Millionaire Teacher

by Andrew Hallam

  Your portfolio might not look like a Ferrari or a Porsche. But I’m guessing your Mazdas, Hondas, and Fords have left most of the 20 biggest hedge funds17 gasping in their fumes, if you’re investing with index funds.

  Over the five-year period ending October 31, 2015, the 20 biggest hedge funds coughed and sputtered. They averaged a compound return of just 6.8 percent. That would have turned $10,000 into $13,894. The S&P 500, by comparison, roared on every cylinder. It averaged an annual compound return of 14.2 percent. The same $10,000 would have grown to $19,423.

  As you can see in Table 9.5, just one of the 20 biggest hedge funds managed to keep pace.

  Table 9.5 Index Funds Trounce the 20 Most Popular Hedge Funds Three- and Five-Year Returns Ending October 31, 2015

  Hedge Fund 3-Year Total Return

  5-Year Total Return

  Bridgewater Pure Alpha Strat 18% Vol 17.6%

  57.3%

  Millennium International Ltd 41.3%

  65.6%

  Bridgewater Pure Alpha Strat 12% Vol 11.9%

  35.6%

  Winton Futures USD Cls B 27.1%

  29.4%

  Millennium USA LP Fund 42.6%

  68.2%

  Bridgewater All Weather 12% Strategy 2.3%

  34.7%

  Renaissance Inst Diversified Alpha Fund 36.0%

  n.a.

  The Genesis Emerging Mkts Invt Com B –3.7%

  –0.7%

  Transtrend DTP—Enhanced Risk (USD) 12.4%

  6.2%

  EnTrust Capital Diversified Fund Ltd—C 11.3%

  13.9%

  Winton Futures GBP Cls D 28.2%

  30.9%

  Bay Resource Partners Offshore Fund Ltd 36.5%

  42.8%

  Baring Dyn Asset Alloc I GBP 15.9%

  25.6%

  MKP Opportunity Offshore Ltd 9.6%

  25.7%

  Pinnacle Natural Resources, L.P. 7.9%

  17.6%

  MKP Credit Offshore Ltd 18.9%

  34.3%

  The Genesis Emerging Mkts Invt Com A –5.5%

  –3.7%

  Aristeia International Limited 7.3%

  21.0 %

  Babson Capital European Loan B EUR Acc 19.7%

  n.a.

  STS Partners Fund 77.4%

  184%

  Biggest 20 Hedge Fund Average 20.73%

  38.7%

  Vanguard S&P 500 Index 55.7%

  94.4%

  Vanguard Balanced Index 32%

  58%

  *Returns to October 31, 2015

  Sources: Barron’s; Morningstar

  Ok, I’ll admit, my comparison isn’t fair. Stocks soared over the five-year period ending October 31, 2015. Many hedge fund managers invest in different asset classes. So let’s compare these faux Ferraris with something more diversified, like Vanguard’s balanced index fund. It averaged a compound annual five-year return of 9.7 percent. Just three of the 20 biggest hedge funds beat this simple Chevy, which is composed of 60 percent stocks, 40 percent bonds.

  Why do hedge funds lag? We know their fees are high.

  Many hedge fund managers also roll the dice. They borrow to invest.18 When their bets crash and burn, they simply walk away. It’s their passengers who perish. John Lanchester, writing for The New Yorker, reported that most hedge funds disappear after just five years. “Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013.”19

  New hedge funds replace them. But the stats are clear. Every three years, one-third of hedge funds get rear-ended and explode just like a Pinto.

  To make matters even worse, hedge funds are remarkably inefficient after taxes, based on the frequency of their trading. Plus, you never know which funds will survive and which funds will die a painful (and costly) death.

  Hedge funds are like hedgehogs. Nice to look at from afar, but don’t get close to their spines. Index funds are better.

  Don’t Buy a Currency-Hedged Stock Market ETF

  There’s a mantra that Wall Street would probably like to banish. If it sounds too good to be true, it probably is. Wall Street, after all, will sell what Wall Street can sell. Such is the case with currency-hedged index funds.

  They sound exotic. But they’re more common than a rusting third-world boat. In fact, when an ETF provider in Canada, Australia, or Europe first offers an international stock market ETF, they usually introduce a currency-hedged version first. They’re also being sold to US investors. Currency-hedged ETFs aren’t just rusting. They leak. That’s why I haven’t included currency-hedged ETFs in any of this book’s model portfolios.

  Here’s what they’re supposed to do. Assume you’re an American who owns a European stock market index. If the stocks within the index gain 10 percent (measured in Euros) you would expect your index fund to earn something similar in US dollars. But reality could be different. If the Euro drops 10 percent, compared to the US dollar, Americans wouldn’t profit. A currency-hedged ETF, on the other hand, would still make money for American investors. At least, that’s the sales pitch.

  Currency fluctuations, however, aren’t always bad. If, for example, the US dollar falls against most foreign currencies, then investors could profit from a nonhedged international index, as the growing strength of foreign currencies against the dollar juice the returns of a foreign stock index in US dollars.

  With a diversified portfolio of domestic and nonhedged international stock indexes, sometimes you’ll win when currencies fluctuate. Sometimes you’ll lose. If the international market drops 5 percent, but the US dollar drops 8 percent against international currencies, Americans gain money if they’re invested in an international stock market ETF. On the flipside, if the international market drops 5 percent but the US dollar gains 8 percent against the index’s foreign currencies, the same investors would lose about 13 percent.

  Currency-hedged ETFs are made to help you sleep. They’re made to limit fluctuations. But they have their own set of problems. First, their management fees are higher than with plain vanilla indexes. Second, they have higher hidden costs associated with the hedging itself. It’s where the leaking boat comes in.

  In a PWL Capital research paper, Raymond Kerzérho examined the returns of S&P 500 indexes hedged to the Canadian dollar between 2006 and 2009. Even though the funds were meant to track the index, they did much worse. They underperformed the S&P 500 by an average of 1.49 percent per year. Currencies were less volatile between 1980 and 2005. During that period, tracking errors caused by hedging would have cost 0.23 percentage points per year. Add the higher expense ratios of currency-hedged funds and they would have underperformed nonhedged funds by about 0.5 percent a year.20

  The more cross-currency transactions that a fund makes, the higher its expenses—because even financial institutions pay fees to have money moved around. Consider the example of a currency exchange booth at an airport. Take a $10 bill and convert it to euros. Then take the euros they give you and ask them to return your $10. You’ll get turned down. The spreads you pay between the “buy” and “sell” rates will ensure that you come away with less than $10.

  Large financial institutions don’t pay such high spreads. But they still pay them. And they reduce investors’ returns.

  Then there’s the opportunity cost from the hedging itself. This gets a bit technical. But here’s a Cliff Notes version. When hedging currencies, there’s always a bit of money that gets left off the table. That money can’t make money. Mr. Kerzérho provides an example of a theoretical S&P 500 fund hedged to the Canadian dollar. Assume that it has $100 million (US) in assets under management. At the beginning of the month, it would be long $100 million in the US S&P 500. At the same time, it would be short $100 million—in US dollars—in foreign contracts versus the Canadian dollar.

  If the US index gained 3 percent for the month, then it would be long $103 million
(because of the rise in the US market). Considering that $100 million was short as a currency hedge, it would leave $3 million exposed and unhedged. If the US dollar drops, the $3 million in unhedged dollars will depreciate.

  Because most financial institutions adjust their hedging once per month, fluctuations in currencies ensure that part of the assets are always underhedged or overhedged. If, for example, the S&P 500 lost money over the course of a month, then the fund would become overhedged. Using the figures above, if the $100 million long position dropped 3 percent to $97 million, the fund would be overhedged by $3 million—exposing it to potential losses on currency movements.21

  Ben Johnson (the research analyst, not the doped former sprinter) published results from a 20-year US study in Morningstar. He says nonhedged ETFs usually beat their currency-hedged counterparts. “By hedging foreign-currency exposure, investors can mitigate a source of risk—but at the expense of a potential source of return.”22

  Stay away from currency-hedged ETFs. Long term, they’re leaking boats, compared to plain vanilla index funds.

  Beware of the Smart Beta Promise

  Marketers are smart. They’ve recognized that a growing number of investors are attracted to index funds. They smell opportunity. That’s why many have created smart beta funds, also known as factor-based funds. Do you remember what I said about Wall Street? If it sounds too good to be true . . .

  Smart beta firms use backtests. They claim that index funds weighted differently produce better returns. For example, take a plain vanilla index. Its stock weightings will emphasize the largest stocks. If Apple is the largest company in the S&P 500, then Apple’s fortunes (good or bad) would have the greatest influence on the S&P 500. Smart beta indexes juggle the components differently. Sometimes, they build higher emphasis on stocks with momentum. Other times, they build an index that’s equal weighted. In this case, larger stocks don’t move the index fund’s needle any more than smaller stocks do.

  Backtests usually dazzle. They prove that such index fund strategies would have triumphed in the past. But the past isn’t the future. Often, the newly emphasized stocks in these index funds become more expensive. This can hamper future returns.

  Research Affiliates’ Rob Arnott, Noah Beck, Vitali Kelesnik, and John West say that smart beta or factor-based funds could disappoint investors. They recently published “How Can ‘Smart Beta’ Go Horribly Wrong?”23 In it, they show that much of the past decade’s market-beating gains from such funds have come from rising valuations. Investors rushed into such funds because they had performed well. That raised the PE ratios of certain stocks to higher than normal levels.

  Higher than normal valuation levels could bring poor returns in the future.

  Smart beta funds are cheap, compared to actively managed funds. But they cost a lot more than most standard index funds. Strategies based on a cherry-picked past sell new Wall Street products. But they aren’t necessarily better for investors.

  Don’t Jump Heavily into Small-Cap Stocks

  Many people stack their portfolios with index funds that are heavily focused on small-cap stocks. And why not? Economists Eugene Fama and Kenneth French say that between July 1926 and February 2012, small-cap stocks cumulatively beat large stocks by 253 percent.24 But not everyone agrees. That’s why investors should temper their small-cap expectations.

  In 1999, Tyler Shumway and Vincent Warther published a paper in the Journal of Finance, “The Delisting Bias in CRSPs NASDAQ Data and Its Implications for the Size Effect.” They should have called it, “Size Doesn’t Matter.”25

  They said small stocks often have shakier financial foundations. They have a tougher time weathering storms. That’s why many get dumped (or delisted) from the stock market. Shumway and Warther say that when we measure small-cap returns, we only see the storms’ survivors.

  Ted Aronson manages institutional money through AJO Partners. He runs two small-cap funds. But he doesn’t believe in the small-cap premium. Interviewed in 1999 by Jason Zweig, Aronson said, “Small-caps don’t outperform over time . . . Sure, the long-run numbers show small stocks returning roughly 1.2 percentage points more than large stocks . . . [But] the extra trading costs easily eat up the entire extra return—and then some!”26

  The firm Research Affiliates is always looking for a performance edge. They created the Fundamental Index in hopes of beating traditional cap-weighted index funds. Their researchers Jason Hsu and Vitali Kalesnik dug deeply into the apparent small-cap premium to see if small stocks really outperform. Based on their research, it appears that they don’t.

  Following Fama and French’s research method, they split stocks into two groups for a variety of different countries. The largest 90 percent were put in one group. The smallest 10 percent were put in the other. They examined performances from 1926 to 2014.

  After adjusting for extra transaction costs and delisting bias, Research Affiliates’ Vitali Kalesnik and Noah Beck say small stocks don’t beat large stocks at all. “If the size premium were discovered today, rather than in the 1980s, it would be challenging to even publish a paper documenting that small stocks outperform large ones.”27

  That’s why I like to keep things simple. Total stock market index funds include large-, small-, and medium-sized stocks. Those who do want a small-cap index should keep its exposure to a minimum.

  When investing, seductive promises and get-rich-quicker schemes can be tempting. But they remind me of why I don’t take experimental shortcuts when hiking. It’s too easy to lose your way. I wonder if the famous French writer, Voltaire, would agree. In a translation from his 1764 Dictionnaire Philosophique, he wrote: “The best is the enemy of good.”28 Investors who aren’t satisfied with a good plan—like simple index fund investing—may strive for something they hope will be “best.” But that path doesn’t pay.

  Notes

  1Benjamin Graham (revised by Jason Zweig), The Intelligent Investor (New York: Harper Collins Publishers, 2003), 146.

  2Erin Arvedlun, Madoff, The Man Who Stole $65 Billion (London: Penguin, 2009), 6.

  3Ibid., 85.

  4“Daryl Joseph Klein and Kleincorp Management Doing Business as Insta-Cash Loans,” The Manitoba Securities Commission, order no.5753: August 13, 2008, http://docs.mbsecurities.ca/msc/oe/en/item/103467/index.do.

  5Gilder Technology Report, www.gildertech.com/.

  6Mel Lindauer, Michael LeBoeuf, and Taylor Larimore, The Bogleheads Guide to Investing (Hoboken, NJ: John Wiley & Sons, 2007), 158.

  7Ibid., 159.

  8Mark Hulbert, “Newsletter Returns: Be Skeptical,” Barron’s, October 3, 2013, www.barrons.com/articles/SB50001424053111903320604579109521642860630.

  9William J. Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between (Hoboken, NJ: John Wiley & Sons, 2010).

  10Morningstar.com.

  11David Swensen, Pioneering Portfolio Management, An Unconventional Approach to Institutional Investment (New York: Free Press, 2009), 195.

  12Morningstar.com.

  13Calculated from 1801–2001 returns of US stocks and gold from Jeremy Siegel, Stocks for the Long Run (New York: McGraw Hill, 2002), then extrapolated further using gold’s 2016 price.

  14David F. Swensen, Pioneering Portfolio Management, An Unconventional Approach to Institutional Investment (New York: Free Press, 2009), 195.

  15Ibid.

  16HFRX Indices Performance tables, www.hedgefundresearch.com/family-indices/hfrx.

  17“Hedge Funds Best-Worst Biggest,” Barron’s, www.barrons.com/public/page/9_0210-hedgefundbestworst.html.

  18“Hedge Funds, Borrowing and Betting,” Barron’s, June 10, 2004, www.economist.com/node/2752920.

  19John Lanchester, “Money Talks,” The New Yorker, August 4, 2014, www.newyorker.com/magazine/2014/08/04/money-talks-6.

  20Raymond Kerzérho, “Currency-Hedged S&P 500 Funds: The Unsuspected Challenges,” September 2010, www.pwlcapital.com/pwl/media/pwl-media/PDF-files/Articles/C
urrency-Hedged-S-P500-Funds_The-Unsuspected-Challenges_2010_10_21.pdf?ext=.pdf.

  21Ibid.

  22Ben Johnson, “To Hedge or Not to Hedge,” Morningstar, November 2, 2015, http://ibd.morningstar.com/article/article.asp?id=635705&CN=brf295, http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295.

  23Rob Arnott, Noah Beck, Vitali Kelesnik, and John West, “How Can Smart Beta Go Horribly Wrong?” Research Affiliates, February 2016, www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/442_How_Can_Smart_Beta_Go_Horribly_Wrong.aspx?_cldee=aGV3ZXN0ZWFtQGhld2VzY29tbS5jb20%253d.

  24John Davenport and Fred Meissner, “Exploiting the Relative Performance of Small-Cap Stocks, AAI Journal, January 2014, www.aaii.com/journal/article/exploiting-the-relative-outperformance-of-small-cap-stocks.touch.

  25Tyler Shumway and Vincent Warther, “The Delisting Bias in CRSPs NASDAQ Data and Its Implications for the Size Effect.” Journal of Finance, June 1, 1998, www-personal.umich.edu/~shumway/papers.dir/nasdbias.pdf.

  26Jason Zweig, “He’s Not Picky, He’ll Take Whatever Is Wounded,” CNN Money, January 15, 1999, money.cnn.com/1999/01/15/zweig_on_funds/zweig_on_funds/.

  27Vitali Kalesnik and Noah Beck, “Busting the Myth about Size,” Research Affiliates, December 2014, www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/284_Busting_the_Myth_About_Size.aspx.

  28Goodreads quotes, Voltaire, www.goodreads.com/quotes/ 80000-the-best-is-the-enemy-of-good.

  Conclusion

  You probably know a few people who are financial train wrecks waiting to happen. You, however, have a choice. You can watch them crash, or you can teach them some rules that they should have learned in school.