing all the time

While I am sufficiently obsessed with investing to devote as much as 50% of my net income to funding new investments – and half my free time to writing this blog, and you’re obsessed enough to read it – more people are in the opposite camp.

Most people come to investing as eagerly as Dracula goes to the dentist.

A constant fear of mine is that Monevator makes investing much more complicated than it needs to be for the average person to get far superior results.

The average person isn’t in slightly too-expensive index funds, or paying too much capital gains tax.

No, the average person is bewildered or ignorant, isn’t saving anything much at all, puts most of any money they do save into expensive managed funds, and never opens a stocks and share ISA.

For them, super simple is best.

I wrote some years ago that a new investor might simply split their savings between a UK tracker fund and a cash deposit account. A straight 50/50 division.

I don’t suggest they worry about bonds or other asset classes until they’ve done this for a few years and got used to the savings habit – and to the stock market wobbling.

It’s what I tell my friends to do when they ask for advice.¹

Of course, I also point them to our posts on diversified ETF portfolios, but few read them. But if I can just get them automatically investing every month into a tracker fund, while buffering the volatility with cash, I know I’ve helped.

We can re-run that two-step automatic savings strategy here, too.

I’m naturally frugal, but I’ve never done a full-on budget in my life. Automatically saving every month means you don’t need to.

It can quickly deliver results

People applaud the 5:2 diet because they see the weight come off quickly.

When you go without food twice a week, you create a calorie deficit. You also temper down your appetite and shrink your stomach, so you don’t pig out as much as you might expect on the other five days.

This is in contrast to worthy plans where you eat only whole grains for 12 months, or ditch carbohydrates for only meat and vegetables, or ignore dieting altogether in favour of cycling naked sipping cold water at 6am in the morning.

All hard work, whereas the 5:2 diet is relatively easy and delivers results quick.

Sadly, there’s not many ways that this part of the 5:2 model can be safely moved to investing – at least not when it comes to returns.

Nearly anything you do to try to get results quickly from your investments is likely to cause more harm than good, whether it’s day trading, spreadbetting, or chasing hot funds.

I’d make one exception, though, and that’s if you have a company pension that offers matching employer contributions. Here you can get results overnight.

A matching contribution is like getting an instant 100% return on your money! You invest £500 and your employer matches it. You’ve doubled your money at a stroke. The only other place you can do that is Las Vegas.

Such pensions are a no-brainer, and if your company offers one, bite its arm off.

More 5:2 style approaches to wealth

Aside from good returns, there are two other crucial pieces to getting richer:

• Make more money.

• Spend less than you earn.

Boosting your income is an under-covered topic in personal finance circles, especially here in the UK. Perhaps it’s because we find talking about our salaries vulgar, or maybe investing for the long-term just attracts a more Spartan crowd.

I for one now believe I’ve made life harder for myself by not pursuing a higher income back in my 20s and early 30s.

I did okay income wise – I was hardly a beach bum – but given what I’ve achieved with my portfolio on what I did earn, I can’t help wondering where I’d be if I’d socked away another £10,000 to £20,000 a year for a decade or so.

Whether it’s by boosting your salary or creating a new side income, getting more money through the door can only help you reach financial freedom sooner – provided you save it of course.

And that brings us to spending less than you earn. (Here UK financial bloggers are definitely on message).

Unlike trying to make an extra 10% from your investments, cutting what you spend by 10% will quickly boost your bottom line in a safe way.

Better still, the first cuts are the hardest. Just as a 5:2 dieter doesn’t fear the fast days once they’ve become routine, you will find more ways to reduce your expenditure once you’ve got rid of the big items like excessive shoe buying or a new car habit.

If you’re in debt, then getting out of debt will deliver the biggest bang for your buck of all. Trying to get richer while paying someone else interest on your debt is like trying to lose weight by eating all the ice cream in the freezer first.

Take radical action – remember that all non-mortgage debt is an emergency!

Not an excuse to binge on bad investments

As I said at the start, I’m not suggesting running some of your money actively or using just a UK tracker fund instead of a global portfolio or keeping 50% of your savings in cash is the optimal route to wealth.

Far from it! But this isn’t an article about perfection.

In an ideal world, nobody would have a beer belly or flabby thighs. We would all eat well and exercise. The 5:2 diet exists because we don’t.

Similarly, these 5:2 investing ideas might help some people get on the right track. Blending your own smoothies or running a marathon can come later.

One caveat. There is some evidence that the 5:2 diet might actually be even better for us than normal eating, because the fast days may activate our bodies’ repair mechanisms. It could be we’re built to go without, and we literally have it too good.

The jury is still out on that. In contrast it’s pretty unequivocal about investing.

Yes, some active investors will beat the market. Yes, you’d have done better if you’d invested all your money with Antony Bolton or Warren Buffett.

But your chances of beating the market or finding the next Bolton or Buffett are very small – and anyway you don’t need to do so in order to achieve your financial aims.

There’s no suggestion here that anything but regular – dare I say boring – investing into tracker funds is the optimal way to go.

And so there’s no point being a 5:2 investor with flaws if you can be a perfectly passive one.

Rats, there goes the investing bestseller!

1. (I have more recently tried sending some to Vanguard’s LifeStrategy funds, but it doesn’t work as well. We know it’s very simple, but they see it as complicated!

A friend of mine used to torment himself with visions of a suave bogeyman named Dex. The imaginary Dex was better looking, richer, and more virile in every respect. And he prevented my friend from forming meaningful relationships. Every attempt was self-sabotaged by the fear that somewhere out there lurked Dex, ready to steal his beloved away.

Yes, my mixed-up friend had trust issues. And so do I when it comes to fundamental indexing.

Fundamental indexing is the debonair Dex to good old passive investing in market cap funds.

It’s newer, glossier, cooler (flying under the beguiling ‘smart beta’ banner) and it has a smooth line in proprietary patter that promises good times ahead.

Come hither, Dex

I’m attracted to fundamental indexing because it offers the chance to capitalise on the value premium. That premium has been worth around 3.5% per year to UK investors over the last 50 years.

There are a few fundamental indexing options available in the UK. First Trust Advisors AlphaDEX (note the Dex!) ETFs are the latest sophisticates, but the main players are the Invesco Powershares FTSE RAFI ETFs.

So how do these smart beta trackers work?

Inside the mind of the Dex

The first thing to note is that fundamental ETFs do not follow a traditional market cap index.

In other words, if company A is ten times the size of company B by market value then it does not automatically get ten times the presence in a fundamental index. That style is out like corduroy slacks.

Traditional market cap indices struggle to defend themselves against the accusation that they bloat up on overvalued equities, mechanically shoveling in more of the hot stuff like a compulsive eater – especially when the market is frothy.

In contrast, fundamental indices are meant to break this impulse by choosing equities according to a different menu.

In the case of the FTSE RAFI ETFs, their index encompasses a broad universe of equities, just like a vanilla index tracker.

However the FTSE RAFI indices rank their constituent companies not by market cap, but by four valuation metrics:

• Sales
• Cash flow
• Dividends
• Book value

These company ‘fundamentals’ are well known health indicators that transmit information about the underlying state of the business.

They are also the source of the value premium, and fundamental indices are tilted in favour of equities that are cheap on those measures.

Also, because a RAFI index uses the average of the last five years’ worth of sales, cash flow and dividends for each company, its rankings are less influenced by short-term noise than a market cap index.

And that’s a good thing…

Who cares what the world thinks? As long as I have you, Dex

…but what if that noise turns out to be news? (Think what 3D printed guns might do to Smith & Wesson!)

Then the RAFI indices will be more slow to adapt to the new reality.

Every time a RAFI index rebalances (once a year) it’s mostly using historical data to determine its rankings – data that only partially reflects the troubles of a recently impaired firm. So whereas distressed firms automatically sink in a market cap index, they actually rebound back up a fundamental index.

Hence fundamental indices favour companies in trouble.

That’s absolutely fine if you believe the market generally over-reacts to bad news, and such companies are reputedly the source of some of the value premium. But we underestimate the wisdom of the market at our peril, and a strategy that doesn’t screen for distressed companies piles on the risk as well as the potential for greater returns.

Dex stripped

The risks of fundamental indexing are highlighted by a comparison of the Powershares FTSE RAFI 100 ETF (PSRU) against its market cap rival – the iShares FTSE 100 ETF (ISF).

The FTSE 100 suffers from diversification risk in the first place, but the fundamental version is even more concentrated:

• 52% of PSRU is devoted to its top 10 holdings versus 48% of ISF and 37% of Vanguard’s All-Share tracker.

• Over 10% of PSRU is in BP – its number one holding. Whereas ISF has just shy of 8% in its top-placed company, HSBC.

• 47% of PSRU is concentrated in the financial and energy sectors versus 38% of ISF.

PSRU’s loadings are the natural outcome of its value tilt – the source of its potential to beat the pants off the market, but also the source of its volatility.

Fundamental products are also typically more expensive than market cap trackers and PSRU is no exception. The Ongoing Charge Figure (OCF) is 0.5% versus 0.4% for ISF and a tiddly 0.1% for VUKE – Vanguard’s FTSE 100 ETF. And that doesn’t take into account costs that show up in tracking error.

Dex’s midnight runner

Riskier, darker, more intense, more money… how can you resist the RAFIsh charms of fundamental indexing?

Well, in this follow-up post, I explain why I have my doubts.

Take it steady,

The Accumulator

Good reads from around the Web.

I seem to have spent years arguing – online and off – with men (invariably men) who are 10-30 years older than me – about exactly the wrong problems.

There’s a certain type of clever man who tends to fret about:

• Peak oil
• The rise of China, especially in the context of outsourcing
• The lack of UK manufacturing and engineering
• The lack of future jobs in the West

Yet not one of these bothers me much at all. (Of course there have and will be switching costs to resolving any issues that do arise).

Peak oil was always a bogus threat, at least in our lifetimes and those of our kids. I didn’t foresee the fracking bonanza that’s handed me a win here quite so quickly, but I knew we’d find plenty more hydrocarbons. The world is still stuffed with them. Our problem is we’re burning them.

Also, alternative energy progresses rapidly. The sort of man I’m thinking of tends to hate alternatives – I think they’re all children of the 1950s at heart, and love to see billowing smokestacks overseen by a man from the Ministry – but they tend to respect mathematics. Eventually alternatives will win on all fronts.

The rise of China may present geopolitical tensions, but like most global trade it’s a big win for us. We get an enormous range of things far made more cheaply than we otherwise would, and we often retain the bulk of the profits generated, too. (See Apple’s margins for more).

UK manufacturing? These laments are a manifestation of the sweatshop fetish of most of the public, but particularly men of a certain age.

Most manufacturing is low-end and makes little money. We’re pretty good at the rest, and we retain a significant manufacturing base, albeit a shrinking one in relative terms because we’re so much better at services.

As for the lack of jobs in the future, that’s just a lack of imagination. Sadly, humanity shows few signs of swapping tat and titillation for more quality time, and I’m sure we’ll find new ways to keep the proles and their bosses busy for decades to come.

Like what? Like 1,000 things I could list and 10,000 we can’t imagine yet.

Just one example – for years I’ve suggested that in the future everyone might want their own custom house, designed and built to their specs by a personal architect, and fitted with bespoke furniture and designs.

That’s a lot of new skilled jobs, compared to fields of Barratt boxes.

Ten-years ago my suggestion was deliberately fanciful, but recent advances in 3D printing have led some to speculate that we might one day build houses an atom layer at a time, from the ground up. (It’s already being pioneered in Amsterdam and elsewhere).

Combine that with the computer-backed architecture that already gives us apparently impossible floating roofs and bending walls, and Acacia Avenue need never be the same again.

What really worries me

I haven’t even mentioned fears of (or relish for?) the end of capitalism and the consequent gold bug mania.

To be honest I suspect this is a temporary concern of people who’ve never read any financial history seeing banks going bust on the news. Capitalism goes through periodic waves of crisis. Always has, always will.

So am I a deranged optimist? Do I have any worries?

Absolutely I do – plenty.

Here are just a few of the things I think are really worth fretting about:

• Environmental collapse and climate change
• The coming uselessness of antibiotics
• The end of all privacy and absolute (if consensual) State control
• Biologically engineered terrorism

On the first of these, I’m indebted to reader Andrew who reminded me that Jeremy Grantham’s latest quarterly letter [PDF] was out. I usually agree with most of what Grantham writes, and this time he tackles ecological collapse and the increasing viability of alternative energy in one coherent message.

I particularly like how he calls out another bugbear promoted by the greybeard doom mongers – that the pension crisis should be solved by stuffing more kids into the bottom of the pyramid – as he like me sees population growth as a top three problem needing fixing.

Grantham writes:

The return on helping encourage a lower population everywhere is incredibly high. Yet little is done at an international level and indeed the issue is treated like a hot potato even by usually well-meaning NGOs.

But we can do it, and my guess is that we will indeed succeed on this front. In the meantime it would be encouraging if economists, The Economist (not to pick on them but I tend to hold them to higher standards than others), and economic discussions in general would look out a few more years and stop discussing lower population growth as if it were a dire economic threat rather than our last best hope.

Of course, as growth rates drop rapidly and populations quickly age, there is an added burden to workers of carrying more non-workers for one generation as the changes flow through the system. Then things stabilize again.

This cycle can be ameliorated enormously by having older people extend their contributions and by facilitating the full participation of women in all countries.

The ruinous alternative is to have an ever-growing population run off the cliff collectively.

There’s also stacks of interesting stuff about alternative energy – enough to encourage me to finally pull my finger out and write the post I’ve been promising some of my friendly opponents for years – and a second article warning on how high profit margins could herald a coming dark age of super-inequality.

Oh yeah, I believe rising inequality is a real existential threat for the West, too. Even for billionaires, although I suppose few of them would agree.

Talking of which, one who does – Warren Buffett – is hosting his annual investing festival in Omaha this weekend.

If you can’t make it you can now follow him on Twitter, where he’s now tweeting.

Slowly.

From the blogs

Making good use of the things that we find…

Passive investing

• No free lunch from the equal-weight S&P 500 – Rick Ferri
• The best performing stock market in the world since 2008 – R.I.T.

Active investing

• Thoughts on gold as an investment – Musings on Markets
• Making each investment count – Clear Eyes Investing
• When defensive stocks play offense – The Reformed Broker
• A US REIT enables you to buy foreclosed homes – Y Charts

Other articles

• A London reader case study – Mr Money Mustache
• The wealth inflection point – DIY Income Investor
• That interest-only timebomb… again… – Simple Living in Suffolk
• Work from home? Bring it on! – The Money Principle
• 10 classic failed tech predictions – Above The Market

Product of the week: Virgin Money has launched a savings bond paying 3%, but you have to tie up your money for five years. Its new 3%-paying five-year ISA savings account is also a table-topper, says The Telegraph.

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site.

Passive investing

• Will index investing kill the market? – Adviser One
• CNBC’s rating decline is good for investors – US News
• Swedroe: Stock market gains come from few top performers – CBS

Active investing

• Is this the most hated bull market ever? – Wall Street Journal
• Turning traders into investors – iii/Money Observer
• What’s this talk of a US housing bubble? – Motley Fool
• How we value Berkshire Hathaway – Morningstar
• How to be a shareholder activist [Search result] – FT

Other stuff worth reading

• Why have so few bankers gone to jail? – The Economist
• Crossrail to boost London house prices – The Telegraph
• Where’s the beef with interest-only loans? [Search result] – FT
• Crowd-funding options for UK DIY dragons – The Guardian
• What’s most important about money to you? – NY Times
• Meet Mr Money Mustache, who retired at 30 – Washington Post
• Matt (cartoonist) on property [Slideshow] – Telegraph

Book of the week: The range of deals offered by Amazon local is impressive – I’m being touted more experience packages alongside cut-price restaurants and the like. Most boast at least a 50% discount, although like all sales bargains be sure you actually want what you buy. (Need doesn’t come into it here!)

Like these links? Subscribe to get them every week!

I see the peer-to-peer pioneer Zopa has evolved again, with the company introducing “Safeguard”, a new and arguably safer way to lend money.

Hitherto Zopa has worked by matching individual lenders and borrowers in a marketplace. You set the interest rate you’ll accept on your loans, and Zopa pairs your savings up with borrowers (or vice versa).

The main benefit of lending via Zopa has been higher rates than you’d get with a bank. Some people also liked the idea of lending direct to individuals, and cutting out those “greedy” financial institutions.

The downside of Zopa was if a loan soured and your smiling borrower turned into a feckless defaulter, then you lost most or all of the money that you’d lent them.

The default option

Your main protection against default has hitherto been Zopa’s usually excellent credit checking, which has kept bad debt well below the predicted levels (though I suffered when it seemingly went on the blink for a month a few years ago).

In addition, you can spread your money between very many borrowers – perhaps lending as little as £10 to any one individual – in order to reduce the impact of any single borrower doing a runner to Gibraltar.

With a fairly large pot of money and typical luck, you could enjoy a healthy average annual return, after deducting fees and bad debts.

Money lent with Zopa is not guaranteed by the Financial Services Compensation Scheme (FSCS) however, and defaults can and do happen, with cash-sapping results. And just to add insult to injury, the way that Zopa interest is taxed, you’re unable to set these bad loans off against your taxable interest income.

So bad debts didn’t even give you the small mercy of a slightly lower tax bill for your troubles.

Bailing out your DIY bank

Zopa’s new ‘Safeguard’ option radically changes this traditional Zopa model, if we can use the word traditional about a seven-year old service!

First and foremost, Zopa claims you will be reimbursed if any of your loans go sour. This will be done via a special fund held in trust for the sole purpose of returning money owed to savers if their borrowers default.

At a stroke, the bad debt problem largely goes away (at least so long as the compensation fund isn’t overwhelmed by bad loans due to some sort of unlikely systemic failure).

The second big change with Safeguard is that if you lend money via the new system, you no longer set a rate you’ll accept for your money.

Instead, all the money goes into the one Safeguard pot that Zopa bundles up to create loans for new borrowers. For some reason this Safeguard money has been prioritised by Zopa for lending, too, so you should see it lent out very quickly.

The interest rate you get for each microloan via Safeguard is determined by a changing tracker rate.

Zopa says it will adjust this rate by looking at:

• The rates being set in its own market

• The rates competitors charge for loans

• Average savings rates

You’ll likely get different rates across the micro-loans you parcel out via Safeguard. Overall though, your average rate should be in line with what Zopa is predicting – which as I type is 5.1% for shorter term loans.¹

The advantage should be that Zopa will be able to fulfil loans more quickly, especially larger loans. This may enable Zopa to feature more prominently on financial comparison tables for a wider range of loan bands, and so drive more borrowers to the Zopa site.

Currently Zopa has a problem where it seems to have a lot of savers but perhaps too few borrowers, considering how competitive it should be given the cheaper loans it usually offers.

You don’t get something for nothing

The immediate disadvantage of using Safeguard is you no longer have any control over the rate you get.

Also, as I see it the rates on offer via Safeguard will likely be lower than might have been available in the usual Zopa market for two reasons:

• Firstly, some of your return goes to fund Safeguard’s reimbursement war chest

• Secondly, bank interest rates are lower than you’ve been able to get via Zopa, and the Safeguard tracker rate will follow them down

I think there are likely to be long-term consequences from this shift in the peer-to-peer model, too.

Experimenting with Safeguard

On the face of it, the introduction of Safeguard is good news from Zopa.

It’s always annoying when disproportionate bad luck means an overall poor result, so spreading bad debt across an entire constituency of savers – just as you do when you put money into a normal bank – will be welcomed by all but the most masochistic.

However as my last sentence implies, this move also makes Zopa more like a standard bank in my opinion – only without the nailed-on guarantee on your savings from the FSCS (Cyprus-style deposit raids notwithstanding!)

Safeguard represents more of a fire-and-forget approach to lending money. If it becomes the usual way to lend with Zopa, then this will hit those who’ve enjoyed ‘gaming’ Zopa for an extra 1-2% in interest. I suspect it will also reduce the community feel over time, too.

As an experiment I’ve shifted some of my Zopa savings to a Safeguard offer to target shorter-term loans, and the money is being lent out very rapidly. A third of it has been lent out in barely two hours!

Lending via Safeguard is trivially easy:

Being a greedy money lender couldn’t be easier with Zopa’s Safeguard option!

Against my expectations, the rate I’m receiving today for most of the latest micro-loans I’m making via Safeguard is actually higher than I was getting yesterday in the normal Zopa marketplace

I wonder though if this is just because the pool of money sitting in the Safeguard pot is still relatively small.

Safety first at Zopa?

It’s anyone’s guess, but I expect Safeguard to eventually become the main method of lending money via Zopa.

Having any bad debts repaid will be just too attractive for most people to resist, even if theoretically they might have done slightly better taking the odd hit but getting higher rates to compensate.

Zopa has been getting simpler and simpler (dare I say dumbing down?) for years. It scrapped its high-risk “C” marketplace and its “Y market” that provided loans to young people, for instance, and it reduced the term options for lenders to “shorter” and “longer”, in place of specific terms measured in years.

I didn’t find those changes detrimental, personally, but the result was undeniably a simpler product.

Some changes have been wholly for the good, especially the “Rapid Return” facility that now enables you to get much of your savings money out at short notice if needed, albeit for a charge. Rapid Return partially addressed the imbalance whereby borrowers could repay early, but lenders had to remain locked into their loans.

I think the new Safeguard product will also prove popular with all but the hardcore, but I wonder where it will end.

It will likely suck more savings into the system, and it will likely bring down rates for those borrowers who find their way to Zopa, too.

But arguably Zopa’s problem is one of insufficient scale, which means any emerging imbalances have tended to be addressed by shifts in its operating model.

In theory, its original market-driven rate-setting system should have produced the perfect equilibrium between risk and reward.

But with Safeguard’s tracker rates partly set by competitors and Safeguard savers having to take what they’re given by way of return, the lofty ideals of the early peer-to-peer enthusiasts seem to be further away than ever.

• For all the ins-and-outs about Safeguard, visit the Zopa website.

1. Note though that as an early adopter I am only paying a 0.5% lending fee. New lenders will pay a 1% fee, which will reduce this predicted rate by another 0.5%.

Looks like it’s game over for cash rebates and the last surviving refuges where small passive investors are spared the pain of significant platform charges.

Within a year, we’re going to be choosing from clean class funds with slimmed down OCFs¹ (Hooray!) while paying beefed-up fees for our platform / fund supermarket / execution-only brokers (Hiss!).

New rules from The Financial Conduct Authority (FCA) will abolish commission-based payments for DIY platforms, bringing them into line with the RDR revolution that hit financial advisors on the eve of 2013.

It’s a massive shake-up for the industry that will force many investors to rethink their choice of funds and brokers.

We’re in for a prolonged buffeting from the bow waves of change as a result, so here’s Monevator’s navigational guidance:

The headlines

• Cash rebates are banned from April 6, 2014².

• Platform services must be paid for by a platform charge that the investor explicitly agrees to.

• Unit rebates are allowed. In other words, platforms may negotiate special offers with fund managers that are passed on to investors as extra shares.

• Critically, the unit bonus must be passed on in full rather than siphoned off in part by the platform.

• 6 April 2016 – the date ‘legacy’ funds bought before April 6 2014 will have to cease their surreptitious commission paying. All funds will be converted to clean class by then.

Why it’s good

Platforms will no longer be allowed to present themselves as ‘free’, while actually carving out a living from the inflated annual management charges (AMCs) that most investors think go to fund managers.

The idea is that investors will know exactly what they’re paying in fees and that will incentivise platforms to become more competitive.

Fund groups like Vanguard, that refused to pay commission, will become more widely available and put greater cost pressure on the rest of the fund industry.

Fund groups won’t be able to use fat fees to push for undue prominence on platforms, supposedly. They’ll probably buy adverts instead.

The FCA has warned the platforms and the fund groups that it’s got its beady eye on them and won’t put up with any naughties.

Why it’s bad

The financial industry is abuzz with theories on how platforms might circumvent the rules. No-one really believes this is ‘over’.

Small passive investors will pay more for platform services. The old regime took 0.1% in platform charges from an HSBC retail index fund. Now the cheapest clean class platform fee is 0.25%.

Unit rebates (along with cash rebates) are now subject to income tax (outside of an ISA or SIPP). They are on the way out like a football manager after a bad run, which is likely to lead to…

Super clean share classes – Certain platforms are already browbeating fund managers to offer them cheaper versions of clean funds.

In other words, Platform A stocks Fund X with an OCF of 0.75%, but Platform B uses its market muscle to get the same fund for 0.65%.

If you’ve ever stared at MorningStar late at night trying to work out the difference between the F, R and I versions of a fund (what, just me?) then you may well fear supping from the alphabet soup that many in the industry are predicting.

On the other hand, if platforms are able to force down fund prices then investors benefit. I have a feeling that they won’t be scrapping over the lean index fund pickings, anyway.

Now what?

You have just under a year to choose your new investment home – unless you’re lucky enough to be with a super-competitive broker already.

We’ll keep our broker comparison table updated to help you make an informed choice in the months ahead.

Right now, the market approach to platform fees for clean class funds is split in two:

Percentage based fees – The best approach for small investors. Charles Stanley Direct and TD Direct charge along these lines.

Flat-rate fees – Fixed charges (say £60) that put a sizable dent in a small portfolio will barely scratch larger pots. You’ll normally pay an annual fee and then extra to trade on top. See Alliance Trust, Sippdeal, Interactive Investor, Best Invest, and The Share Centre.³

To calculate whether you’re best off with flat rate or percentage-based fees:

Estimate the best annual flat-rate platform charge you can get including trading fees. Divide that number by the best rival percentage charge.

For example:

£60 / 0.0025 (or 0.25%) = £24,000

That number is the breakeven point. At that point, a portfolio worth £24,000 will pay the same platform fee (£60) regardless of whether your broker charges a flat rate or a percentage.

If you’re well under that figure and will remain so for years then go for the percentage based platform.

The example assumes you can buy an identical portfolio of funds at either broker. If not, then our article on clean class funds will help you factor in fund OCF differences.

Do nothing

Most brokers have yet to wean themselves off the commission sugar. There will be a flurry of activity in the next six months as they work out a platform charge fit for the new paradigm.

I believe the majority of investors will be better off sitting tight and waiting for the shake down. Moving your portfolio can be a costly business, so it’s best to do it only the once.

Until April 2016, if you’re sitting on a heap of old-style funds then you will only incur a platform charge on the portion of funds that are sold or ‘changed’ after April 6 2014.

Change does not include:

• Reinvesting dividends.
• Automatic rebalancing.
• Regular contributions set up before 6 April 2014.

Change does include:

• Increasing your regular contribution.
• Switching funds in a SIPP.
• Re-registration.

By 6 April 2016 all funds will be converted into clean class anyway, and commission payments will cease. Not long now.

Take it steady,

The Accumulator

1. Ongoing charge figures.
2. Bar leeway of £1 a month per fund so platforms can run promotions and the like.
3. From end of May. Full details of charges are yet to be finalised.

Good reads from around the Web.

The tensions between inequality, meritocracy, communism and the incentives of capitalism have been endlessly debated over the years.

But for too long capuchin monkeys were denied their say.

This injustice was corrected by research showing that the little fellas react just as angrily to inequality as any Occupy protestor running low on Skinny Chai Lattes from the oppressors at Starbucks.

The following video shares the story:

(The full version of this TED lecture is available on its website).

I am not sure whether this video really does show the monkey is reacting angrily to not getting equal pay – or whether he’d just like some grapes, too, as they’re clearly on offer.

A better approach might be to deliver the same type of “pay”, but to give greater amounts to the monkey who demonstrates superior performance. Would our furry friends be happy to see higher skill rewarded?

I have no idea, but I do feel sorry for the losing monkey. It all seems a bit cruel.

Why not just put cameras in City offices at bonus time for equally mean but more amusing results?

From the blogs

Making good use of the things that we find…

Passive investing

• Blended real returns from 16 countries – Mebane Faber Research
• The price-bubblegum ratio and future returns – Rick Ferri

Active investing

• Return and ridicule – Fred Wilson
• Are BG shares a good investment? – UK Value Investor
• The fine art of being wrong – The Big Picture
• Bunzl: A growth company worth paying for – iii blog
• I survived the flash crash of 2013 – The Reformed Broker
• The activist investor – Wexboy

Other articles

• Understanding what your PAYE tax code means – TaxFix
• An unfriendly savings bond – Dosh & Nosh
• Why should I be frugal, when I’m so rich? – Mr Money Mustache
• Please don’t call me cheap – Len Penzo
• A peek into the workings of capitalism – Simple Living in Suffolk

Product of the week: I long for a big, cheap mortgage. Reader Brendan pointed me to a new 3.99% ten-year deal from Yorkshire, which is profiled in The Guardian. Low fees!

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site.

Passive investing

• Terry Smith: A reminder to keep a lid on costs [Search result] – FT
• Swedroe: Big stock market drops are frequent occurrences – CBS
• Low volatility ETFs outshining counterparts – Index Universe
• iShares launches cheap active ETFs in the US – Index Universe

Active investing

• Why emerging markets have lagged – The Economist
• Wall Street analysts tell all – Wall Street Journal
• Seth Klarman: Lost lessons from the crisis – Guru Focus
• What Apple can learn from Warren Buffett… – Bloomberg
• …even if its buybacks are a big deal – Fool and Reuters [plus charts]

Other stuff worth reading

• Nicholas “Black Swan” Taleb has a hissy fit on Twitter – B.I.
• FCA bans fund rebates – Telegraph & iii & FT Adviser
• Merryn: Latest ruse of the City fat cats – Moneyweek

Book of the week: I am really enjoying Money Mavericks, which was billed as the “Confessions of a Hedge Fund manager” but which is more endearing for being far more mundane than that sensational sub-title implies.

Like these links? Subscribe to get them every week!

I am not immune from the gambling instinct. Many years ago I opened a spreadbetting account and had a go at day trading.

I was thrilled when the blinking lights of the trading platform flashed green, and less so when they turned red – though losing money only doubled my resolve!

And there, in a nutshell, is the gambler’s curse.

Losing money makes you want to go back for more. Las Vegas wasn’t built on the triumphs of its punters, but on the takings of the house. And in the long run, the house nearly always wins.

I learned quickly that day trading was dangerous, and never wavered from my main strategy of methodically investing in passive funds and shares.

My interest in investing is intellectually stimulating, and there are certainly some sunny old days when strong company results come in.

But a laugh a minute it is not.

Day trading for fun and profit

When people discover my interest in investing, they usually respond in one of three ways.

• The most common is complete disinterest, if not mild disdain.

• They may tell me they’ve got some shares in ARM / Google / BP / RBS and they’re a few hundred quid in profit. What should they buy next?

• Or thirdly, they might tell me they once had shares in ARM / Google / BP / RBS, and they lost half their money. Shares are a mug’s game!

I can’t recall anyone gleefully telling me they invested in passive index funds. A few when pushed have admitted they “have some sort of ISA in shares”.

Even when it comes to stock picking, it’s once a year that I meet a stranger who reveals they own a portfolio of carefully selected long-term holdings.

No, for the public, being in shares means punting on prices going up and down.

And while that might be expensive fun (though I suspect filling your hot tub with Cristal and scantily clad Eastern Europeans delivers more bangs for the buck) it’s no way to make money.

Making money can be challenging and stimulating. Rewarding, even.

But the selling point is never that it’s easy or fun.

Get rich slowly? Boring!

Of course we’ve all heard entrepreneurs tell us to “follow our passion” to make our money. When running a business feels like fun, you’re already a winner.

I’m sure that’s true, but even if you’re having fun, you’re still not having it easy.

You might smile as you wake at 6am for another 12-hour day with no promise of a pay cheque, but I guarantee you’ll be doing more than clicking a few buttons for your reward.

What about investing in a tracker fund, or buying your own home? Most people make money through home ownership, after all. And it’s not exactly an arduous ordeal – you get to sleep in your investment every night. No sweat!

But the tricky bit with passive investing or buying a home is the long-term commitment. You’re hunkering down for 20-30 years of sticking to a plan.

There’s also the small matter that you have to earn the money to fund these investments with a job, and that is unlikely to be a rip-roaring affair. The returns from residential property or from a typical run in the stock market will not make you rich unless you put a fair amount of money in first.

Who wouldn’t rather put £1,000 into a day trading account, and duck and dive their way to riches?

Who wouldn’t prefer to have a view, push a button, and “take a position”, as the advert says, rather than pushing crates or taking it from the boss?

Yep, you, me and the rest of us. And when everyone wants to do something that is effortlessly easy to do, then you can be pretty sure that all the profits were long since wrung away.

The horrible business of getting rich

I was discussing all this with a friend who told me she’d invested in a wine fund because it was “more fun” than the tracker fund I’d suggested.

If the wine didn’t go up in value, she could drink it!

True, but another failure of the fun test. Too much fun – so it’s less likely to make her real money.

To give yourself the best shot of making a fortune, you need to do something that nobody else wants to do – and where you’ve also found a way to make an outsized profit. (Few people want to be dustbin men, but that won’t make you rich. Owning a toxic waste dump might).

Here are a few examples.

You could start your own business

Long hours, uncertain rewards, a massive chance of failure, and an almost inconceivable list of things nobody ever tells you about that you’ll have to do every day. Most people cannot be entrepreneurs, let alone successful ones, which is why the few who succeed can make a fortune.

Create you own property empire somewhere skuzzy

Head to a grimy part of Manchester or Birmingham, start buying run down properties, refurbish them with sweat equity, hire some heavies to get your rent collected, and wait 30 years for gentrification to finally roll up at your front doors. High chance of success. Strong chance of having a terrible time.

Invest in unlisted start-ups in boring sectors

The returns from investing in successful private companies dwarf those you’ll make from the stock market. No surprise – it’s much harder to find good ones, they’re very illiquid and even harder to get out of than to get into, and a great many fail. Also the best opportunities will be doing something dull and unsexy, so you won’t want to brag.

It’s worth comparing backing boring unlisted firms with being an angel investor in theatre or films.

Who wouldn’t want to be the patron of a troop of bright young things? To be flattered as you’re asked about a new creative concept, and to go to the opening night to be gushed over by your family and friends?

Too much fun, very little effort – and an extremely high chance of losing all the money you put into it.

Do you feel lucky, punk?

Someone somewhere will back the next Cats or Evita this year. Someone will buy a vintage wine or find the next Damien Hirst at a college art exhibition. Someone will pick up shares in a future Amazon-slayer on the day of its IPO.

Being lucky is the easiest way to get rich (though I suspect it’s actually not the most fun – but that’s an existential conversation for another day).

If you want lottery odds on making your fortune, there’s an easy solution – buy a lottery ticket. For every one person who stares in disbelief as their numbers come up and they make a million, another 20 million crumple and toss their tickets in disgust.

Not exactly great fun, but not too much effort, either. And at £1 a week it’s a hell of a lot cheaper than day trading.

Are chimps making chumps out of trackers? In a trial of the fittest run by academics at Cass Business School, traditional market cap weighted indices were beaten by indices picked by 10 million monkeys (or rather by their randomly generated computer simulations).

Market cap indices are the spine of the vast majority of index trackers. News that they’re apparently taking a beating from primates therefore caused some consternation here at Monevator’s Passive Investing HQ.

So should we be pounding the earth like Charlton Heston and preparing to worship our new masters in a passive investing version of Planet of the Apes?

Er, no.

The Cass Business School’s two-part paper is called An Evaluation of Alternative Equity Indices (here’s part one and part two).

The research reveals that investment strategies with the power to capture return premiums like small cap, value and low volatility have historically delivered more OOMPH! than you got from the regular old market.

But this is no surprise. Academics have been telling us this for 20 years and we cited similar revelations a month ago on Monevator.

Broad market indices are designed to capture beta – the return of the market. But there are other sources of return out there.

Essentially, this paper shows that other types of index can angle their satellite dishes so they receive some of the beta channel, and also the small cap and value channels, too.

We’ve previously discussed how you can invest in some of those approaches – like the fundamental indices – by putting money into value-tilted passive funds.

Mind the cap

The standard argument for market cap indices is that they are transmitters for the wisdom of the crowd.

The gestalt human investment brain allocates capital efficiently to the firms who will make best use of it, and this is reflected at light-speed in the index.

The case against market cap indices is pretty clear, too. They are passive victims of the misjudgments of the market. For instance, they are mechanically forced to accept overvalued equities that balloon in the index with the smiley face of irrational exuberance painted on.

You’ll often see passive investors challenged in heated comment threads about how their portfolios would have been swamped with Japanese equities in 1989 or tech stocks in 1999, like a council landfill site crammed with trash.

These accusations fail to account for the sheer global diversity of a passive portfolio. Nor do they acknowledge just how many active investors get trapped in expanding bubbles.

Active investors are the ones making the active decision to chase the bubble higher, after all.

The pros of market cap index tracking

There are still good reasons for holding funds that track market cap indices. It’s worth reflecting on those as an antidote to getting too clever by half:

Simplicity – Market cap indices are easy to understand. The bigger a company is relative to the rest, the greater its presence in the index. That’s it, bar common-sense rules to guard against over-concentration in the event we all go bananas and back SnakeOilSystems.com to take over the world.

One of the issues with the alternative, so-called Smart Beta indices is they are often presented in the language of a black box. Too often proprietary strategy jargon and marketing pseudo-science seems designed to lacquer on an extra layer of fees and play to our desire to believe in magic rather than to promote understanding and transparency.

Without transparency we break the first decree of the DIY investor: ‘Never invest in something you don’t understand’. Without transparency we risk investing in complexity rather than efficiency, and paying extra for Advanced Methyl Ether Rejuvenator Balm when we just need creosote.

Low costs – Broad market cap indices contain the most liquid equities and have low turnover which is why they can cost 0.10% to own in fund form.

Academic research rarely takes the actual cost of implementing alternative strategies into account. It deals in a frictionless world where equities can be freely traded and there isn’t a maze of middlemen to dash through.

The Cass Business School paper demonstrates that some alternative indices beat the market cap approach by around 2% per year. In the UK, you’ll be subtracting 0.3 to 0.5% from that in higher Ongoing Charge Figures (OCF) plus bid-offer spreads and any tracking error that creeps in.

Costs are nailed on. Potential returns aren’t.

Availability – We’re now served by a wide range of market cap index trackers that encompass both the weird and the wonderful.

In contrast, many of the indices cooked up in the academic labs just aren’t available as funds you can buy into in the UK.

No guarantees – Debate rages as to why the return premiums exist. Are they rewards for extra risk (in which case they should persist) or the behavioural errors of flawed humans (therefore erodible through exploitation)?

So far the return premiums have stood up to the scrutiny of the markets, but you have to be prepared for the possibility they could evaporate in the future. As Vanguard founder John Bogle says in The Little Book of Common Sense Investing:

I’m skeptical that any kind of superior performance will endure forever. (Nothing does!)

Personal risk factors – If you work for a small cap firm then a good deal of your future returns (i.e. your salary) are dependent on the fortunes of that part of the market. Tilting your portfolio in favour of small cap funds would concentrate your risks rather than diversifying them.

The same principle could apply to some extent to most of us. Consider how your earning power correlates to the economic cycle before tilting your portfolio in favour of, say, value strategies that generally take a beating during recessions.

Performance chasing – Different strategies work best in different time periods, as shown in the Cass paper. Even market cap has beaten all-comers during a raging bull market. Strategies will be declared ‘hot’ based on recent performance – witness the flurries over low volatility and high dividends recently – reducing their likelihood of outperforming in the future.

Johnny-come-latelys will swarm in, then dump the funds when they fail to make ‘em rich. As ever we must resist the temptation to jump on board a bandwagon.

Tracking error regret – How will you feel when your alternative strategy eats the market’s dust for five years straight?

When returns soar we take it as confirmation that we’re as brilliant and blessed as we always thought we were. But when our high-cost strategy is left billowing black smoke in a lay-by as the rest of the market whizzes by, how happy will we be then? That’s not a pain you’ll ever have to feel when you simply invest in the market.

Hard evidence – Twenty years is a reasonable amount of time to judge a strategy’s performance. Ten will do, five is barely acceptable. Anything less is irrelevant.

It’s hard enough to get ten years of performance data for a market cap index fund. We’ll have to wait years for useful numbers on the latest financial products.

Back-testing is used to fill the gap, but be aware that many strategies that glitter in the data mine have lost their lustre in the cold light of day. As ever, investors are wise to be cautious and wary of products with insufficient miles on the clock.

Enough monkey business

I say all the above as an investor who’s convinced by the arguments for factor investing, smart beta, fundamental indexing – whatever you want to call it.

But I know it’s a risk and so I won’t be entirely abandoning market cap investing.

Both approaches will work in tandem in my portfolio because, although I’m prepared to take a chance on the extra reward, sometimes you just can’t beat the tried-and-tested.

Take it steady,

The Accumulator