It is a good idea to use ETFs for the bulk of your equity allocation

My preference for equity exposure is 80% in index funds and a smaller amount with active funds to access less-efficient markets, says Henry Cobbe. 

This is the third in a series of articles by Henry Cobbe, head of research at Elston Consulting,  exploring the world of index investing. Henry is co-author of How to Invest With Exchange-Traded Funds.

In previous articles, I looked at things to consider when designing a multi-asset portfolio. Let’s say, for illustration, an investor decides on a balanced portfolio with 60% invested in equities and 40% in bonds. The “classic” 60/40 portfolio.

There are e a number of options of how to populate the equity allocation in that portfolio. I consider each option in turn.

Equity exposure using direct equities: ‘the stock selectors’

This is the original approach and, for some, the best. We call this group “stock selectors”: investors who prefer to research and select individual equities and construct, monitor and manage their own portfolios. To achieve diversification across a number of equities, a minimum of 30 stocks is typically required (at one event I went to for retail investors I was slightly nervous when it transpired that most people attending held fewer than 10 stocks in their portfolio). Across these 30 or more stocks, investors should give due regards to country and sector allocations.

Some golden rules of stockpicking include:

1) Understand the macroeconomic factors that impact a company and its trading and reporting currency

2) Understand what drives a company’s future earnings, and the risks to that earnings

3) Evaluate the management to understand their strategy for the company

The advantage of investing in direct equities is the ability to design and manage your own style, process and trading rules. Also by investing in direct equities there are no management fees creating performance drag. But when buying and selling shares, there are transactional and other frictional costs, such as share-dealing costs and stamp duty.

The most alluring advantage of this approach is the potential for index-beating and manager-beating returns. But while the potential is, of course, there, as with active managers, persistency is the problem.

The more developed markets are “efficient”, which means that news and information about a company is generally already priced in. So to identify an inefficiency you need an information advantage or an analytical advantage to spot something that most other investors haven’t. Ultimately, you are participant in a zero-sum game, but the advantage is that if you can put the time, hours and energy in, it’s an insightful and fascinating journey.

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The disadvantage of direct equity is that if it requires at least 30 stocks to have a diversified portfolio, then it requires time, effort and confidence to select and then manage those positions. 

The other disadvantage is the lack of diversification compared to a fund-based approach (whether active or passive).  This means that direct investors are taking “stock-specific risks” (risks that are specific to a single company’s shares), rather than broader market risk. In normal markets, that can seem ok, but when you have occasional outsize moves owing to company-specific factors, you have to be ready to take the pain and make the decision to stick with it or to cut and run.

What does the evidence say?

The evidence suggests that, in aggregate, retail investors do a poor job at beating the market.

The Dalbar study in the US, published since 1994, compares the performance of investors who select their own stocks relative to a straightforward “buy and hold” investment in an index fund or ETF that tracks the S&P500, the benchmark that consists of the 500 largest traded US companies.

The results consistently show that, in aggregate, retail investors fare a lot worse than an index investor.

There could be a number of reasons for this, including, but not limited to:

Information asymmetry: retail investors dabbling in stocks do not have the same access to information as professional investment managers and therefore may be late to news, developments, or turning points that affect a share price.

Behavioural biases: retail investors are subject to a range of behavioural biases that means they may be reluctant to sell winners (confirmation bias), and/or not quick enough to sell losers (status quo bias)

Over-trading: retail investors may be tempted to “tinker” with their portfolio. Some studies show that the more frequently investors trade, the worse the performance.

So while it may be in the interest of some brokerages that rely on dealing costs for income to encourage investors to trade frequently, it may be in investors’ best interests to “buy and hold” their chosen 30 stocks and review them just once or twice a year.

But selecting the “right” 30 or more stocks is labour-intensive and time-consuming. So, if you enjoy this and are confident doing it yourself, then there’s nothing stopping you.

Indeed, you may be one of the few people who can, or think they can, consistently outperform the index year in, year out. But it’s worth remembering that the majority of investors don’t manage to do so.

For most people, a direct equity/direct bond portfolio is overly complex to create, labour-intensive to manage and insufficiently diversified. Furthermore, owning bonds directly is near impossible owing to the high lot sizes. So why bother?

Investors who want to leave stockpicking to someone else have two options: they can be “fund” investors selecting active funds, or “index” investors selecting passive funds.

Equity exposure using active funds: the ‘manager selectors’

A fund-based approach means holding a single investment in fund that holds a large number of underlying equities, or bonds, or both.

Investors who want to leave it to an expert to actively pick winners and avoid losers can opt for an actively managed fund. We call this group “manager selectors”. But you have to pick the “right” actively managed fund, which also takes time and effort to research and select a number of equity funds from active managers, or seek out “star” managers who aim to consistently outperform a designated benchmark for their respective asset class. And while we all get reminded that past performance is not an indicator of future performance, there isn’t much else to go by.

In this respect, access to impartial independent research, such as interactive investor's Super 60 (which covers both active and index-tracking funds) and ACE 30 fund lists is an invaluable time-saving resource.

The advantage of this approach is that with a single fund you can access a broadly diversified selection of stocks picked by a professional. A disadvantage is that management fees are a drag on returns and yet few funds persistently outperform their respective benchmark over the long run, raising the question as to whether they are worth their fees. This is evidenced in a quarterly study known as the SPIVA Study, published by S&P Dow Jones Indices, which compares the persistency of active fund performance relative to asset class benchmarks. For efficient markets, such as US and UK equities, the results are usually quite sobering reading for those who are prefer active funds. Indeed, many so-called active funds have been outed as “closet index-tracking funds” charging active-style fees, for passive-like returns.

Of course there are “star” managers who are in vogue for a while, or even for some time. But it’s more important to make sure that a portfolio is properly allocated and diversified across managers, as investors exposed to Woodford found out.

In my view, an all-active fund portfolio is overly expensive for what it provides. While the debate around stockpicking will run and run (and won’t be won or lost in this article), consider at least the bond exposures in a portfolio. An “active” UK Government Bond fund has the same or similar holdings to a “passive” index-tracking UK Government Bond fund but charges 0.60% instead of 0.20%, with near identical performance (except greater fee drag). Have you read about a star all-gilts manager in the press? Nor have I. So why pay the additional fee?

What about hedge funds? Hedge funds come under the “true active” category because overall allocation exposure can vary greatly, and there is the ability to position a fund to benefit from falls or rises in securities or whole markets, and the ability to borrow money to invest more than the fund’s original value. But most “true active” hedge funds are not available to retail investors, who are more limited to traditional “long-only” retail funds for each asset class.

Equity exposure using index funds: the ‘index investor’

Investors who don’t want the time, hassle or cost of picking active managers, or who believe that markets are “efficient” often use passive index-tracking funds. We call this group “Index Investors” (full disclosure: I am a member of this group!). These investors want to focus primarily on getting the right asset allocation to achieve their objectives, and implement and actively manage that asset allocation but using low-cost index funds and/or index-tracking ETFs.

The advantage of this approach is transparency around the asset mix, broad diversification and lower cost relative to active managers. The disadvantage of this approach is that it sounds, well, boring. Ignoring news on companies’ share prices, and which single-asset funds are stars and which are dogs would mean that 80% of personal finance news and commentary becomes irrelevant!

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On this basis, my preference is to be a 100% index investor – the asset allocation strategy may differ for the objectives of my parents, myself and my kids. But the building blocks that make up the equity, bond and even alternative exposures within those strategies can all index-based.

A blended approach

While my preference is to be an index investor, I don’t disagree that it’s interesting, enjoyable and potentially rewarding for some retail investors and/or their advisers to spend time choosing managers and picking stocks, where they have high conviction and/or superior insight. Traditionally, the bulk of retail investors were in active funds, but more and more are becoming 100% index investors. However, there’s plenty of ground for a common sense blended approach.

For cost, diversification and liquidity reasons, I would want the core of any portfolio to be in index funds or ETFs. I would want the bulk of my equity exposure to be in index funds, with moderate active fund exposure to selected less-efficient markets, for example, small caps, and up to 10% in a handful of direct equity holdings that you follow, know and like.

What would a blended approach look like for a 60/40 equity/bond portfolio?

60% equity of which:
Min 70% index funds
Max 20% active funds
Max 10% direct equity “picks”/ideas

40% bonds of which:
100% index funds

Summary

For most people, investing is just something that needs to get done, like opening a bank account. If you are in this group, using a ready-made model portfolio or quick-start fund makes sense.

For others, investing is more like a hobby and something that they are happy to spend time and effort on. If you are in this group, you have to decide if you are a Stock Selector, Manager Selector or Index Investor, or a blend of all three, and research and build your portfolio accordingly.

Henry Cobbe is a freelance contributor and not a direct employee of interactive investor.