Investing Demystified

by Lars Kroijer

  Generally speaking, some index products can be incredibly expensive and best avoided. The Virgin FTSE All-Share Tracker fund charges 1% a year in fees while the Vanguard FTSE All-Share index charges 0.15% in on-going fees.1 Why people would pay six times as much for the same product unless their circumstances did not let them invest in the cheap one is beyond me. Add to this that some index-tracking funds have up-front fees and the cost differential for what is essentially the same product becomes eye watering.

  So with index funds like ETFs on top of the checks you need to make to ensure that you get a product that is suitable for your specific needs, make sure you get proper diversification and that you are not being overcharged by the product provider.

  A few issues with index replication through ETFs or index funds

  As I’m suggesting that we should be investing through broad-based and cheap investment products I want to flag a few things that some people could see as issues with these products. In no particular order, they are as follows.

  Different indices on the same market will perform differently?

  Index providers have different rules on things like free float (the fraction of shares that freely trade as opposed to being owned by controlling shareholders or management), liquidity, re-balancing, etc. and as a result will perform differently even if they follow the same market. So one index provider might lower Facebook’s weighting by 50% because of its low fee float while another reduces it by 66%. Who is right or wrong is open to debate, but the index returns will be different as a result of the different weightings. While this is correct and leads to slight differences in performance there is no reason to expect one index to consistently outperform another. The index providers are trying to do the same thing: provide a good representation of that market and while their interpretations differ slightly you can expect different indices on the same markets to act very similarly. Most of the securities in the index are the same and in roughly the same proportions.

  (Related to first one) Index tracking funds and ETFs have a tracking error

  Correct. Practically speaking, product providers can’t match the index 100% all the time. Sometimes the rebalancing is done slightly differently or perhaps providers have slightly different proportions of the less-liquid constituents. Indices typically rebalance quarterly. Imagine that because of a reweighting you have to include Facebook in your index-tracking product with a 5% weighting as of the 1st of next month. Theoretically you would buy all those shares at the closing price on the day prior to the 1st, but that is not practically possible. Instead you have to decide how you scale into the stock. Perhaps some traders buy the stock five days before and after the 1st while others do it all 10 days before the 1st. As a result, their performances will be different and one will track the index less closely than the other. If an index tracker/ETF consistently underperforms other products on the same index it may point to problems in its implementation (or hidden fees) and it may be worthwhile looking for alternative products.

  Not all countries are in the world equity and bond indices

  Correct. One day they probably will be, but not for now. Some countries don’t have functioning capital markets (try buying shares in North Korea). That said, the world equity indices represent countries that in aggregate constitute more than 95% of the world gross domestic product (GDP), in my view making it representative enough.

  Most indices don’t represent all stocks or bonds in a country

  Correct. Having all traded stocks or bonds represented in an index would make it extraordinarily tough and expensive to implement or increase tracking error as index trackers would often not include them in trading for practical reasons of liquidity and cost of trading. (Similarly, as discussed earlier, the stock or bond markets represent varying proportions of the domestic economies in different countries.) Besides, if we have an index that represents 95% of the total value of all stocks in a market then the last 5% outside the index would have to massively outperform before the omission is material.

  Licence fees will eat into my returns

  Index providers charge the product providers an annual licence fee. The size of the fee is mostly confidential, but 0.02–0.03% a year is probably a decent guess. This is what iShares pay to MSCI to call it the World MSCI index instead of just the World index. While I would personally be happy to save the 0.02–0.03% a year for a white-label index brand the product providers obviously think the association with the MSCI, S&P, FTSE, Stoxx, Russell, Dow, etc. is worth it. I would not be surprised if firms like Vanguard not only pay far lower fees, but also eventually consider its own brand strong enough so that it follows its own index creations or very cheap independent ones.

  Your performance will only be average

  Yes. Hopefully. The point is that we can’t outperform the market and as a result should buy broad market exposure in the cheapest and most tax-efficient way. Of course this means that we won’t only own the next Apple going up 500%, but nor will we have all our savings in the next Enron or Lehman.

  Comparison sites

  There is every chance that by the time you read this there will have been new product launches or changes in the fees of some of the products mentioned above. With that in mind, you need to do some of your own research on the best available products before investing. Here are a few comparison websites you may consider (there are many others):

  Morningstar.com

  Trustnet.com

  Indexuniverse.com (or .eu)

  Funds.ft.com

  Bloomberg.com

  Reuters.com

  Investmentfunds.org.uk (UK biased)

  Barrons.com

  I would caution you against taking the information on the websites as fully correct and complete. Before making any investments ensure you go to the product provider’s website and look at the fund facts in detail. Only there can you be sure that the information is up to date and correct.

  If you have a financial adviser it would be a reasonable expectation that he or she has an educated view on how to best to get similar information.

  On the site you should be looking for the fund screeners. The categories are not always straightforward and sometimes the sites don’t allow you to screen for ‘index tracking’. A good way to get around that is to search for the funds/ETFs with lowest total expense ratios (TERs); perhaps even look for terms like ‘index’ in the names of the funds. Likewise you will find lots of different styles like ‘mid-cap value’ or ‘high yielding’, etc. but not the simple ‘global’ portfolios we are after. Also, in some cases certain products will simply be absent from the product offering section of some supermarkets so be sure to check a few. Have patience and keep trying – it’s worth your while. Failing that you can always revert to browsing through the ETF or index fund providers listed earlier. While many other product providers try to compete with them there is a reason that those listed are among the market leaders.

  Some index fund providers charge a small trading fee to get into the fund, just like they do if you redeem from the fund. This charge just reflects the cost to the fund of investing your money in the underlying securities. If there were no charges and you were a long-term holder of the fund (like you hopefully will be) you would instead indirectly be paying the trading fees as other investors come in and out of the fund. While entry/exit fees are explicit in index funds, in ETFs those charges are implicit in the bid/offer spread, or in some cases if the ETFs trade at a premium or discount to the net asset value. (So there is a discount if the ETF trades at £99, but the aggregate value of the holdings is £100, etc.)

  For all its growth, index-tracking products still only represent around 10–15% of investments in equities (less in other products), and will not be pushed hard by the comparison sites. Keep in mind that index-tracking products like index funds or ETFs charge low fees and as a result far greater profits are to be had for the finance industry from flogging other products on the platform.

  Execution

  I
f you are at the point where you know what index fund or ETF you want to invest in, all that remains is to execute the investment and start reaping the benefits of index tracking.

  Since buying an ETF is like buying a normal stock, you can use a normal online discount broker for this. The commission rates should be very small even if you buy via some of the more established banks, although in both cases be sure to avoid ‘hidden’ extras. You are a ‘bare-bones’ customer. The products we have discussed are all liquid so your order should not have a market impact, unless you have investment assets as large as those of the Emir of Qatar. For less-liquid ETFs study the daily volume and normal bid/offer spreads before making an order. If your order seems like it could move the market of that ETF you may want to reconsider if that is the best choice of investment product for you.

  Buying an index fund is often best done via one of the fund supermarkets. Make sure that you get ‘execution only’ and withstand the offers of expensive services. Because there are so few fees in the cheapest index tracking funds some of the supermarkets charge a maintenance fee if you buy the tracker through them. (The supermarkets often get a cut of some funds’ fees so no wonder that they push ….) While the fees at a couple of pounds a month may look small, make sure that your investment is of a size that this will not eat into your returns in a significant way. (£2 a month on a £10,000 investment is still 0.24% per year, so you are probably better off owning an ETF.)

  A few suggested (UK-specific) supermarkets are as follows:

  bestinvest.com

  hl.co.uk

  cofunds.co.uk

  fidelity.co.uk

  alliancetrust.co.uk

  iii.co.uk (Interactive Investor)

  In many countries, including the UK, you can buy government bonds directly from the treasury at little or no cost. While there is a small cost saving to doing so this means you are responsible for ensuring that the maturity profile of your bonds is in line with your target on average time to maturity as it naturally changes with time. For most people it is worth paying the cheap product providers’ small costs so that everything is taken care of for you.

  Trading is expensive and pulling the trigger can be nerve wracking

  Trading is expensive and one of the main reasons many investors underperform, but by changing allocations when you are trading securities you will be able to save money on transaction costs. Some product providers offer combined products with fixed weightings between bonds and equities. While they have the same issues outlined here they also have the huge advantage of large natural flows from customers and have lower costs as a result. If you find a product that suits your profile this added advantage is worth noting.

  When rebalancing your portfolio also consider your ticket size. If you are trading a $10,000 position and split that into four ETFs or securities, even cheap commission charges will add up. If you pay $15 per trade you will have incurred a 0.6% ($60/$10,000) brokerage fee. Do consider if you really need all four securities this time around. Keep in mind that, for example, the equity portion of the rational portfolio can easily consist of only one security, which is an advantage when it comes to keeping down commission costs.

  If you are just getting started on saving money up and building your portfolio from scratch it may be a bit daunting to pull the trigger and invest the money all at once. You would hate to buy into the market only to see markets drop 10% in the weeks after making the decision. All that hard-earned money up in smoke just because you were unlucky and picked the wrong week to invest.

  While it may be harder emotionally you should put the money to use sooner rather than later, once you have made your plan, decided allocations and figured out the best products for you. We think markets will increase slowly over the long term, but also know they can go anywhere in the short term. Of course if you invest everything at the same time you increase the risk that you randomly picked a bad moment, but while you wait to implement your portfolio you are expecting at least the equity portion of it to go up at an annual rate of 4–5% equity risk premium. So unless you know something about the short-term direction of the markets and can pick a better moment to invest, there is no time like the present.

  If this ‘all at once’ allocation seems too risky you may consider splitting the allocations into chunks where you add a little at a time over a certain period, although don’t forget that you will pay more in commission that way. (Investors typically pay a fixed amount each time they trade.) If you are fine with the higher commissions and hassle of doing multiple trades you may consider strategies like dollar-cost averaging (where you buy more as markets are dropping) or value averaging (similar but subject to investing a fixed amount over a period of time).2 Personally I don’t subscribe to these methods as I think you are essentially saying the market follows a mean reversion pattern (and thus you claim an edge), but if it gives you greater comfort in getting started it may be a good idea.

  Rebalancing your portfolio

  Any investment book worth its salt will tell you that you need to think carefully about formulating a plan and sticking to it. Swapping in and out of securities will significantly reduce long-term returns, mainly because of the transaction costs and taxes you incur.

  While market movements or changes in your personal circumstances may alter your risk/return perspectives, generally you want to set yourself up so that you have a fair bit of flexibility in your portfolio before those factors force you to trade securities. Suppose, for example, that your risk profile is such that you want a 60/40 bond/equity mix in your portfolio, but that strong equity markets made this ratio 55/45. Should you sell 5% of equity and buy bonds to get back to the 60/40 split?

  How far you are willing for your portfolio mix to diverge from your ideal allocation is an individual choice and partly depends on how fixed your split was to start with. Obviously you want to avoid trading too narrow ranges: if you reallocated every time the allocations got more than 1 percentage point away from your ideal allocation (so 61/39 or 59/41) you would end up trading very frequently which would be expensive and probably not necessary. One rule of thumb you might consider is to reallocate once a year if the allocations are more than 10% out of sync, or during the year if more than 15–20% out.

  Keep in mind that just like you originally planned your allocations and came up with a 60/40 split, that split is not written in stone. Your circumstances may change, prompting a rethink, or development in the markets may change your desired allocations. If, for example, you started with £100,000 and a 60/40 bond/equity split, and equities rallied 50%, without rebalancing the split would have become 50/50 (£60,000 in bonds and £60,000 in equities). You might find that you don’t need more than £60,000 in bonds to be comfortable and you therefore could keep all the additional money in the higher risk/return equities (and not rebalance in that case). Note how rebalancing typically involves selling the better-performing asset and buying the underperformer, something which sits uncomfortably with many investors.

  So a few thoughts on rebalancing your portfolio:

  After you determine your initial mix of the portfolio, have an idea of what kind of bands you are happy to operate within before rebalancing. If you are more than 10% out of sync, that is probably a good time to rebalance.

  Whenever you have money coming into or out of your portfolio use that as an opportunity to rebalance a little bit. So, if your ideal mix is 60/40 bonds/equities and you are currently at 62/38 and have money coming in, use that money to buy equities, not a 60/40 mix. In the long run this will save you money in rebalancing the portfolio as you save additional trading costs.

  Periodically, and at least yearly, review the portfolio and make sure you are still happy with the mix. Have things changed in your life so that 60/40 no longer is the best ratio? This could include the passage of time; as you get closer to retirement you should have fewer assets in equities and more in bonds.

  Summary

  Portfolio implementation is obviously incredibly impor
tant, but the choices you have are much better than they were only a couple of decades ago. Cheap and liquid index exposure is now commonplace and something most major financial firms offer.

  The right product for you is really an individual choice dependent partly on your tax and currency situation. But the key facts are the same. Buy as broad an index tracker as you can and as cheaply as you can. If you do that, you are doing pretty well.

  1 At the time of writing, in the UK the only way to buy the Vanguard funds below £100,000 is through Alliance Trust. Vanguard has been making noises about introducing easier and more direct options.

  2 See The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William Bernstein (American Media International LLC, 2004).

  part four

  Other things to think about

  chapter 15

  * * *

  Pension and insurance

  For many individuals their investing lives are dominated less by issues relating to their rational portfolio, but rather by the options and choices with regard to pensions, life annuities and related products. Wearing the rational portfolio hat, here are some thoughts on these topics.