When a hedge fund manager tells you he has found a way to build a portfolio that is better than 90 to 95 per cent of investors’, you are likely to take this claim with a pinch of salt.
However, when he says that the reason you have never heard of this method is that neither he nor anyone else is going to make any money out of it, it starts to sound like it may contain a kernel of truth.
The idea from Lars Kroijer, founder of hedge fund Holte Capital, is simple: investors should simply place the majority of their savings in a low-cost global index tracker, putting the balance – depending upon their time horizon and attitude to risk – in the highest-rated government bonds.
Performance of sector vs indices over 10yrs
Source: FE Analytics
The manager said he was compelled to write Investing Demystified, a book based upon this thesis, for his mother after she began to express an interest in investing.
“My mother, like a lot of people, had some savings and she thought she could beat the market,” he explained.
“Her claim to fame was that she would buy Danish shipping company Maersk’s shares because they had gone up so much, or Danske Bank because it had a nice new logo. And her real edge, she thought, was she had a London-based hedge-fund manager son. And that was how she trumped any argument among her friends.
“And I thought, ‘Boy, that was useless’.”
Kroijer is not interested in declaring whether the market can or cannot be beaten, calling this “an unnecessarily broad and big question". He said that what is far more important is whether the final investor has a genuine edge that allows them to beat the market, either through picking the right fund managers, stocks or asset classes.
However, he said the problem is that the vast majority of investors don’t have this edge. And yet despite the overwhelming evidence of this fact, most people allow emotions – specifically pride – to cloud their judgment.
“There is edge in everything,” he explained. “If you take an S&P 500 index tracker, you just have to pick one stock out of thousands of securities that is going to beat the market. It sounds so easy, but then a guy like me comes along and says, ‘You can’t even do that’. It seems like a cheap surrender.
“Statistically it is virtually impossible for retail investors, and even institutional investors find it very hard to do. And again, I want to come back to the premise that it is not about whether edge exists, it is whether you as an investor have it.
“If you take someone like my mother, and there are many, many millions of people like her, there is basically no chance in hell they will be able to beat the market. And that’s the premise of what I am saying. Now that doesn’t mean that others can’t, but she as the ultimate investor can’t.”
Kroijer said it is important to use a global tracker rather than your home index in this hypothetical portfolio as it offers instant diversification – for example, he said that while the figures for compound returns in the US over the past 100 years are spectacular, for the Russian market “they are less so”.
He also warned against trying to supplement the global index fund with more specialised trackers.
“Typically they cost a little bit more than a global equities index,” he said. “And you are actually paying extra fees on the differential, which sometimes resemble active management.
“I will talk you through what I mean. Say you have an index of global equities where you pay 15bps [basis points] a year and then you have another index of global equities with low price-to-book where you pay 30bps, you are paying 15bps a year.
“But if the overlap of securities is two-thirds, which it often is, in these slightly different indices, the fee differential on the one-third is actually three times, so just be aware of that.”
This brings Kroijer to the main reason why he thinks the portfolio he is recommending is such a powerful proposition: cost. He said that as well as over-estimating their own ability to beat the market, most investors also underestimate the long-term compounding impact of charges, which he described as “astounding”.
To illustrate this, he pointed to the example of someone who earns an average of £50k a year over the course of their career, who puts 10 per cent of their salary into their pension. He then assumed annualised returns of 7 per cent, which after 2 per cent for inflation would mean a 5 per cent real return.
Kroijer said that if these were the gross figures for the average actively managed fund, after charges the pension would be worth £900,000, while if they were gross figures for a low-cost tracker, it would be worth £1.5m.
“In today’s terms discounted back in real terms for inflation, there is a difference of £280k worth of savings, equivalent to seven Porsches,” he added.
“So just take a step back – I use this example as it is very real because it is someone who will probably never be able to drive a Porsche but who will over his lifetime pay seven Porsche cars in fees, more than he needs to.
“You pay fees in an index tracker, but you pay a lot more in an active fund, so this matters a tremendous amount to people’s lives.”