Does dollar cost averaging really work better in a volatile equity market?

Say that your equity market outlook assumes that one of two scenarios is true.  Either:

1. You expect equity markets to be volatile over the next 10 years or,
2. You are convinced that neither you nor anyone else knows what equity markets are going to do over the next 10 years!

but you still expect equities to outperform other asset classes over this term.

In this kind of environment a program of drip-feeding funds into the market makes sense as most research seems to suggest that market timers usually do worse than a more unemotional dollar cost averaging process. 

What is dollar cost averaging?

Dollar cost averaging refers to the process of investing the same amount to some regular timescale. When the price of the equities is low you will acquire more, and when high you will acquire less.

It may seem obvious, but is still worth stating, that dollar cost averaging essentially delays investing, which means that broadly as prices tend to rise over time this may reduce your returns…

Dollar cost averaging however itself has two problems aside from the implied delay element:

1. There are transaction costs
2. Can it be automated?

Transaction costs of dollar cost averaging

Ostensibly the transaction costs do not seem that high. You can download a very simple Excel model where you can put your own portofolio figures in here: Dollar cost averaging share purchases transaction costs.  

On the basis of $150k portofolio spread out over 10 sectors asset allocation sectors, with 10 trades per sector (100 trades in all), at $32 per trade (eTrade’s costs in Australia to private investors) you are looking at a transaction cost of around 2.13% on the whole portfolio using a dollar cost averaging strategy in establishing your portfolio:

Can you fully automate dollar cost averaging?

In an ideal world many time-poor private investors would prefer to set up a plan in advance e.g. ‘complete my dollar cost averaging plan over the next 2 years’, for example.  

This raises the question of whether share purchase orders set ‘at market’  or ‘at best’ can be poorly priced, whether deliberately or accidentally by the broker?

The short answer is the jury is out …. there didn’t appear to be any easily identifiable research and presumably it differs on a broker by broker basis.

However a common-sense approach might suggest that low liquidity shares with bigger bid/ask spreads might be more at risk of mispricing than broadly traded shares or ETFs.   

Know better? Comment below.

Posted under investment strategies, market timing

Beliefs of Americans about investment returns from different asset classes

The thing that has bothered me over the years about investing in low cost equity tracker funds which eliminate all that stock-specific risk and have historically performed far better than any other asset class, is that they seem like such a no-brainer. Surely it is so obvious that everyone can see this with average actively managed fund performing worse than low cost passive vehicles?

And if everyone can see this then isn’t there going to be a whole pile of ‘dumb’ money piling in driving index constituents to ever higher price earnings multiples, whilst ignoring the fundamentals of these stocks? Who’s going to be left to actually look at individual stocks to do the number crunching to really evaluate their value?

Ok, I realize that nobody ever went broke (particularly casinos) by basing their business on the public thinking they were cleverer than the average Joe but still? Admittedly there is also a lot of rubbish quoted out there that makes it look like stocks do not offer good long term returns. One of my pet hates is writers just quoting the index e.g.

“the S&P is back where it was 10 years ago”

and the writer not realizing that, for example, (from Standard and Poors) dividend income has represented roughly 1/3rd of the monthly total return on the S&P 500 since 1926, ranging from a high of 53% during the 1940s to a low of 14% in the 1990s (when investors focused on growth).

But there is also a huge amount of very compelling research identifying long term returns on different asset classes…

It looks like I needn’t have worried about crowd mentality when it comes to trackers looking at this survey though!  Sadly another thing that stands out about the Gallup results is that lower income investors are more likely to view savings accounts as better investments (obviously imposing an inherent ceiling on their growing their personal wealth) although equally oddly higher income investors believe most in investment in real estate!

The study also bears out that  we investors are so into driving by looking into the rear vision mirror … with equities (now that they represent better value) falling in popularity by 15% or so over the last 2 years (the same survey has been carried out since 2003) and bonds and cash which have performed better over the same period (despite the forward inflationary risk with a wall of government debt bearing down on us) becoming much more popular…

Posted under index trackers, investment strategies

Watching the Obama government fiddle around with the various creditors in Chrysler (and in other government bailouts where political calculations are coming into play in Australia and the UK) it’s pretty obvious that there is ‘political risk’ coming back into investment in a big way.

It is something that Bill Gross at Pimco was also keen to stress in his latest podcast, “2+2=4”, that equity and debt holders may be looking at a highly regulated future where the ‘dead hand of government’ plays a significant role in setting future growth rates and income distributions (no doubt Mr Gross would be horrified by this oversimplification).

Another way to look at it is simply that the debt being run up in stimulus packages may create an irresistible temptation for governments to tap funding sources which currently might appear to be protected.

One obvious group of people who are being ‘stuffed’ in the current environment are holders of cash, with interest rates of .5% in the UK or a (comparatively) generous 3% in Australia, perhaps a realization which may play a small part in the recent market runup.  In a future environment it may be that holders of non-inflation protected assets are also going to get stuffed.

As someone I know puts it more succintly, “the older generation are going to get stuffed somehow.”

However one other obvious source for governments to target are Super funds and pension funds.

As Kris Sayce puts it well in ‘Money Morning’ with regard to Australia:

“perhaps the biggest giveaway is the $1 trillion held in private superannuation accounts. At the moment these balances are almost untouchable by the government. It is up to the fund managers and trustees of the funds to decide where the money is invested.

That is a position that no government will allow to remain for too long. Not when there is a $300 billion public sector debt to be paid off. And a $100 billion public sector pension liability to be financed.

Not to mention all the increases in welfare payments that will arise in the next few years.”  

Given the time horizons involved we should all be thinking about what the government might do to get their hands on it to pay their bills. Mr Sayce’s view is that there may be inducements from the government to “swap their defined contribution super plans in return for a defined benefit government pension”, however we probably need to consider other possibilities as well. For example:

• could the government change the tax rates on super funds from 15%?
• could the government set maximum super fund sizes?
• could the government change the cap on non-concessional contributions (currently $150k)?
• could the government change the preservation age (the age most of us can access their super) – it’s been suggested that preservation age move to 67 by the interim Henry Review?
• could the government further target temporary residents (it is already taking their unclaimed super within 6 months of them departing Australia)?
• introduce tax on super income streams after preservation age (60), currently for most people there is no tax if the cash was taxed ‘going’ in).

From the government’s point of view there are  two risks:

1. loss of votes amongst a segment of the population that is getting larger (retirees)
2. reducing the savings rate (pretty much what it wants to do at the moment anyway and of course a mandatory super contribution level in effects sets a savings rate the government can fiddle with as well)

The level of risk overall should a key factor (especially for wealthier individuals given the budget changes to super) in whether you choose to put your money into the superannuation sandbox or operate outside it.

Posted under investment strategies, Risk

In the old (pre-internet) days to create a market rumour you actually had to go to the trouble of making a phone call to a broadsheet journalist. As a university prank we rang a major newspaper’s Property columnist, told him we were from the (fictitious) “Real Estate Institute” and did he know if there was any truth to the market rumour that there was a Sheikh in town with $200m to spend on property?

Unsurprisingly (because we’d just made it up) he didn’t know if there was any truth to it but that didn’t stop him printing it prominently the following day, “the real estate scene is abuzz with the rumour that there is a Sheikh in town with $200m to spend on some property acquisitions…” (I have no idea whether or not that benefited someone flogging property over the succeeding couple of weeks, if it did please forward me a cheque care of this blog). 

[PS Don’t try this sort of thing at home, it’s too easy to succeed, and probably illegal into the bargain.]

These days you don’t need to even get someone on the other end of a phone. Last Monday you could watch the internet equivalent of  this sort of rumour-mongering playing out in the blogosphere and email world and it’s interesting to take a closer look at how the rumour spread and why.

The Rumour

On Wednesday I received the following item forwarded by email:

“Monday, April 20, 2009
Stress Test Results Leaked

Posted by [name omitted] at 8:08 AM
Turner Radio Network out with a shocker on what they claim are the leaked Stress results. We paraphrase:

The Turner Radio Network has obtained “stress test” results for the top 19 Banks in the USA.

The stress tests were conducted to determine how well, if at all, the top 19 banks in the USA could withstand further or future economic hardship.

When the tests were completed, regulators within the Treasury and inside the Federal Reserve began bickering with each other as to whether or not the test results should be made public. That bickering
continues to this very day as evidenced by this “main stream media” report.

The Turner Radio Network has obtained the stress test results. They are very bad. The most salient points from the stress tests appear below.

1) Of the top nineteen (19) banks in the nation, sixteen (16) are already technically insolvent.

2) Of the 16 banks that are already technically insolvent, not even one can withstand any disruption of cash flow at all or any further deterioration in non-paying loans.

3) If any two of the 16 insolvent banks go under, they will totally wipe out all remaining FDIC insurance funding.

4) Of the top 19 banks in the nation, the top five (5) largest banks are under capitalized so dangerously, there is serious doubt about their ability to continue as ongoing businesses.

5) Five large U.S. banks have credit exposure related to their derivatives trading that exceeds their capital, with four in particular – JPMorgan Chase, Goldman Sachs, HSBC Bank America and
Citibank – taking especially large risks.

6) Bank of America`s total credit exposure to derivatives was 179 percent of its risk-based capital; Citibank`s was 278 percent; JPMorgan Chase`s, 382 percent; and HSBC America`s, 550 percent. It gets even worse: Goldman Sachs began reporting as a commercial bank, revealing an alarming total credit exposure of 1,056 percent, or more than ten times its capital!

7) Not only are there serious questions about whether or not JPMorgan Chase, Goldman Sachs,Citibank, Wells Fargo, Sun Trust Bank, HSBC Bank USA, can continue in business, more than 1,800 regional and smaller institutions are at risk of failure despite government bailouts!

The debt crisis is much greater than the government has reported. The FDIC`s “Problem List” of troubled banks includes 252 institutions with assets of $159 billion. 1,816 banks and thrifts are at risk of failure, with total assets of $4.67 trillion, compared to 1,568 institutions, with $2.32 trillion in total assets in prior quarter.

Put bluntly, the entire US Banking System is in complete and total collapse.

More details as they become available. . . . . .” 

Spreading a Rumour

There were two other interesting features about the email aside from the fact that it took two whole days (!) to get to us.

Email Your Market Rumour

Firstly, my contact had had this email to him on Tuesday by a large investment banking house which I won’t name whose employee noted that “I am sharing this not to create undue panic but simply to let you know what is out there right now” and who also noted that he was sending this to his “valued clients and friends”.

One could argue that in a sense it’s this professional investor’s job to send round stuff like this if it, a) creates a reason to do a trade (!) and b) to let his clients know what rumours are doing the rounds in the rest of the market. Of course one could also argue that there is a bunch of people out there who could also use the those relatively unknown tools available like Google to check  the truth of what they’re disseminating.

The second thing that I thought was interesting was the speed this rumour spread at and how it spread.  In email terms there were already 3 headers from three different on-forwarders on the version of this story I sent.  Assume, for example, that each person in those 3 ‘layers’ forwarded it to 10 people then that’s 1000 individuals (10 X 10 X 10). Clearly some would have not forwarded it at all and some might have forwarded it to more or less than 10 but you get my drift (and it makes the math trivial).

Blog Your Market Rumour

Bloggers receiving this email unaware (maybe) or at least not bothering to check what was on the web just posted it verbatim on their blogs (actually they had been sent by email the full text of a blog post that was already up). In what NPR’s must-listen-to “On the Media” refers to as the “echo chamber of the blogosphere” it spread quickly, with on Wednesday there being about 96 web pages posted repeating the item verbatim, and when I did this search today (Saturday) there were 441 web pages repeating it. If you’re familar with Google you will also realize that Google’s PageRank system regards a link as a ‘vote’ for the importance of a website (whether your link actually says “here’s a bunch of crap” or “hey look at this item I think is a permanent and unique truth”).

So if you’re trying to spread a bear market rumour you need to realize that a blog post may not be enough: you really need to use email as a mechanism to get it out there (because bloggers reading the email may assume that the item is only being circulated by email and therefore that if they post it quickly on their blogs they may be amongst the first to break it on the web).

What Makes a Market Rumour Work

The best kinds of rumours ride the concerns already out there. This rumour was probably helped by two things: Bank of America’s results happened to also come out on Monday and they weren’t good (a 41% leap in non-performing assets) and of course the general concerns swirling around about banks anyway.

The best kind of spam also circulates effectively because it references an ‘authoritative source’.  The ‘Turner Radio Network’ from the email sounds pretty authoritative doesn’ t it?

Well errr… actually it’s totally unrelated to Turner Broadcasting and as is a blog run by a guy called Hal Turner and hosted using Blogspot’s free hosting service (I’m not going to link to it because PageRank does what it does and I’d merely be driving more traffic to it).

A $527m Market Rumour

Mr Turner himself seems to have been pretty impressed with the results:

“When the U.S. Stock Markets opened, Bank stocks were immediately impacted by folks spreading my report. Bank stock values plunged by eleven percent within 6 minutes. On the S&P 500 alone, bank stock values plunged by about $527 million dollars.”

 And he’s not alone on this anway: CNBC notes that the “Select Sector SPDR Financial ETF was down 5.4 percent after the blog post was widely disseminated by at least two third-party news services” and that a Treasury spokesman actually had to publically say the Treasury didn’t have the Stress Test results.

On one point it looks pretty clear Mr Turner is right, a good market rumour spread by people who don’t fact check carries its own momentum. As he noted on Monday night:

“Sorry guys, but whether the Turner Radio Network has the real results or not is no longer material.”

If you’d read this item from Mr Turner and immediately gone out and shorted US bank stocks (and maybe even forwarded it along ,and filed it a few times yourself as comments on articles on prominent financial sites) you also wouldn’t care whether it was right or wrong.

Posted under investment strategies, market timing

It will not have escaped people’s notice that shorting some indices last year would have been very lucrative. What about in 2009?

As a company we do some business with Hong Kong and Chinese clients. Recently we’ve been receiving letters in response to our invoices which read along the lines of:

“whether there is a possibility of a one-off discount for this year.. In view of the economic clouds and down cycle on the horizon our ..budgets for 2009 are very tight and in fact downsized – we would very much appreciate your kind and considerate courtesy in this matter.”

At the same time there is quite recent investor comment around about shorting China. For instance the Christmas edition of MoneyWeek suggests using the ‘Ultrashort FTSE/Xinhua 25 Proshares (US:FXP), an exchange traded fund that matches 200% of the inverse movement in the Chinese market.

However, looking at an indices chart of emerging markets  comparing the FXI (the long version of the FXP) and the Indian equivalent (the BSE30) and the Dow Jones index both China and India large caps have tracked down very closely (and at least 10% more than the DJI) at levels of 50% or so.

Admittedly China is not the worst emerging market performer of last year (Russia is down for example some 70%) but this does not appear to be a ‘new’ story (on a 5 year view these indexes are down some 150% from the heights they reached at the end of 2007) so one suspects that shorting China at this point could be a risky business. 

In ‘short’, this boat has sailed.

Posted under index trackers, investment strategies

The whole market is on sale, 30%+ below its high.

So it doesn’t matter what you buy, you can just buy a tracker fund / index fund right? That will give you a low risk, low cost, highly diversified bet on the long term value of equities. Sure, you may want to drip-feed funds in, because it could fall another 20%.

We….ll, as ever, maybe it’s not that simple.

Industry sector weights in the ASX 100

For example, if you look at the broader Australian stockmarket, you find that actually were you to buy an ASX 100 tracker you are effectively taking a bet on two sectors in a big way, financials and mining. For instance Jun 2008 S&P sector weights show that the ASX 100 is 8.41% energy, 28.17% Financials-ex-Property, and 30.1% materials. In other words 64% of the large cap end of the index.

Industry sector weights in broader ASX indexes

So what about a broader tracker, for instance the State Street SPDRs tracker for the ASX 200?

Well this is actually a similar sector bet. For example Oct 2008 figures (i.e. even after the credit crisis fallout of the last 12 months) show a sector weight of 39% on financials, and 21% on materials, and 6% on energy, a total of 66%…

It is only when you get to the ASX Small Ordinaries (companies in the S&P ASX 300 but not in the S&P ASX 100) that financials drop to 7% but materials is still 31% and energy is still 14% taking the weight for the 3 to 51%.

You can not buy a tracker of the Small Ordinaries, you’d have to look at a managed fund like BT Microcap Opportunities or the equivalent, so in a sense this is rather academic, but it does give you a pointer to the extent that the Australian economy is dependent on these sectors, even after a commodity price fall and the banking price fall.

Sector weights in UK indexes

The FTSE 100 is 22% oil and gas, 21% financials, and 15% basic materials as of June 30 2008, another significant bet on mining and banking.

However the FTSE 250 is a significantly more diversified bet: 27% financials, 6% oil and gas, and 5.4% basic materials as of 30 June (probably significantly less of a financial and mining bet as of Oct 2008).

Non-standard ‘stylistic’ trackers can also give you some variation on the standard sectors. For example, the FTSE UK Dividend Plus tracker, which consists of the highest dividend yields in the FTSE 350 filtered by specific liquidity requirements, is 32% financials and 4% oil and gas as of 30 June.

Aren’t trackers about not guessing themes?

None of this is to say that we should be trying to guess what themes will do well (for instance a tracker that is heavily weighted to financials and diversified might not be a bad thing to buy at the moment).

It is also the case that not all trackers are equal. So-called ‘Enhanced Trackers’ where the managers have some freedom to track the index somewhat more loosely and use derivatives, supposedly often perform better over the longer term by anticipating index departures and arrivals, but more of that later.

Posted under index trackers, investment strategies

When it comes to investment strategy for self managed super funds or self invested personal pension plans, unless you are a retiree with lots of time on your hands or a very competent stock picker, index/tracker funds or actively managed funds are probably going to play some role.

In making the choice for your SMSF strategy between passive trackers and actively managed funds there are two commonly cited reasons as to why you should choose passive versus actively managed funds:

1. Cost – and specifically the impact of management costs over the long period of a superannuation fund investment. According to Rainmaker’s most recent survey, cited in the Australian, “the fee varies according to what you buy: workplace super funds average 1.41 per cent, personal super funds average 2.03 per cent and retirement funds average 1.86 per cent. ‘Out of that, the weighted industry average is 1.36 per cent,’ says Andrew Keevers, Rainmaker’s associate director of research.”

Of course this includes ‘unavoidable’ costs like compliance costs but it also includes perhaps more avoidable costs like trailing sales commissions paid to advisors.  It is not an entirely fair comparison (simply because it does not include super-specific running costs) but the management expenses of something like the iShares IJP tracker runs at .5% (and that’s not the cheapest tracker around).

1% or so difference between an actively managed fund and a tracker doesn’t sound like much on the face of it but the impact of just 1% over a longer period can be quite high. For example, from memory the average SMSF in Australia is around $250,000. Assume two SMSFs, one with passive trackers, one with actively managed funds (with slightly higher expenses) are both held for 15 years starting with a balance of $100,000 (to make it simple I have assumed no new contributions). Assume the same return of 6% p.a. (see point 2 below about returns) but a 1% higher management fee in the actively managed fund so the net return on the passively managed SMSF (after expenses) is 5% and the net return on the actively managed SMSF (after expenses) is 4%:

So a 1% difference in returns compounded over 15 years leads to a 20% difference in the value of the fund on retirement … now imagine the impact with new contributions every year plus longer timelines given increasing life expectancy…

2. Returns – tend to be lower in most managed funds than passive funds. Whilst individual managers may have periods of outperformance this tends not to last.  It is sometimes thought that active fund managers may perform better in bear markets, but even this doesn’t look like it is true:

“Lipper Inc. studied active managers’ performances in bear markets (defined as a drop of 10% or more in the equity markets). Lipper found that active managers underperformed the S&P 500 Index in the six market corrections occurring between August 31, 1978, and October 11, 1990. For example, the average loss for the S&P 500 Index in these episodes was 15.1%, compared with a 17.0% average loss for large-cap growth funds.” [Source Vanguard] 

Both these points are commonly cited when it comes to comparing active management and tracker funds. However the advantage that you do not see mentioned so much relates to entry and exits.

Whether you are picking stocks yourself, or paying an active manager to do it for you, it often seems like the hard part is knowing when to sell … knowing when to buy is much easier.

For instance, if you are a value investor (you tend to buy stocks that you think are undervalued on say price/sales ratios or PE or whatever) broadly speaking one of two things is likely to happen, you were right (it was undervalued and the price goes up), or you were wrong (it was actually overvalued because it had a load of debt that it is having trouble refinancing and that wasn’t captured in the ratios you used).

Assuming you picked well at what point do you sell? When it’s priced at the correct ratio? What if things have changed in the business and it’s long run returns look better?

And if you picked badly how do you recognise this? If you are a value investor a la Mr Buffett you’re supposed to ignore the price falling and just buy more … but what if the fundamentals in the industry have changed (like Mr Buffett you quite like the newspaper industry but increasingly everyone is getting their news for free online)?

Add to this the well known predilection that people have for finding it hard to cut their losses and finding it equally hard to let their profits run, rather than take them too quickly, and it is easy to understand why so many private investors (and fund managers!) end up portfolios full of dogs. It’s not that they can’t recognise value when they see it: it’s that they can’t recognise when they’re wrong, and equally they don’t know when to sell when they’re right…

The great advantage of tracker funds is that they make these buying and selling decisions for you without your emotions coming into it (and without your time being spent on constant re-evaluation of your picks).

Posted under index trackers, investment strategies