Passive investing doesn’t remove the need to make choices

I’ve been thinking about the passive vs active debate for a while. There has been a clear shift towards low cost passive investing. Many personal finance bloggers are massive advocates of index investing, some preaching  very high exposure to US equities.  Bloomberg just published “5 ways ‘Passive’ Investing is Actually Quite Active” by Eric Balchuna. The media commentary seems to be shifting from a simple active vs passive argument, to a more nuanced discussion on what passive investing actually is.

When reading about personal finance / DIY investing online, it appears some people think passive investment removes choice from investing. That is, you don’t need to think about, or know anything about investing if you choose to invest passively. This is obviously not true. You need to make important decisions such as:

  1. Asset allocation decisions (e.g. equities vs bonds vs real estate vs cash)
  2. Geographic exposure decisions (e.g. Home country vs global)
  3. Index selection decisions (e.g. S&P 500 vs  S&P total US stock market)

The above 3 choices can have a profound impact on your long-term investment performance. To see the wide variation in 1Y, 5Y and 10Y returns across the 334 ishares ETFs go here.

In summary, passive investing is preferable for most retail investors, but it doesn’t remove the need to make choices.

Book review: Black Edge

Black Edge: Inside Information, Dirty Money, and the Quest to Bring Down the Most Wanted Man on Wall Street. (Sheelah Kolhatkar)

Stevie Cohen’s SAC Capital Advisors had delivered c. 30% returns for two decades. He was The Man, when hedge funds were still the new kings of Wall Street. Sheehan Kolhatkar has successfully woven together the tale of how the government tried (and plot reveal – failed) to put Stevie in the can. You should read this book, but you will be disgusted by: (1) How crooked some hedge fund managers (and their enablers) are; and (2) The fact the big fish got away.

The book also gives a small peek into the lifestyles of the rich and famous. The anecdote involving casino mogul Steve Wynn accidentally putting an elbow through his Picasso after he had sold it to Stevie Cohen for US$139m is particularly amusing.

Buy a copy by clicking on the link below.

Note: I may receive a small commission from Amazon if you buy the book after clicking on the above link.

Head to the “Books” page to see a collection of other books you may enjoy.

Investing exponentially

The article “Soft Bank CEO Masayoshi Son Banks on Exponential Growth”  by Vitaliy Katsenelson (Contrarian Edge) really made me think about how I invest. Soft Bank has been in the news recently for its US$32bn investment in Arm Holdings (at 48x earnings!) and its US$100bn technology investment fund. The CEO has proven a master at placing bets on companies in rapidly accelerating industries.

A younger Masayoshi Son

Source: Wikipedia

Before discussing Masayoshi Son’s investment approach further, I’ll provide a bit of background about my own investment philosophy. I believe an investment philosophy is crucial for those interested in personal finance and financial independence. As a non-professional investor, I’m a huge fan of using index ETFs for cheap and low hassle exposure to equities. However, I also think I’m a smart guy, who occasionally comes up with a good investment idea, so I like to do some non-index investing. I know I will struggle to beat the index over-time, but don’t care. In summary, my philosophy is “mostly use low cost ETFs, but leave room in the portfolio for some small bets”.

My view of the market at the moment is:

  • P/E multiples (particularly in the US) are outrageous, particularly for many low growth businesses
  • However, money has no-where else to go if people are seeking real returns
  • The low interest rate environment could last for decades. Government and corporate debt levels make significant interest rate increases unlikely (but not impossible)
  • For those with a long-term horizon, investing in equities remains a no-brainer
  • But, you have to accept the risk of multiple contraction which will reduce your portfolio’s value

I’ve been doing a lot of thinking about what types of investments I should pursue with my non-index fund allocation. Here is where I am at:

  • Making investment in individual companies which are unlikely to perform substantially better than the market is more expensive and higher risk than index ETFs – it is pointless
  • Macro investing at times of significant volatility is attractive, but often difficult to execute for non-professional investors (e.g. profiting from the oil price crash has proved difficult, Oil ETFs tracking of the price recovery has been dismal)
  • The growth of PE/VC means getting early access to fast growing companies is increasingly difficult for retail investors

Now back to Masayoshi Son. Vitaliy Katsenelson’s article summarises Son’s investment approach, which is based on exponential (non-linear) thinking:

To understand this acquisition [purchase of Arm Holding for US$32bn], we need to come to terms with Son’s investment strategy and his mental models that have made him the richest person in Japan. Son is a master of exponential (nonlinear) thinking. Examine his past investments and you’ll find that he identifies industries about to go from high but linear growth into the exponential phase — where the rate of growth is accelerating.

Son has done this over and over again during the past 40 years. It started with PCs in the ’70s, when he built a software distribution business in Japan to capitalize on PC growth entering the accelerating phase. He saw the inflection point of Internet growth in the ’90s, bet on Yahoo and created Yahoo Japan (a joint venture with Yahoo).

In the early 2000s he saw e-commerce and the Internet taking off in China and purchased a stake in Alibaba, turning his $20 million investment into $60 billion today…

Identifying industries that are entering an exponential growth phase is hard enough, but acting on the insight is even more challenging. I remember looking at a report on Apple in 2009, analyzing smartphones’ potential market size, assigning a conservative market share to the iPhone and basically saying that over the next several years Apple’s sales could accelerate (or continue at the then-current rate of 30 percent or so) and reach $100 billion from less than $20 billion that year. I saw the logic in the analysis, but it was difficult for me (and, I think, for most people) to mentally process a high growth rate going exponential. By the way, iPhone annual sales reached $155 billion in 2015.

Investing at the pivot point when growth rates accelerate is especially tough for value investors (present company included). As revenue growth accelerates, costs usually don’t rise as quickly, and therefore earnings increase at an even faster rate than revenue — now earnings growth is truly exponential. This dynamic creates a lot of value, which our linear brains may or may not process…

Son believes we are at the inflection point when the Internet of Things (IoT) market is about to enter the exponential growth phase. There are 7 billion people in the world today. In 2015, ARM sold 15 billion processors — about 2 processors per person. By 2020, ARM expects to sell 75 billion processors a year — a fivefold increase.

Do read the whole article, available here.

This is a more operational and nuanced approach than typical big picture thematic investing. After all, Son is running companies. He is buying for the medium to long term. He’s not just chasing momentum or short-term returns.

This article has made me realise I need to refine my framework for making my “small bets”. I should be looking for both shorter-term macro bets, and bolder longer-term exponential growth bets. As discussed above, identifying, timing and executing exponential growth bets is very difficult. I won’t be placing many of these bets over the years, but will remain on the look-out.

On China, stay sceptical

I was in China a few months after Lehman Brothers collapsed. Guangdong, the manufacturing heartland bordering Hong Kong, was a mess. Factories were closing and previously buzzing night spots were shuttered. Yet the economy kept chugging along according to official statistics.  I assumed they were making them up.

The Chinese government response to the Global Financial Crisis, was to order a massive indiscriminate lending binge. They responded to a crisis caused by sub-prime lending, by accelerating their own sub-prime-lending. China undoubtedly cooks its GDP figures, but the lending binge did support the economy.

The below chart shows the Chinese miracle has involved an unprecedented acceleration in indebtedness.

Source: Blackrock

China’s private debt-to-gross domestic product (GDP) ratio has surged to more than 200%. Never has a big economy piled up so much debt so quickly…

…Thanks to its large domestic savings rate, it has little external debt—the original sin that has sparked many emerging market (EM) crises. Beijing is working on fixes for internal debt issues, such as turning short-term bank debt into long-term bonds and redirecting credit to the private sector and households. But ultimately, China needs to find more sustainable engines of growth beyond further debt accumulation by unproductive national and local SOEs, or accept slower growth.

High foreign debt prevents aggressive currency devaluations. By choosing not to borrow from foreigners, China has left open their ability to significantly devalue the currency to enable export fuelled growth. It will be interesting to see if China will risk a devaluation, with an US President more focused on protecting jobs than his predecessors. A currency devaluation won’t work if the response from the developed world is tariffs.

There are two other key unresolved questions when looking at China’s medium to long-term prospects. (1) How much longer can China keep piling on debt?; and (2) Will the political system be able to absorb lower growth?

On China, stay sceptical.

NB: If you want to see how your country I positioned on the above chart, go here.

Do you know the sector composition of your index ETFs?

Good article highlighting the difference in performance between similar index ETFs by The Irrelevant Investor:

Small value stocks are up 25.5% YTD. Small value stocks are up 32.5% YTD. Nope, that’s not a typo. The first one represents Vanguard’s ETF, VBR. The second and better performing small-cap value ETF is IWN, from iShares.

As you can see from the chart below, they were neck and neck until the election, and then IWN kicked into high gear. The reason for this divergence is 29% of IWN is in financials, VBR is just 18%. Does this mean that iShares is the “better” option? Of course not, at least not due to twelve months performance. Over the last five years, IWN has returned 107%, while Vanguard’s offering is up 121% over the same time (also, does not mean Vanguard’s is superior).

Read the full article here

High exposure to financial services could increase the volatility of broad index funds during financial crises. It’s something to consider when choosing which index funds/ETFs to invest in.