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It is sometimes easy to forget that when markets rise and fall, we are looking at this through an aggregated, market-capitalisation weighted lens.  In reality, the fortunes of individual companies and even sectors may be quite disparate over both the short and longer terms.  Take a look at the figure below that illustrates just how widely dispersed US stock outcomes have been year-to-date 2023 (to the end of April).  The S&P 500[1] is up by around 9% in USD terms (4% in GBP terms as Sterling has strengthened against the US dollar).

In the first quarter of 2023, the top ten contributors to performance accounted for 90% of the market rise, with Apple, Microsoft and Nvidia contributing to half of the rise.  Yet in 2022 the top ten companies by size collectively fell 37% compared to the market fall of around 18%[2].

Figure 1: Individual US stock returns differ widely (YTD to 30/4/23)

Note: (1) This represents the return of the Vanguard S&P500 ETF in USD. Holdings data from Morningstar Direct © All rights reserved.

A combination of recency and hindsight biases can tempt the unwary into thinking that it is easy to pick stocks (e.g. ‘It was obvious that Meta would rebound after last year’s plummet in share price!’). Nothing could be further from the truth.

Active investors – who aim to beat the market through their stock-picking skills – see charts like the one above and lick their lips at the opportunities they offer.  Yet they are not guaranteed to beat the market, or even deliver the market return.

Passive investors on the other hand – who believe that markets work well incorporating all public information into prices – see the dangers of picking the wrong stocks and missing out on the returns that market, in aggregate, delivers. They can, more-or-less, capture the market return with a high degree of certainty.

A research paper in 2018 titled ‘Do stocks outperform treasury bills?’[3] had the remarkable effect of being claimed by both the active and passive sides of the investing debate as evidence as to why their approach is valid. He identified that the US$32 trillion of wealth created between 1926 and 2015 in the US market, was entirely generated by the top 1,000 companies, or put another way, less than 4% of the total number of companies that had existed on the US stock exchanges. A follow-up paper[4] focusing on non-US markets found that over 60% of all stocks failed to deliver a return higher than US T-bills and less than 1% of companies delivered all of the wealth creation from 1990 to 2018. The author states (in his original paper):

‘Not only does diversification reduce the variance of portfolio returns, but non-diversified portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex-post, generate large cumulative returns. Indeed the results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance.’

The challenge of structuring a highly active, concentrated portfolio to attempt to identify and capture the returns of these few wealth generating firms is immense, and at risk of both hubris and a lack of humility around the power of the collective market view (‘it’s all in the price’). The active management industry’s track record of delivering on its promise to beat the market is well-documented and extremely poor, with over 95% failing to do so over a twenty year period[5].

For those who accept that markets work, they can simply capture the market return through a low-cost, highly diversified systematic fund (of which index funds are a subset).

As the late, great John C. Bogle, the founder of Vanguard liked to say:

‘Don’t look for the needle, buy the haystack!’

Risk warnings

This article is distributed for educational purposes only and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Reference to specific products is made only to help make educational points. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]      This represents the return of the Vanguard S&P500 ETF in USD

[2]      Nasdaq, (2023) Top 10 Names in S&P 500 Responsible for 90% of Q1 Gains, April 05. https://www.nasdaq.com/articles/top-10-names-in-sp-500-responsible-for-90-of-q1-gains

[3]      Bessembinder, H. (2018) Do stocks outperform Treasury bills? Journal of Financial Economics, vol. 129, no. 3, 440–457. https://doi.org/10.1016/J.JFINECO.2018.06.004

[4]      Bessembinder, H. (Hank), Chen, T.-F., Choi, G. and Wei, K.-C. (John). (2019), Do global stocks outperform US treasury bills? SSRN Electronic Journal.  https://doi.org/10.2139/SSRN.3415739

[5]      SPIVA | S&P Dow Jones Indices. (2022) https://www.spglobal.com/spdji/en/research-insights/spiva/spiva-library/

We fundamentally believe that a systematic approach to investing provides the best chance of experiencing a successful investing journey. Sticking to some key guiding principles – which are grounded in evidence and logic – gives investors a solid foundation on which to build a sensible investment solution. This short note provides an insight into five of our favourite insights from experienced and accomplished academics and practitioners and explains how these words help us plant our investment philosophical flag in sensible space.

1.    A focus on risk management, rather than chasing performance

‘You don’t find out who’s been swimming naked until the tide goes out.’

Warren Buffet, Berkshire Hathaway 1994 Annual Meeting

The financial media enjoys reporting on top performing fund managers. Humans like exciting stories. Good investing, however, should – to most – seem relatively boring through taking a ‘risk-first’ approach. Ultimately, sensibly considered risks should be rewarded appropriately over time. The risk management process involves deciding which risks one wants to be exposed to in portfolios (such as broad global equity market risk) and which we do not (such as the use of leverage). Managing these risks tightly over time and monitoring them on a regular basis is key.

2.    Be diligent and act rationally, with due patience

‘Activity in investing is almost always in surplus.’

Charles D. Ellis, Winning the Losers Game, 1993

Ensuring any decision made is free from an emotional reaction is a must. Many are prone to making knee-jerk – and sometimes permanently damaging – investment decisions. Taking steps to avoid this is well-advised.

3.    Take part and believe in capital markets

‘You’ve got to talk yourself out of the market portfolio.’

Eugene Fama, Nobel laureate, speaking with The Rational Reminder Podcast, May 2020

Owning a share of companies through investing in capital markets is an effective way for investors to grow their wealth over time. Owning a little bit of everything is not a bad place to start. Luckily for investors these days, one can do so with relative ease through investing in mutual funds. Doing so enables investors to participate in the growth of listed companies from around the world in a diversified manner, avoiding being overly concentrated in a single stock.

4.    Keep costs low

‘In Investing, You Get What You Don’t Pay For.’

John C. Bogle, Founder of The Vanguard Group, February 2005

Cost is by no means the only factor separating better and worse investment solutions, but it is a significant one. Costs can be implicit (e.g. frictional trading costs) or explicit (e.g. fund manager fees). Clearly, any saving made by an investor is retained in the portfolio, rather than being passed off to another party in the process.

5.    Stick to the plan

‘Real-world application of fundamental investment principles produces superior outcomes.’

David F. Swensen, author and former CIO of Yale University endowment, 2005

An investor who can recall their key investment principles stands in good stead to avoid making mistakes. Abiding by some simple guidelines – such as those outlined by the investment mavens in this note – enables investors to employ a robust and repeatable process for managing their wealth.

Unfortunately we now live in a world of fake news and ‘alternative facts’[1] where parties shamelessly push their own agenda at the cost of salient facts.  In order to be heard in the noise of social media, research headlines need to be bigger and more eye-catching.

For those investing using an evidence-based approach that means it is important to make sure that any evidence being reviewed is based on true facts, reliable data and sound research methodologies.  There is much good research and empirical evidence available, but some of a lesser quality occasionally makes the headlines.

A recent piece of research by a fund management firm that manages over US $580 billion[2] is a case in point, making the statement:

‘Active funds beat passives in every market in the UK over a 20-year period’

That is quite a claim to make.  The firm looked at funds in seven Lipper categories[3] and – somewhat surprisingly for an investment house filled with bright and talented people – compared how the fund with the best performance over the past 20-years had done relative to passive alternatives (index funds) and the index.  The methodology is so evidently flawed as to hardly be worth reviewing. It is best summarised as requiring a fund-picking strategy of perfect 20-20 hindsight!  They concluded that it would have been worth identifying the best active fund instead of using a passive fund. The problem is that this is almost impossible to do without a crystal ball.

Alan Miller of SCM Direct – a firm which has campaigned to improve investor outcomes – summed it up most effectively:

‘It’s a bit like saying you’re better off buying a lottery ticket than putting your money in the bank because had you won the lottery each year, you’d have done much better.’

Unfortunately this type of naïve research risks misleading retail investors, and even some advisers, against a sensible evidence-based approach suggesting that a passive approach makes good sense.

In their own data, the fund management firm in question revealed that in the six Lipper categories where there was a passive fund with a 20-year track record, in five the average passive fund beat the average active fund.  In the sixth, there was nothing much in it.  The best passive fund – which you do have a fair chance of identifying, unlike an active fund – outperformed in all six categories.  Another methodological flaw arises; no account seems to have been taken of the high proportion of UK-based funds that would have failed to survive the period.  A reputable study[4] reveals that only around 50% of GBP-denominated funds survived the 10-year period to the end of 2022.  Over 20-years this figure is likely to have been even worse.  We also know from this study that, on average across the eight categories of funds denominated in GBP (so a similar fund set to the flawed research above), 80% of active funds failed to deliver on their promise of beating their market benchmark over 10-years.  For a 20-year period this is likely to be higher, as evidenced in the US version of this study.

‘Enough, already!’ as our American friends might say.

[1]      This was a term used by White House adviser Kellyanne Conway to defend an untrue statement about the number of people attending President Donald Trump’s inauguration.

[2]      As reported in https://www.trustnet.com/News/13368133/columbia-threadneedle-says-active-funds-beat-passives-in-every-market–do-its-claims-stack-up/

[3]      Lipper is a data provider who break down the fund universe into categories such as global equities and emerging market equities.

[4]      SPIVA Europe Year-End 2022 Report https://www.spglobal.com/spdji/en/documents/spiva/spiva-europe-year-end-2022.pdf

By and large, behavioral science suggests that human beings make lousy investors. Whilst we are excellent problem solvers, we suffer from a whole host of well documented biases that, on average, erode the investment returns on offer from markets[1]. Being aware of our biases is a useful exercise if we are to limit the impact that they have on our decision making. In this short note, we look at both anchoring – the tendency to be influenced by a particular reference point or ‘anchor’ – and recency bias – the tendency to overemphasize the importance of more recent experiences relative to less recent ones.

Today’s capital markets are extremely well integrated, costs are low and anyone with internet access can use the power of Google (or even perhaps ChatGPT) to conduct their own research. However, historically investors have favored companies listed in their home country as opposed to those abroad. Partially this was down to the additional cost, complexity, and unfamiliarity of investing overseas, although these hurdles are relatively negligible nowadays. Even so, recent data suggest that the ‘home bias’ – the extent to which the home country is weighted in a portfolio over and above its market weight – persists.

Table 1: Investor home bias by region

Source: FTSE (2019) Appraising home bias exposure. https://content.ftserussell.com/…

Perhaps anchoring to the performance of one’s domestic market is to be expected given the above. For UK investors, the FTSE 100 measures the performance of the largest 100 firms listed in the UK and is frequently quoted in the papers and media outlets[2]. For some time, the UK has performed dismally when compared to international (ex-UK) developed markets. For example, the decade of the 2010’s saw the FTSE 100 companies return ≈75% to investors whilst international equity markets delivered a staggering ≈255% in GBP terms[3]! Since the start of 2021, the roles have reversed with the FTSE 100 delivering 31% versus 16% from international markets³.

Enter recency bias. The charts below investigate the shorter and longer period returns of the FTSE 100 and global developed equities further[4]. In the top chart, rolling annual returns show that the UK has generally lagged, although it has enjoyed a handful of 12-month periods of outperformance.

Figure 1: Rolling 12-month returns of the FTSE 100 and global equity markets

Data source: Morningstar Direct © All rights reserved. Funds: HSBC FTSE 100 Index Fund, Vanguard Global Stock Index Fund.

Zooming out to rolling 10-year periods paints a different picture. This is due to the many small periods of underperformance above compounding up to provide poorer outcomes over longer horizons, as demonstrated below.

Figure 2: Rolling 10-year returns of the FTSE 100 and global equity markets

Data source: Morningstar Direct © All rights reserved. Funds: HSBC FTSE 100 Index Fund, Vanguard Global Stock Index Fund.

The point is not to suggest that the UK is some sort of anomaly, or that this level of relative underperformance is to be expected moving forwards. There are plenty of examples throughout history demonstrating exactly the opposite. The point is that getting swayed by recent performance, and perhaps anchoring to one’s domestic market, is best avoided.

Removing our performance hats and replacing them with our risk ones, there are some very sensible reasons why having too many eggs in the 100 largest companies in the UK makes little sense from an investment portfolio perspective:

• The FTSE 100 is highly concentrated with over 33% of the assets held in just the top 10 companies – the likes of Shell, HSBC and AstraZeneca being the top holdings at present.
• The FTSE 100 is materially overweight to certain sectors such as energy (12% vs 5% globally) and underweight to the point of almost not having any in terms of technology (1% vs 21% globally).
  • This explains much of the recent performance differential above – where technology has struggled, energy stocks have flourished in the high-inflation environment exacerbated by the Russian invasion of Ukraine.
  • Over longer periods technology stocks have dominated (Apple, Microsoft, Tesla etc.).
• The global opportunity set consists of over 10,000 companies across over 50 countries. Diversifying across them all as a starting point makes good sense and should lead to a smoother investment journey.

Be aware of that anchor and make sure that you do not get overly influenced by what has just performed well.  You have no chance guessing which market will do well next.  Just own the world.

[1] Nobel laureate, Daniel Kahneman, has a fantastic book called ‘Thinking, Fast and Slow’ that unpacks why we make the decision we make. It is a very accessible read for those looking for a new book! https://www.amazon.co.uk/Thinking-Fast-Slow-Daniel-Kahneman/dp/0141033576

[2] It rarely appears in headlines when things are going well, but you can be sure it will when we experience the next poor investing day/month/year. Another one – negativity bias!

[3] Funds: HSBC FTSE 100 Index Fund, Vanguard FTSE Developed World ex-UK Index Fund.

[4] Global developed equities (including UK) due to much longer track record.

The spectacular work ‘Another Place’ by the British sculptor Antony Gormley[1], of one hundred naked men scattered along 1.5 miles of Crosby Beach in Liverpool, provides a useful twice-daily reminder about hidden risks in the financial world.  As Warren Buffet once said about easy money and favourable markets hiding risks:

‘You only find out who is swimming naked when the tide goes out.’

The demise of Silicon Valley Bank (SVB) is one such case of being exposed by a falling tide.  The bank focused on providing banking services, including the placing of deposits, to many early stage and start-up tech firms, alongside venture capital firms, both in the US, and via SVB UK, to UK firms.  At the end of last week, depositors began to worry about whether the bank was going to be able to meet its obligations and began withdrawing their cash.  The root cause of their concern lay in the exposed reality of the risks the bank had taken by accepting deposits and then investing the money in longer-dated US Treasuries.

That worked just fine when short-term interest rates were near zero and longer-dated bonds paid higher yields.  Unfortunately, SVB’s skinny dip into the bond market was exposed by the rapid increase in bond yields in the second half of 2022, which saw yields on 10 Year Treasuries rise from 2% a year ago to almost 4% at the end of last week.  That put a huge dent in SVB’s balance sheet, due to the losses incurred on the bonds as a consequence of these yield rises (bond prices move in the opposite direction to bond yields).  This in turn lead to a rapid loss of confidence that the bank could meet its liabilities.

SVB UK was purchased by HSBC for £1 and its depositors’ money was secured, allowing its young tech firm clients to avoid a severe, even terminal, liquidity crunch.  In the US, the Federal Reserve, the US Treasury and the FDIC, which secures deposits up to US$250,000, came up with a plan to protect all depositors, including those uninsured by the FDIC.  The Fed also set up a borrowing facility for other banks to provide liquidity against US Treasuries (and some other assets) based on the bonds’ par (i.e. redemption) value at maturity.  Although other small banks are under pressure, this has likely stopped any systemic risk to the banking sector.  Equity and bond holders of SVB rightly face the risk of losing their capital.

We may see some volatility in bank stocks until the full picture becomes clearer (i.e. is everyone else wearing swimming trunks and will the Fed’s towel cover the embarrassment of any who are not?).

What lessons can we learn?

Perhaps the most important aspect of this debacle is to identify what lessons we can learn.  Here they are:

1. A deposit is an unsecured loan to a financial institution. Your money moves onto their balance sheet and you only get your money back if the bank remains solvent.
2. Government backed insurance schemes, have limits on how much they will protect you. For example, the UK’s FSCS guarantee on deposits is only up to £85,000 per eligible person banking group[2].
3. Diversification is critical to managing risk. For those with cash, diversifying it between banks or via a money market fund should be an important consideration and advice should be sought where necessary.  CFO’s of these tech start-ups, and those of the venture capital firms, should have known better.
4. The other aspect of diversification is at the security level. SVB has a global market capitalisation of around 0.03%, which is an insignificant amount in a diversified, systematic portfolio.
5. Never assume that all financial institutions are smart. The age old mistake of borrowing short and lending long has brought down many institutions over the ages, not least Northern Rock in the UK during the Credit Crisis of 2007-9.  Many institutions regrettably pumped client money into Bernie Madoff’s multi-billion dollar Ponzi-scheme fraud through insufficient due diligence.  More recently, many high profile firms backed Sam Bankman-Fried’s now-collapsed FTX exchange in crypto-world (another area where a lack of swimming trunks is rapidly being revealed).

A systematic investment process can protect you from many risks, not least through broad diversification.  Whilst it is not Canute-like and the market’s tide will ebb and flow, at least you know that you are swimming with your trunks on!

Risk warnings

This article is distributed for educational purposes only and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Reference to specific products is made only to help make educational points. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]      It is a most spectacular installation, not to be missed if you happen to find yourself in Liverpool. https://www.visitliverpool.com/things-to-do/another-place-by-antony-gormley-p160981

[2]      More information here: https://www.fscs.org.uk/what-we-cover/banks-building-societies/

Most investors – at some time – will be either tempted to time when to be in or out of equity markets – or wish they had when markets fall.  It would be great to be able to capture the upsides and avoid the downsides, but that is wishful thinking.

Investors may well underestimate the rapidity and magnitude of the movements that markets make, although the very material double digit daily moves around the Covid- crisis (March 2020) provided a useful lesson. In fact, a small number of days account for much of the market movement over time.  Picking which those days are – either to be in or out of the markets – is an extremely difficult prospect and the chances of long-term success are rare.  An analysis of missing the best days in the market (Albion, 2023) provides some food for thought, as the figure below illustrates.

Figure 1: Missing the best few days in the markets could be very costly

Source: Albion Strategic Consulting.
Data: Morningstar Direct © All rights reserved: SSgA SPDR ETF. Returns in USD. 23/01/1993 – 30/01/2023

Whilst these types of study imply a binary approach to being invested in equities or cash, which is a somewhat unreal scenario, it is evident that a few good days, weeks or months drive the bulk of market returns and missing them can be costly. Missing the best 30 days in this 30-year period deliver only 17% of the rewards that the market delivered[1].

Likewise missing the worst 30 days would be highly beneficial, yet the ability to pick them does not seem to show up in the data. The October 2022 Liz Truss/Kwasi Kwarteng ‘mini-budget’ in the UK provided evidence of just how quickly new information can impact markets, in that case the bond market.  Being right is quite a challenge. Being wrong can be very costly. The odds of success in market timing are slim.

A seminal piece of UK research (Cuthbertson et al., 2006) concluded that only around 1.5 % of UK equity funds demonstrate positive market timing ability.  The Nobel Laureate Professor William Sharpe agrees:

‘An [investor] who keeps assets in stocks at all times is like an optimistic market timer. His actions are consistent with a policy of predicting a good year every year. While such a manager may know that such predictions will be wrong roughly one year out of three, such an attitude is nonetheless likely to lead to results superior to those achieved by most active market timers.’

Stay invested!

[1]      As an aside, the data used is from the first US ETF launched thirty years ago, almost to the day.  It was revolutionary at the time for providing cheap and tradable (not necessarily a good thing!) access to the S&P500 index.