Passive investing part 2: diversification

In this second post of my series of articles focused on passive investing for Europe based investors, I would like to explain why passive investing makes sense as a strategy for an individual investor not only from costs perspective but also from returns perspective. In particular I will write about the impact of diversification.

Diversification

The theory says that there are two risks associated with investing in equities – the market risk and the idiosyncratic risk of the particular company. For example, if you chose to invest your portfolio in 5 stocks with equal amounts invested in each and one of them got into sudden unexpected problems (e.g. German company Bayer), this would disproportionately harm your returns. However, if you invest in a well diversified portfolio, in theory all the individual risks cancel out (negative surprises offset the positive ones) and you end up receiving the “market” return.

Therefore, passive investments in ETFs that offer a wide portfolio of stocks at low fees can be an easy way to harvest the benefits of diversification without much effort.

Of course, in practice diversification is not so simple to do – portfolio can be diversified across countries, sectors or other metrics. Since many ETFs tend to weight their investments based on market capitalization of the companies held, you might often be surprised to find out how much overlap there is between ETFs with seemingly very different aims. I will come back to this topic of how ETF names can be misleading your diversification efforts a bit later. However, general rule is the more mainstream ETF you choose, the more likely you’re going to be just fine.

If you have any questions or feedback, please leave a comment below.

Passive investing for EU based investors, part 1

Passive investing (or indexing) is a popular way to invest, as outlined in my earlier post. This is the first article of many in which I would like to explain in a simple way:

  • what is passive investing/indexing
  • why indexing can make sense and what returns are to be expected
  • why sticking to your initial strategy is perhaps the most important thing
  • how to start investing passively
  • avoidable indexing pitfalls
  • possible future risks for indexers

What is passive investing/indexing?

Passive investing is an opposite of active investing. Where active investors try to analyze companies, macroeconomic and political trends or employ quantitative models to provide better than market return, passive investor believes that sticking to a simple widely diversified (see diversification) portfolio.

It used to be the case that creating and maintaining a diversified portfolio was very expensive as each position (in a stock or a bond) had to be executed individually. However, nowadays investors can choose from thousands of exchange traded funds (ETFs) that hold such diversified portfolio for them at extremely low management fees ranging roughly from 0% (for certain most popular ETFs) up to 1% for the most complicated ones.

For example iShares MSCI world ETF (as iShares is by far the market leader in ETFs for Europe based investors) at the moment provides you with a portfolio compose of stocks listed in the following countries:

Note that the composition above can and will change if you’re reading this article some time after publishing.

As a result, ETFs now provide a fairly high benchmark, tracking a widely diversified portfolio of even thousands of stocks across countries and sectors at very low costs. Why costs have a far higher impact on your long term investment results and what kind of returns can be expected will be discussed in the next article.

Spaarbelasting changes part 2

As more and more people start to notice that the headline of 440,000 euros being tax free comes with a cost to everyone who invests his savings, or at least does not keep them on his bank account, there are some interesting articles for example this one on Business Insider. The article goes through a couple of examples that show some very interesting points:

  • Currently if someone invests 100,000, the effective tax is approximately 0.4%. Based on the new proposal, this turns into 1.63%. For someone who invests 300,000 the jump is relatively smaller, from 1% to 1.71%.
  • This hike in tax rate can have massive impact on someone saving regularly small amounts for retirement. Again an example is given where saver who puts aside 400 euros per month is left after 30 years with 314,000 eur under the current system and 266,000 eur under the new system.

Therefore the change will hurt smaller investors much more than till now. Moreover, actively investing on your own for, say, retirement will now be dramatically disadvantaged as regular pension accounts (probably) won’t be taxed.

Who are the winners then?

  1. Savers, i.e. people who keep all their money on their bank account.
  2. Banks. As banks worry about having to pass on negative rates to deposit holders, this gives bank accounts 1.75% advantage over most alternatives.
  3. Pension investment providers (such as Brand New Day) as this becomes considerably more attractive option than before.
  4. Possibly insurance companies, if there turns out to be a policy structure that avoids the tax.

If the tax changes are implemented as proposed, it will be an interesting experiment in how lowering the risk premium of investments by 1.75% affects the decisions of (potential) investors. As till now the tax was seen as an incentive to invest, we might see many people choosing the safety of bank accounts.

Obviously the big losers will be people buying second homes, investors and potentially whoever provides services to investors. Some types of investing will become pointless, for example given the flat 5.33% return assumed on any investment, corporate bonds don’t seem to have much value left especially if any other fees are involved.

The Dutch wealth tax overhaul

Last week the Dutch government published an idea to overhaul the Dutch wealth tax system. Currently, the system assumes a return on any wealth above 30.846 euros which is then taxed at 30%. This results in approximately 1.2% tax (see details below copied from the press release) at 4.2% which is the rate assumed on savings between 73k-1m. Note the system changed relatively recently, it used to assume 4% return above 30k savings without any tiering.

The new system will take into account the allocation of the wealth into savings and investments. Details on this are still a bit unclear but let’s stick to the example above. The assumed return on cash savings will drop to 0.09%. This results in a headline catching statement: 1.35m people won’t pay wealth tax anymore. This makes sense given that the 10Y Dutch government bond now yields negative 0.5%.

The less positive (for some) is the fact this measure is designed to be budget neutral. This means that investments (i.e. any non savings wealth – with some exceptions?) will have to make up for the 4.5bn (as per fd article) of lost income. Based on the scheme above, it seems like the tax would then be about 1.75% on any investments above the cutoff.

Many details are still quite unclear, e.g. rules on second homes, mortgage/debt deduction, exact rates, exact calculation (e.g. as of when is the asset split evaluated). Nevertheless, this is a major overhaul and I believe the fact that 1.75% would be shaved off the risk premium on risky investments relative to savings accounts might have some major implications on both individuals and major institutions which I will discuss in another post.

Books: Capital Returns by Edward Chancellor

As I find regular recommendations algorithms not so useful when it comes to good books about investing or economics, I will try to share books I read and find good. I will keep the reviews short but hopefully you will also conclude that the books mentioned here are not a waste of time.

I found “Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15” by coincidence before my last holiday. The main message is pretty simple, besides the usual focus on business models and value, you should also be aware of the cycle and act accordingly and you might have to take a very long view to get your returns. What I really enjoyed is how practical the book is: they share in detail thinking on particular companies, industries but also what indicators they were looking at to try to understand what’s the current sentiment in the market and if it’s a good time to be defensive or take more risk. Moreover, it’s refreshing to read a book with individual examples of stocks listed in Europe in contrast to the usual US centered view of the investment community.

At 211 pages the book is short with very strong message making it, in my opinion, great value for the time you have to spend reading it.

EU listed ETFs and how to find them

As assets managed by US based Exchange Traded Funds (ETFs) hit $4tn, it’s fair to say that passive investing has become mainstream due to fairly acceptable reasons:

  • easy to access
  • low fees
  • similar returns to actively managed portfolios (at least in equities)

Now the third point might be up for a discussion from both directions – some would say they beat most active portfolios, some might point out that maybe the past 10 years won’t be a good indication of the upcoming 10 years – but more about that maybe another time.

Since most investment advice/books tend to be tailored to US investor, it might come as a surprise for EU based investors that ETFs might not be so easy to access or cheap at all. Since 2018 European investors are cut off from most US listed ETFs due to European regulation. As a result, EU investors are mainly left with UCITS compliant ETFs and, confusingly, many of the often used tickers are exactly the ETFs that can’t be accessed.

Instead, you can use the Morningstar screening tool to find UCITS compliant ETFs or, since iShares is by far the dominant provider in Europe (see this article) you can as well go directly to the iShares website which is at the moment a bit faster to use.

So what’s the catch?

If there are so many EU compliant ETFs available anyway, what’s the the problem? Well, except for possible small difference in fees (higher for the European option), lower liquidity in those ETFs might mean that if you’re not careful, you might end up trading far more expensive than expected. So while EWZ US is a well known large ETF with 8bn AUM that gives investors exposure to Brazilian equities, IBZL, the European equivalent, has only $400m in assets and here execution can definitely become an issue, especially in case of overtrading.

I will definitely write a bit more on the topic of choosing ETFs and why staying mainstream is perhaps the best thing to do if you choose passive investing. Let me know what you think about the topic in the comments below or if you have any particular questions!

Why you need to watch American Factory

American Factory is a documentary published on Netflix about a week ago. There are many reasons that helped its success, being produced by Obamas helps. However, what you take from it is absolutely up to you, be it the difficult reality of workers in Ohio or what I’d say many people in the developed world are used to in contrast with tough working conditions in China (The Economist).

I think it rarely happens that one documentary covers many questions that have been keeping investors busy this year. My take is:

  • it’s fairly eye opening to get first hand look into the lives of people in the Rust Belt and why their political choices can make a lot of sense
  • many people are not ready for the world where we need to interact far more across cultures
  • if Chinese see Americans as living overly comfortable lives, it makes me wonder what would they think about Europe
  • Private Chinese companies are a force to be reckoned with going forward
  • it probably matters a lot whether standards converge by Chinese workers’ requirements increasing or western standards getting pushed lower as that probably wouldn’t be an option in many places. Having said that, Chinese workers are increasingly pushing for better treatment so the upward trend is already a reality.
  • Automation might mean that the previous point doesn’t necessarily have an obvious happy ending for workers anywhere
  • and obviously many thoughts on trade war and China – America (in)dependence. When even Chinese businesses producing in the US are under pressure (e.g. CRRC), what’s the point and what’s the end game?

As a side note, Fuyao Glass, the company featured in the movie, has Hong Kong listing under ticker 3606 HK. If you’re afraid (as I am) of buying bombed out Chinese car makers as there might be no winner eventually due to competition, knowing that Fuyao dominates the Chinese market for automotive glass might allow you to sleep better although it also didn’t drop as much as other sectors.

If you have any view on Fuyao stock or want to share what you took from the documentary, please do so in the comments below!

Update: there’s a nice article on SCMP about Fuyao. Obviously the auto sector slow down is an issue but it’s completely different competitive environment in glass.