Amid the endless chatter about market direction (“have we reached the bottom?”), bargain stock picks and so on, I wonder if investors aren’t missing the more important point: how to manage a portfolio in a world of lower and more volatile returns.
I’ve already questioned whether a simple strategy of buying and holding actually delivers the goods – I’m not sure it does any more. So, this week, I’ve been examining how to add different strategy “layers” to a portfolio, to boost long-term returns.
But before even considering additional portfolio holdings, you have to consider the impact of extra costs. If you have the time, I’d recommend downloading a cracking analysis paper by Geoff Considine, a US analyst, called The Humble Arithmetic of Portfolio Management (www.quantext.com/HumbleArithmetic.pdf). He runs a company called Quantext which constructs cheap, index-tracking portfolios, and his paper builds on the polemics of investment maverick John Bogle, who delivered a blistering attack on the global fund management industry back in 2005.
Bogle challenges the prevalent Efficient Markets Hypothesis (ie, markets get it right most of the time) by suggesting his own theory, called The Cost Matters Hypothesis. His contention is that fund managers and advisers fleece investors with high costs and low returns. In total, he estimates that the charges levied on private investors in the US in 2005 were “approximately $350bn, all directly deducted from the returns that the financial markets generated for investors before those croupiers’ costs were deducted”. In 1985, he estimates these costs were a “mere” $50bn. The bottom line is that these huge costs reduce long-term portfolio returns substantially.
Considine picks up the Bogle attack by spelling out all the ways in which the fund management industry kills private investors’ returns. Between 1983 and 2003, he points out that the S&P 500 returned an annual average of 13 per cent, from which private investors had to deduct an “average fund lag” – due to poor management and high expenses – of 3 per cent a year. On top of this, bad timing by investors lost another 3.7 per cent a year. Finally, the net effect of inflation was 3 per cent a year. So the final real return was just 3.3 per cent a year. If, by contrast, those investors had chosen an average index-tracking fund, that return would have been just under 9.8 per cent a year.
Those in the industry may protest (as a fund of funds manager did in these pages in December), but long-term statistics and academic studies show that, the more active the manager, the higher the costs – and most active managers fail to deliver these expensive goods.
Considine then addresses the challenge of boosting returns in a world where long-term returns might be closer to 6 to 8 per cent a year – based on analysis that suggests company earnings have tended to grow by about 6 per cent a year, on average. He suggests that using different “layers” could add returns to your portfolio.
At its base, he says, should be diversified exposure to different markets and assets, some of which will, with luck, produce returns that are uncorrelated to each other. That can seem hard to achieve when all assets are being thumped at the same time. However, there is evidence that – outside of crises – some asset classes do move independently (do a web search for Re-evaluating Asset Allocation in a Basket World by Peng Chen of Ibbotson Associates).
Above this base, there could be a layer weighted towards individual stocks that might increase returns – but this is a risky practice probably best avoided by all but the more adventurous investor right now.
Next comes the strategy layer – the one that most investors, obsessed with stock picking, miss out on.
Strategy can include momentum investing (using measures such as relative share price strength) or systematically seeking out value stocks with high yields (using fundamental index tracking, for instance).
Evidence for the importance of strategies comes from the quant types at SocGen who maintain their own indices that track strategies rather than individual shares. One that has been delivering strong positive returns in the last year is something they call the Wise strategy – up 35 per cent in the last year in the US alone.
This is a combination of momentum (earnings surprise) and value strategies and I suspect that a product based on the strategy will soon be available for private investors.
Crucially, the SocGen strategy includes a factor that Considine ignores: short the bad stuff. Most of the returns for Wise come from shorting stocks that fail to meet the momentum and value criteria.
Finally, there is the layer of intelligent market timing – using ideas I’ve mentioned in previous columns about looking at moving averages, or the cyclically-adjusted price/earnings ratio.
Add all these up – and use cheap index-tracking funds intelligently – and Considine reckons that investors could boost returns by up to 5 per cent a year, which over 20 to 30 years makes a huge difference.
