Smart Money Asia

You may remember we talked a little about trade-offs already. Well another investment trade off is active vs passive strategy. This is a trade-off we are hearing more and more about these days. Fifteen years ago, almost nobody was talking about index funds and Exchange Traded Funds (ETFs). You would either buy stocks and bonds directly; or you would buy a mutual fund, run by a manager who was benchmarked against “the market”. Hedge funds were only just becoming accessible to regular investors, rather than being for sophisticated or high net worth investors only.

You may have heard about a bet that Warren Buffet made almost 10 years ago: He bet that a passive investment in the S&P 500 index would beat any given portfolio of hedge fund strategies over a 10 year period ending December 31st 2017. The only takers were an alternative investment specialist firm called Protege Partners LLC, and there is a million dollars riding on it to go to the winner’s charity of choice.

So how’s it going? Well, in truth it’s not even close. Despite starting the bet before the 2008 financial crisis the S&P 500 is sitting on a return of 85.4%. (7.41% p.a.) The hedge funds average is 22%. (2.2% p.a.)

So what can we learn from this? Well here are a few lessons:

• It’s time in the market that matters, not timing the market.
• Fees really matter – the hedge funds have performed ok, and with lower volatility. But an annual fixed fee and 20% performance fees are going to eat into investor returns.
• You have to hang in there! Think back to 2008 – the housing crisis, Lehman Brothers goes down, the stock market plunges, it feels like the end of the world…and you just invested a chunk of your savings in the S&P 500! Be honest here, would you have sat on that bet and waited? It’s easy to say yes with hindsight, but an awful lot of people sold investments at the bottom of the market, when despair was at its highest, and then sat out in fear and missed the big rebound.

So does this bet settle the active vs passive investment debate? Well, not exactly. Hedge funds vs the S&P 500 is not really a good comparison. If, however,  it was US large-cap mutual fund managers vs the index, then we would be comparing apples with apples. According to this article, 66% of large-cap managers failed to beat the index in 2016, and if you lengthen the time period, the numbers just get worse. And out of the managers who do beat the index over a three year period, only about 5% go on to beat the index over the next three years. So we can conclude that it’s very hard to beat the market.

So does this mean we should just lump all of our money into an equity index fund?Although there are worse things you could do, it’s not a very balanced approach. Getting a diversified blend of different asset types, and rebalancing this blend over time, can help smooth out returns, lower risk, and make it easier to sleep at night when the stock market takes one of its downturns. We will look at this in more detail in future posts.

Ok, we have covered the different asset classes, and we have understood that the basic minimum benchmark is inflation in our base currency. So how are these assets likely to behave over time relative to that benchmark? Well three of the asset classes are correlated to inflation and to each other, so although we can’t predict exactly, we have a pretty good idea what they will do over time in a particular base currency:

Take a look at the diagram above. It shows a rise in the cost of goods and services (inflation) over time. The first thing to note is that in the short term we really have no idea which asset will perform the best. We do know that cash will at least hold it’s value. Stocks, on the other hand, could rise or fall significantly. So, if you have a pile of money and are planning to do something important with it in the next 12 months, like make a down-payment on a house, you would be ill-advised to invest this money in the stock market. It might go down 30%! Therefore money for short term needs should stay in the bank.

Over the longer term, you won’t make money in cash. As you can see, cash tracks inflation to preserve your spending power, but it won’t increase it. If inflation is 2%, you might earn 2.5% in the bank. In Japan, where inflation is near zero, interest on a cash deposit is also very near zero. So if you want to make money over the long term, you have to take some risk.

One way you could take some more risk is by lending money to the government. The price of bonds may fluctuate over time, but in order to attract investment, bonds will pay a better return than cash. Note here that all bonds are not the same. A Japanese government bond may pay low interest, but there is little chance of default. A Venezuelan government bond may pay outstanding interest (10.43% p.a. on a 10 year issue at the time of writing), but there is a greater risk you won’t get your money back at the end of the term. Likewise corporate bonds carry higher risk than bonds issued by solid governments.

If you are looking for still higher returns, then it’s time to invest in the stock market. Although stocks are unpredictable in the short term, historically they outperform over a long period of time. This is because over time the economy and population tend to grow, and workers become more productive. This economic ground swell makes businesses more profitable, which drives up stock prices.

Although the other asset classes are uncorrelated and less easy to chart here, they can add valuable diversification. In building your own investment strategy there are a few things you need to take into account here:

The first is your base currency. The second is your time frame, which may vary from one investment objective to another. And the third is how you feel about the ups and downs in each of these asset classes, otherwise know as your attitude to risk. The better you understand the behaviour of different investments over time, the more you may find you are comfortable taking risk on a certain portion of your capital.

Striking the right balance between the different asset classes and maintaining that balance over time is know as Asset Allocation, a subject we will cover in future posts.

How do you know if an investment you have made is doing well or not? How can you tell if it’s worth paying an investment manager rather than just buying an index fund? Is 8% per year a good return?

The simple answer to each of these questions is, it depends what you compare it to. You need to have something meaningful to measure an investment against in order to gauge how it is doing. This is known as benchmarking. Whether you realise it or not, you are probably already familiar with some benchmarks:

• MSCI Global Index – covers global stocks
• S&P 500 – covers US stocks
• FTSE 100 – covers UK stocks
• Nikkei 225 – covers Japan stocks
• Citi World Government Bond Index – covers global bonds

So a mutual fund manager running a US Growth Stock fund might be benchmarked to the S&P 500 index. If he is underperforming the index, he is not worth paying fees to. If he is outperforming the index his fund will be popular. If he is getting a wildly different result to the index then he is doing something very strange and likely won’t keep his job for long!

So is 8% a good return? Well it partly depends on what your expectations are. The S&P 500 has returned, on average, 7.1% per year over the last 10 years, so 8% seems like a pretty good return. However, if your goal was to be aggressive and get a 20% return you might still be disappointed. In 2008 the S&P 500 fell by 37%. Even a 1% return that year would be nothing short of exceptional!

So how should the average investor benchmark their investments? I would say the basic minimum benchmark should be inflation in your base currency. Inflation is defined as the rise in the cost of goods and services over time, and is the reason we don’t just lock our money in a safe. Take a look at the table below showing the effect of inflation on $100:

We are currently living in a low-inflation environment, particularly if you live in Japan. However, if you look at the historical average, 3% is a good guide. So at 3% inflation, if you put your $100 under the mattress for 20 years you will still have $100, but it will only buy you $54.38 in goods and services. The spending power of your money has almost halved!

One thing I will stress here is that we are talking about inflation in your base currency. If you are living in Japan, but you are planning to retire in Australia, for example, don’t be fooled by the low inflation rate in Japan. Back home the current rate of inflation is 2.1% and rising. Keeping money in your Japanese bank account is not only a currency risk, but you are losing 2.1% per year in spending power!

There is no such thing as the perfect investment. They all come with advantages and disadvantages, or trade-offs.

One of the simplest explanations of these trade-offs I have heard goes as follows:

Any investment you make needs to balance three factors: low risk, high returns, and liquidity. You can have any two of these but not all three.

If you want high liquidity (easy access to the money) and low risk you are going to have to sacrifice high returns. Your money is going to be in something like a savings account.

If you want high liquidity and high returns you are going to have to take a lot of risk. This could mean an investment in stocks that could go down significantly in the short term.

If you want low risk and high returns, no-one is going to give you that unless they are able to keep your money for a long time. The best performing hedge funds and capital guaranteed products often have lock-ins, preventing investors from withdrawing their money for a fixed period.

Another trade off to consider is capital versus income. Some investments provide capital growth, but little or no income. Income generating investments may have lower prospects for capital growth. Before investing it’s important to understand which is best for you at your current stage in life.

One more trade-off to consider is absolute versus relative return. Absolute return is what an investment returned over a particular period. If a mutual fund returned 10% over the last 12 months is that a good return? Well, it depends on what the rest of the market returned. If the market returned 18%, then 10% is not particularly good. In fact in relative terms it’s a minus 8% return. Active fund managers are benchmarked in this way in order to gauge their performance. We will talk more about benchmarks starting tomorrow.

Depending on who you ask, you will find that there are varying opinions on the different types of assets out there that you can invest in. In my opinion there are six basic asset classes, plus an extra category we may call “alternatives”.

The main point here is to avoid confusion with investment products. There are thousands of products available, all packaged up with pretty brochures and power point presentations, but the majority of these products are simply investing in one or more of the six basic asset classes.

Let’s start with some simple definitions:

1. Cash – a means of exchange and a store of value.
2. Bonds – government or corporate debt.
3. Equities – stocks and shares representing an ownership interest in a company.
4. Property – a building or buildings and the land belonging to it or them.
5. Commodities – raw materials or primary agricultural products that can be bought and sold.
6. Collectables – items valued and sought after by collectors.

Cash is sometimes confused with currency, but they are not the same thing. If I have ¥10,000 and I step outside my house in Japan and wander into town, I can exchange this for goods and services readily. If I get on an plane and fly to the UK, can I do the same at my destination? The answer, of course, is no. I first need to exchange my Japanese Yen for British Pounds, and this is done at a market determined rate that can fluctuate from minute to minute. The JPY I hold has become a commodity that can be bought and sold.

Bonds are complex instruments, but they have some basic characteristics we can recognise: they have a creditor, who is the bond holder, and a debtor, who is the bond issuer. Bonds have a face value, which represents the amount of principal the bond holder will receive at maturity, and is the amount the issuer pays interest on. They also have a market value, which is what people are willing to pay for them today. They have a maturity date, when that nominal face value amount is typically repaid. They also have a coupon, which is the interest rate the issuer pays to bond holders.

Most people are familiar with the idea of equities or stocks in publicly traded companies. However, it is also possible to own stock in private companies, known as private equity. Private equity is not a separate asset class, however it is less liquid and carries different kinds of risks to investing in listed companies.

For some people property is the simplest asset to understand because it is tangible – you can see it and touch it. Property comes in many different forms: land, buildings, houses, apartments and even collective investments. It’s possible to buy a property fund or Real Estate Investment Trust (REIT) that gives you exposure to the asset class, but with a lower investment amount and potentially higher liquidity. The ability to borrow money to invest in physical property makes it a potentially powerful asset class.

Commodities are exciting due to the high level of price fluctuation, or volatility. This means there are many opportunities to buy low and sell high and make money. It’s also very easy to get it wrong and lose money. Commodities used to be for expert traders only, but these days, with the advent of Exchange Traded Funds (ETFs), it’s simple for anyone to invest in gold, oil or even coffee.

Collectables are about more than just a hobby. An educated investor can make incredible returns  buying and selling artwork, stamps or antiques. However it takes a significant level of knowledge and expertise to make money in collectables and it’s easy for amateurs to get duped. You may want to hang onto that heirloom your grandparents handed down to you though!

As I said, the majority of investment products can be fit neatly into one or a combination of these six categories. However there are “other” investments that may not fit in perfectly. Hedge Funds have long been touted as an asset class all of their own, although I would argue that most hedge funds simply invest in a combination of the above asset classes, albeit it an innovative or original way.

For the average individual investor, concerned with saving and investing for their future, a solid understanding of the six basic asset classes, and the risks and trade-offs associated with them is more than enough to get them started on the path to building wealth.