A while back I saw some research highlighting a growing threat facing index funds. Since it is well know that many smart investors are putting money into them, people who are out to beat the market can trade against those predictable decisions. This may reduce index returns in the future. This research showed an abnormally large increase in a stock’s price once it is announced that it will be included in the index. If this effect is widespread it would mean that index investors are overpaying for stocks, but this is likely to be a more recent effect since index funds weren’t popular at the beginning.
To do a quick test on this I compared Vanguard’s S&P 500 index fund with its Total Stock Market index fund. The S&P 500 is easy to target, but the Total Stock Market fund holds every stock so it wouldn’t be possible to front-run trades from investors in that fund.
The results show that the Total Stock Market fund consistently outperforms the S&P 500. The actual fund returns are:
- 0.08% higher in the last year
- 0.20% higher in the last 3 years
- 0.49% higher in the last 5 years
- 0.73% higher in the last 10 years
And the benchmark returns show similar outperformance:
- 0.10% higher in the last year
- 020% higher in the last 3 years
- 0.50% higher in the last 5 years
- 0.74% higher in the last 10 years
Aside from showing how great Vanguard is at tracking the index, this demonstrates that you would have been better off holding all US stocks rather than just the S&P 500. The difference isn’t huge, but we go to great lengths to avoid an extra 0.73% in fees on our funds and reducing returns by that amount has the same effect.
This doesn’t prove that it’s simply because of trading against the index. It’s possible that the smaller stocks in the Total Stock Market index simply did better. In fact given the past returns for small cap stocks that may be explain the full outperformance.
It’s also interesting to note that the outperformance has decreased in recent years, even as the indexing message continues to spread.
Overall this is not a convincing demonstration that index funds are truly under attack from smart traders. Even if they were they still remain the best choice since it’s better to be under attack from a few smart traders than to side with the many dumb traders. The growing popularity may attract unwanted attention but it also makes it possible for large funds to go past the representative index and just buy everything.
A couple of years ago the financial press had great fun trumpeting the news that the US stock market was going the way of Japan, since it had returns of approximately 0% over the last decade. That “reporting” no doubt contributed to the many people who are still afraid of stocks despite their nearly 100% returns over the 2 years following 2009.
While researching an idea I saw a chart of the S&P 500 total returns over the last decade, as of this November. I quickly noticed a couple of interesting things for an investment made 10 years ago in 2002:
- At the peak in 2007/2008, it would be up 80%
- At the best prices of 2009, it would be down almost 12%
- As of last month, it would be up 83%
So what was a lost decade only a couple of years ago is now an 83% gain. That’s a bit less than stellar since 7% returns should double your portfolio in 10 years, but it’s still a solid gain for a decade with a lot of surprises. And of course dollar-cost averaging and rebalancing could also contribute to higher returns, even without counting the potential for those who recognized the lows before 2002 and in early 2009 and bought in.
It all depends on the timing. The “lost decade” idea was a result of using the peak of the tech bubble as a starting point. Obviously anyone who invested a lot in that market would not do well. I wasn’t active at the time but my investment policies are designed to always move away from overpriced markets and avoid that type of situation.
Even if we do get caught buying at higher valuations it’s not a big deal because calculating 10-year returns like this depends on prices from only 2 days. If we invest the same amount every month, the amount we put in during the worst month will be 0.8% of what we invest that decade. Since we try to increase the amount we invest every year, a true lost decade would mean we actually put in more during the years when we get better prices. We should be so lucky!
It’s been a while since I’ve written about my asset allocation. I guess that’s why the markets are melting down and politicians can’t agree on anything…
I’ve made a couple of small adjustments since my last update. First, here are the new allocation targets:
- Bonds 3-4% (was 14% last year, at 3.9% today)
- CDN index 30-33% (was 27.3% last year, at 29.3% today)
- US index 28-30% (was 29.5% last year, at 30.3% today)
- EAFE index 33-36% (was 28.8% last year, at 36.4% today)
And here are the index numbers:
- DEX Universe Bond Index: yield 2.30%. 12-month return: 3.1%
- TSX: dividend yield 3.04%, earnings yield 5.4%, P/E 18.44. 12-month return: 7.2%
- S&P 500: dividend yield 1.99%, earnings yield 5.9%, P/E 16.90. 12-month return: 12.7%
- EAFE: dividend yield 3.13%, earnings yield 5.8%, P/E 17.35. 12-month return: 15.5%
These number surprised me when I put them together. Despite bond yields moving lower, they are actually closer to the stock index earnings yields than they were last year. This can be blamed on stock markets rising, even the EAFE (of which over 60% is based in Europe). And even the fiscal cliff spectacle hasn’t knocked the S&P 500 off its 5-year high. This is disappointing news.
Last year everyone was talking about how it’s a terrible time to be an investor since bond yields have to rise and the stock market was ready to drop again. Unfortunately neither of those things happened so today is an even worse time to be an investor.
Bonds = Bad
Bond yields are still insultingly low. For the last couple of years bonds have defied all rational expectations. Smart investors are usually too early with their calls and I may fall in the same category if I say their yields will go up in the next year. I’m not sure if that will happen but there still seems to be an unnatural desire to own bonds at the moment and I don’t want to follow the herd. Throughout the year I have only added to stock indexes, letting the bond component drift down.
It’s possible that stocks will experience a drop first and holding more bonds would provide extra capital to take advantage of that. However my policy is to form an allocation based on how attractive each investment is over the next 10-20 years, not on short-term predictions. Bonds fall beneath the dividend yield for both the TSX and EAFE and barely top the dividend yield on the S&P 500. And that’s not even counting the earnings yields which are a reasonable-but-not-exciting 3 points higher than bond yields.
They are not an attractive option at the moment. I will not add to bonds until the yields get better. If we see a nice drop in the stock markets I will liquidate the remaining bonds to buy in.
Stocks: Are They Still OK?
The TSX has a reasonably attractive dividend yield but that may not be sustainable since it represents a full 56% of the earnings yield. Either dividends are about to fall or Canadian corporations really have nothing good to do with their capital. Or corporations may be responding to investors who are looking for income anywhere they can find it. Bumping up the dividend would be a great way to draw in more investors and increase the stock price. In the current environment where individual investors can barely get a positive real return it doesn’t seem rational to want to receive cash rather than leaving it in corporations where it can do more.
The TSX is the worst-performing of the 3 stock indexes over the last year which may make it slightly less risky to go along with its tax advantage. However it’s still an undiversified market so I don’t want to be overexposed to it. As a classic commodity-heavy market it may be held down a bit by the fears of global or continental recessions.
The S&P 500 has had a good year. It’s pushing into higher valuations again which is a bit of a concern since there are some indications that corporate profit levels aren’t sustainable unless the economy really comes back fast. The stock market often moves before the economy so that may be what’s happening. The government manipulation is also a potential negative since it may be increasing the current valuation of the market. Considering that it was in the 1400s 5 years ago, the economy may have come along enough to really push higher this time. The US stock market remains one of the most diversified and active markets in the world so it gets a little extra weighting for that.
The EAFE has unfortunately done the best of the 3 markets. I was hoping bad news would drag it down for a bit longer to give us more buying opportunities but it seems that the bad news is running out. Assuming the EU manages to turn their short-term crisis into a long-term dull pain more investors might come back to the market.
On the other hand the valuation shows that many investors may have already seen through the theatrics (which are almost as good as those in the US) and realized that nothing resembling an open disagreement will ever happen in European politics (we obsequious Canadians ain’t seen nothin’ yet). Or they’ve just seen so much repetitive news that they don’t pay attention to the latest updates and assume everything is really ok. Either way once news starts coming out that reports an “all-clear” in Europe the prices may still have room to move up. I’m still attracted to the EAFE index due to the overwhelming negative opinion in recent times.
Preparing For The Future
Overall I want to be positioned on the right side for rising interest rates, increasing inflation, and surprisingly good economic growth. It seems like a lot of people aren’t expecting much and are still scared of stocks and avoiding them. Of course if we get back to the market participation levels of the 90s and early 2000s stocks could get overvalued again. If things play out well bond yields will have risen nicely by then to let us lock in profits in something that pays actual cash. As always, I’m an optimist!
We’re increasing our monthly investment amount by 25% next month so I’ve adjusted those flows to gradually bring us to the new targets. The differences aren’t big enough to sell anything at the moment.
The amount of data available about markets is a modern innovation that allows us to quickly dig into any corner of the financial world and feel like we know something about it. All too often that feeling is wrong as we get confused by imaginary trends in random noise or focus on the wrong information. But you don’t need to go into the greek letters to find numbers that do more harm than good. Even something as simple as a rate of return can be very misleading.
Most of the time, a rate of return translates to a rate of growth. It’s easy to calculate and it sounds simple and descriptive. The only problem is that it tells us what has happened already in a situation that will not repeat itself again which isn’t very useful.
Take Apple’s market cap which is $500B today. 5 years ago that market cap was $182B. Both of those numbers were determined by generally good reasons. 5 years ago Apple was selling a good number of iPods and had just started selling the first iPhones, making it a fairly valuable company. Now it defines the smartphone market and the number of models and the total sales have shot up, making it one of the most valuable companies today (though it may still be overvalued).
Based on those factors it’s fair to say that Apple went from being a mid-market large cap to being at the top of the range. The fact that its market cap went from $182B to $500B in 5 years is very clear. If you calculate the growth rate on that, the market cap grew at a rate of 22%/year in that time. That is also true but it’s much less helpful.
A growth rate implies a constant progression, making it seem like it’s natural for Apple to grow at 22%/year. But just a small shift like measuring 2006-2011 instead of 2007-2012 changes that result a lot, giving a different growth rate of 33%/year even though 80% of that was in the same period.
The underlying number, the market cap, is approximately right in each of those years based on many factors. Management at Apple worked hard to change those factors, causing the market cap to increase to a higher level. But the growth rate we calculate from that is mostly accidental and doesn’t have a deeper meaning.
In the end a growth rate can be very accurate but almost meaningless. There are so many conditions that led to that specific growth rate, it is most likely just a one-time event. Attempts to forecast the future based on a constant growth rate are more likely to be wrong than right. Like fish in a pond, businesses will dart from one point ($182B) to another ($500B) and then quickly change direction. Expecting them to go in a straight line is not a reliable way to predict the future.
This applies to other areas such as your portfolio. If you hold a certain selection of stocks 20 years from now, they will have some value on Dec 31, 2032. That future value, the price you bought them at, and the length of time you hold them will determine the rate of return you experience. Since each of those 3 parts can vary, the rate of return varies quite a bit based on small changes. Starting from the current value and adding a historical rate of return to determine the future value can sometimes be a useful guess at the unknowable but it’s a very limited forecast and is often used where it isn’t very predictive.
We all know that variable rate mortgages result in lower interest costs than fixed rate mortgages the vast majority of the time, leading us to question the sanity of anyone who chooses a fixed rate even when exceptionally low rates are available. Or do we? An insightful post from Canadian Mortgage Trends shows why the common statistics are wrong.
According to well-known studies from Moshe Milevski, variable rates come out on top 88-90% of the time. However there are several reasons that we don’t have the same options now that led to those results:
- His studies were based on posted rates, which today are a mockery of Canadians’ financial ignorance. If you use discounted fixed rates similar to those you can get today, variable rate mortgages win only 75% of the time.
- His studies also used a larger variable rate discount than you can get today. Using a discount similar to those you can currently get on a variable rate, they would have come out on top approximately 50% of the time.
- The data he studied was from 1950-2000 in one instance and 1950-2008 in another. Another common study was from 1975-2011. These all include the great bond bull market from around 1980 to 2010, when anyone who bet on falling interest rates came out ahead. Interest rates cannot come down 15% in the next 30 years. The effects of this have not been tested.
Unless posted fixed rates really were the best you could get in the past it seems that the options today don’t point to variable rates doing better on average. I see fixed rate mortgages as a reverse bond and I believe the bond market is slightly irrational today.
There is a reasonable chance that interest rates will stay low for the next few years and give an advantage to variable mortgage holders. But if interest rates stay completely flat, choosing a super-cheap variable rate of 2.55% over a fixed rate of 2.99% would only save you a total of approximately 2.2% in interest over 5 years. If you made that same choice and interest rates went up 0.5% at the end of each year over the term of your mortgage it would cost you an extra 5.6% (approximately) in total interest. 10-year fixed mortgages may be an even better deal since they provide a much longer lock-in at a slightly higher cost and would be a big win if we have an inflationary decade.
There’s no guarantee rates will go up by 2% in the next 5 years. They could rise less than that or even more. If the choice between fixed and variable typically has even odds, and there is a lot more room for rates to rise than there is for them to fall, today’s conclusions may be different than the usual decision. If rates do fall enough I’ll just refinance again to get some extra savings.
Are fixed rates an expensive insurance or just another option that ends up with the same result on average? I’ll let you know in 5 years!
One of the premises of index investing, which is my primary strategy, is that markets are generally efficient. If this is true then the best price for any tradable asset is the current price, and it’s impossible to accurately forecast a higher or lower price in the future. The idea is frequently attacked on the basis that investors don’t have perfect information and rational behavior. This is certainly a big flaw. But even in a world of perfect investors, the markets would not be efficient.
The reason is that investors have different needs and goals. A pension plan that needs to pay benefits for the next 30 years will buy 30-year bonds even if the yields aren’t great. An individual investor who needs 10% returns to make their retirement plan work will sell those bonds if the yield is too low or interest rates are likely to rise.
Moreover, the demand for various risk/return profiles will continuously shift as the finances of each person and organization change. So you can’t just figure out who else is in the market and then expect that to stay the same. To make things even more variable, the trades made on any given day are from only a small portion of the market participants and don’t fully represent everyone’s opinion. Most of the time I don’t even know the current price of my holdings. I might trade a lot more if I did.
To take a concrete example, I recently read a private economics report that forecasted the US dollar will grow stronger over the next 5 years, in part due to increasing oil and gas production that reduces the need for imports. This is just about as obvious as the number of protests for any new pipeline. So how could someone forecast an obvious future price change when rational investors would already have built that into the price?
One possible reason is that many people actually trading the US dollar today might have needs that don’t extend to the next 5 years. If they’re buying US dollars to pay a contract next month, they don’t care that it will be worth more in 5 years. Due to random circumstances there might be a surge of selling on one day that drives down the price for no good reason. My business gets a lot of income from the US but I don’t speculate much on the future exchange rates because that income is needed to pay expenses in Canadian dollars today.
For similar reasons, housing markets can be more predictable than financial markets. Due to the limitations on individuals owning many houses in one city, and the fact that larger investors and businesses don’t want to own a bunch of single-family homes all over the place, facts about the housing market can be known well before they have their full impact on the prices.
It’s hard to say how these factors play into prices since there are many different participants with different intentions and we only know a few of them. As usual, being a contrarian helps if you can actually figure out what the popular opinion driving the market is. When mutual fund managers have an urgent need to dump an unpopular stock before it shows up on their year-end report and gets them fired, you can come in with a 30-year perspective and pick it up at a discount. An even simpler way is to identify temporary desires. If everyone desperately wants to get rid of European stocks this month, then helping them with that need is like selling shovels in a snowstorm.
On the other side this seems like very bad news for traders. They typically focus on short-term profits and trends which is where most other market participants seem to make their decisions. As a result short-term trading can only get more competitive and even successful strategies are likely to eventually wipe out all past gains like LTCM ended up doing.
If the market is focused more and more on short-term results this is good for long-term investors. When I hear that people are dumping stocks because of a few bad years I get excited about the buying opportunities. All investors need to understand their needs and preferences and know how to take advantage of a good deal when they see one. At times other peoples’ different needs will make those deals available. A good deal could last anywhere from a few hours to a decade.
Even though this seems to show that stock picking works, it’s good for index investors because it shows that the index can be bought at a discount and with far less research than stock picking requires. And it might have another ironic result: active managers who claim to run circles around boring old pension funds might actually be giving away their clients’ capital to the investors with a longer perspective.
If you really want to beat the market it seems like the best strategy is to do your research to see where others are wrong and then make long-term decisions instead of being a day-trader. In other words Warren Buffet is right once again.