GlobalMay 2 2017

How to invest amid crumbling post-war certainties

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How to invest amid crumbling post-war certainties

It is in such times of uncertainty that investors need to remember the purpose of investment. It is not easily done. The very beginnings of stock market capitalism in 1600 combined two very different functions: investing in the cargoes of Dutch East Indiamen in expectation of the market riches they would bring back from Asia, and gambling that their ship would actually survive the dangerous voyage back to Holland.

 

Concentrating on certainty

That gambling instinct was given added weight in the 20th century by academic studies purporting to ‘explain’ the behaviour of stockmarkets, as well as simpler and quicker means of investing in all markets of the world. So today private investors must concentrate on what is ‘safe’ about investment, rather than what is possible but far from certain.

The former is income – regular, and rising, and compounding over the years. Such an income can only arise from ‘real’ as opposed to ‘paper’ assets, such as the shares of quoted companies, or rental-producing property.

It is also an income that is small in relation to the capital invested – perhaps on average between 3-5 per cent a year, so the costs that reduce this income are important.

Just because those costs look so low – a quarter per cent here, a half per cent there – they are all too often ignored by the investor and even by the manager.

These managers are rightly more interested in earning their management fees, which can vary between one-half of 1 per cent or more for the fortunes of large private clients, to the 2 per cent or so that can be charged by publically promoted unit trusts or ETFs.

But once the costs of dealing within the trust or fund are added, total costs come close to wiping out the income from the capital. This is especially true of those investment managers who react to every bit of news – good, bad or indifferent – and are more would-be dealers than managers, with annual portfolio turnover of 50 per cent or more.

Not surprisingly, then, both investors and managers end up of wondering about the purpose of investment, and come to the conclusion that it is all about capital gains and not income at all.

Indeed, today, the general belief within the investment industry is that no one can beat the market; it is a zero-sum game and the best thing to do is to keep costs low by buying index funds.

 

Problems with what we know 

However, few private investors share this pessimistic belief, for they know that many of their counterparts have proved it wrong. It is an example of a widespread investment problem – something seen as so obviously correct that it is never questioned. 

Aberdeen Asset Management has now commissioned Fund Consultants to compare the performance of investment trust NAVs and exchange-traded funds (ETFs). The report says:

“Passive outperforms active. This has become a widely accepted truth, supported by regulators, by many advisers and, increasingly, by private investors. The logic is seductive: The argument is that investment is always a zero-sum game. In every trade, someone wins and someone loses. Therefore, on average, passive will always outperform because the fees are lower.

“This is correct in theory, but it doesn’t appear to hold true for investment trusts in practice. Investment trusts are a good representative for active management because they have a fixed pool of capital. The manager does not have to manage inflows and outflows, so therefore performance could be said to be a purer expression of their skill and judgment. 

“The report took ETFs as a proxy for passive investment and compared the two. The research compared ETFs and investment trusts within comparable Morningstar sectors. 

“At the top level (the Global Broad category), investment trusts outperformed overall in all four of the categories reviewed – equity, allocation, fixed income and miscellaneous. They also outperformed in triple the number of instances – 11 compared to four – so it was not just a few great funds influencing the results. 

At the sector level, investment trust outperformance also held true. They outperformed 53 per cent of the time against ETFs over one year, 76 per cent over three and five years, and 90 per cent over 10 years. The research isolated 19 sub-categories: Over 10 years, closed-ended funds outperformed in all categories except one: US Equity Large Cap Blend.”

 

What makes investment trusts different?

The fundamental difference is that they are constituted under company law; unit trusts, open-ended investment companies (Oeics) and ETFs are creatures of trust or other specific laws.

The beauty of company legislation is that it gives responsibility to boards of directors, as well as to investment managers, by creating a hierarchical structure. This clarifies responsibility and ensures good communications. 

Boards lay down strategies and managers execute that strategy through their agreed tactical investment plans. Both sides can ‘do nothing’ when markets make it clear that nothing is to be done. This is more often the case than investors imagine.

Company law enables profits from good years to be held back for when times turn bad, so prudent investment trusts can maintain dividend income through the years. Certain members of the Association of Investment Companies have held or increased their dividends for 50 or more years. 

It is this compounding of small annual sums that produces large fortunes and justifies equity investment.

This is why using Isas to hold cash or invest in fixed interest securities is wasteful. Fees are paid for tax advantages that only accrue through rising dividends, and investment trusts are the best source of those. 

However, it should be noted that yesterday’s income certainties, such as banks, insurance companies and global food and retail giants, are now all faced with disruptive technological competition or obsolescence.

All tools used to manage risk and return are based on the discredited efficient markets hypothesis (EMH), and simply add further costs to what you are already paying your manager.

Above all, adopt a long-term investment approach; this must be based on detailed analysis of the investment being bought and of future profits and dividend flows rather than momentum or short-term price changes.

Since this is difficult for most private investors, choose a trust manager; one where the annual report shows such skill is required of the manager, and performance shows that this has worked. The metric to beat may not be an index, but a stable benchmark such as growth of GDP, plus a risk premium of between 2-3 per cent. 

Do not pay performance fees, nor engage in alternative investments – hedge funds, private equity, commodities – most of which are based on calculations based around EMH with heavy – and not always transparent – fees. 

Finally, ensure everything in your portfolio is traded on a public exchange, and do not believe that professional fund managers know the future any better than you. Brexit showed that economists guess just like the rest of us, and with equal capacity for misjudgment. 

In addition, technological change is destroying what were once historically useful rules of thumb. The world, and not just America and Europe, is now full of investment riches, and only full-time, disciplined investment trust managers can identify them on our behalf.