This is a transcript of David Kuo's podcast with James Norton of Evolve.
You can listen to or download this podcast here.
David:
This is Money Talk, the weekly podcast from the Motley Fool. I'm David Kuo, and today I'm joined by James Norton of Evolve FP. Welcome, James.
James:
Hello David.
David:
Now, it's been a while since we had Evolve on MoneyTalk, but having said that, Antony Williams was recently with me for an hour on LBC.
James:
Lucky Antony.
David:
Well yes, lucky me also, I mean he can't half talk the hind legs off a donkey sometimes.
James:
Tell me about it, he's our MD.
David:
He is very good, he's got the gift of the gab. Now James, I was reading your biog recently, and you used to be a stockbroker, which meant that you enjoyed picking shares; Evolve, on the other hand, is very much into passive investing, so can you explain to the listeners what the difference is between active and passive investing?
James:
Yep, good question and a good place to start. You could really say I've seen the light, I'm come over from the dark side of active management, but to put it simply, active management is all about trying to beat the market, trying to beat the index, whatever your benchmark may be, and you can do that in a number of ways: you can try and pick individual stocks, which stockbrokers do; you can try and time markets, so that's going in and out of market sectors, in and out of cash, into equities, into commodities – whatever the instrument may be; or you can actually outsource all of that to an active fund manager, investing in a unit trust. So that's active management, passive investing is totally different, and it's admitting at the beginning that you're not going to beat the benchmark, you're just going to track it, and therefore there are two things that are important – tracking error and costs, and it's as simple as that, at its basic level.
Now, you could say that that sounds very very defeatist, you're kind of giving in before you've started the game, but actually I don't think it is – William Sharpe, who's a Nobel economics laureate, I think back in 1990, described investing and the zero sum game that it is, and to put it simply, if you take the passive investment community, assuming that they are tracking the market, their return before costs must be the market return.
David:
Correct.
James:
You then look at the active industry, now if one part of the industry has delivered the market return, the remaining part of the industry must, by definition, deliver the market return, so active and passive, before costs, deliver the market return. You then take costs off, now I don't actually know what the average cost is for an actively managed fund, but 1.5 is a reasonable figure to go for. A passive fund is probably going to cost you 0.5, could well cost you an awful lot less – the likes of Vanguard coming into the market at 0.15 for the UK, therefore simple mathematics tells you that the average passive fund has to outperform the average active fund, and the academic evidence, all the reports that come out, show that time after time after time that's what happens – the average passive fund outperforms.
David:
But you mentioned Vanguard just a few seconds ago, and now John Bogle of Vanguard, I mean he found that two-thirds of fund managers underperform the market, which means that, isn't the trick for investors to try and find those one-third that outperform the market, so that you can actually reap those much better gains?
James:
Yes, absolutely.
David:
So you are looking for the likes of a Warren Buffett – you are looking for the Anthony Bolton, aren't you, in order that you can outperform the market?
James:
That's absolutely true, however I think that the figures from John Bogle actually, I think actually it's a lot worse than that. There was very interesting research from Standard and Poor's published on, I think it was 20 April this year, and it was looking at the performance of active managers in the US in the bear market, so it was looking at performance from 2004 roughly to 2008. Now, the numbers were actually quite startling: it showed that of large cap funds, tracking the S&P 500, which is the benchmark index out in the US, 71% of funds underperformed that index. When you've got mid cap funds, the figure was, I think it was 76% of funds underperformed.
David:
Three-quarters?
James:
Three-quarters, but it gets worse – where active managers really tend to say they can outperform us in small caps, the market's less efficient, our managers have more time to meet the management of the company, in the small cap sector 86% of active managers underperformed the benchmark. Now, to me those figures are quite staggering, but it even gets worse than that!
David:
Can it really get worse than that?
James:
It can get worse than that, S&P said that those figures weren't just true for the US, they were true for international markets; they weren't just true for equity markets, but they were true for fixed income markets; and they weren't just true for this bear market, they were true for the last bear market as well. S&P don't have any bias, they're just crunching numbers, and I think numbers like that are very compelling. I'm not for a minute saying that (a) active managers are stupid, I don't think that's true for a minute; I'm not for a minute saying that no active manager can outperform, because they do, but finding those active managers in advance is very very difficult. How many individuals invested in Anthony Bolton back in 1981 or 1982?
David:
Very few, I would have thought.
James:
Whenever he launched his fund.
David:
But those who did have done very well.
James:
If they started then, had all their money with him, they've done extremely well, Anthony Bolton is extremely unusual, he's extremely unusual in that he managed a single fund for so long, fund managers move from house to house to house on a regular basis, he's also even more unusual in that his performance was so good over the long run. However, I've got to caveat it slightly, because it was not a smooth run, if you were with Anthony Bolton for the whole run. In 1989 he had outperformed the market by 8% a year for six years, on average, which is pretty exceptional. It was still a fairly modest fund then, the special situations fund, but it was gaining a lot of traction because the performance had been so good.
So if you looked at that fund back in '89, you'd think, "Yeah, I want a bit of that action", investors pile in, as you'd expect, but performance for the next three years was torrid. If you invested £10,000 with him in 1989, three years later that £10,000 would be worth £9,500 – not a disaster, until you compare it to the market, which was I think £14,300, so it was underperformance of 45% from Anthony Bolton. Now, he caught up, by 1996 he was more or less back with the peer group; '97/'98 were bad years, but then in 2000 he'd caught up with the market and overtaken again, but that was an 11-year period, where depending on when you went in you could have had a pretty tough time, with probably arguably the greatest fund manager in UK history, so it's not plain sailing at all.
David:
OK, so having done active and also passive – which one is more fun, James?
James:
I don't think investing should be about fun.
David:
No, here at the Motley Fool we try and tell people that investing is fun!
James:
Yeah, I note your card is "educate, amuse and enrich", but talking about long-term savings, investing shouldn't be fun, it's about trying to achieve financial independence, and I've got no problems with people investing a little bit of their money on the side, punting a bit – I think that's great, and active, stop picking, picking funds, is great fun, I've done it in the past, I loved it, but I don't think it should be about fun, I think investing is serious, I think most people should get their kicks elsewhere.
David:
OK, now having been a stockbroker, and now you're into passive investing – do you still get a hankering every now and again when you open up the Financial Times, and you have a look at the share price of a particular stock, and you think, "That is extraordinarily cheap", and then you feel like whipping out your wallet and going, "Right – here we go, I'm going to actually have a little punt on that, because that cannot possibly be that cheap"?
James:
I'd love to say no, but I'd be lying. As you said in the introduction, I used to pick stocks, I was an active manager, and as I've just said again, it was great fun. In my ISA I still have one individual equity holding, back from the glory days of the tech boom, and it's Trafficmaster, and I'm not proud to say, but I paid an awful lot of money for it back in 2000, I bought more a couple of years later, and more a few years later.
David:
What was it back in about 2000?
James:
Eerm, (he mumbles) £10?
David:
Did you say £10?
James:
I did say £10.
David:
And what is the current share price?
James:
I'm not sure, because I don't follow it that closely, but it's probably around 30 pence.
David:
Why do you keep it in your portfolio?
James:
It's a reminder.
David:
Of?
James:
It's a reminder that things can go badly wrong, very badly wrong. Not only can they go badly wrong, but it's a risk that most people just do not need to take.
David:
So, in terms of passive funds, what are the kinds of passive funds that you would recommend to clients?
James:
By that, do you mean the actual instruments?
David:
The various funds themselves, I mean I'm talking about bond funds, I'm talking about various types of funds that are out there – high dividend funds?
James:
So you mean the asset classes?
David:
Exactly, yeah.
James:
OK, well at Evolve, we keep it very simple really, we think a lot of financial services is about packaging, marketing and that overcomplicates things, so we think that the main asset classes are cash, equities, fixed interest, and property. Most people own a lot of property anyway, so mainly we're looking at equity funds and fixed interest funds, and the types of way that we actually access the low cost passive funds are mainly through institutional index tracking funds, which are unit trusts or OIECs; most private clients can't access those, because they simply haven't got enough money, we've got buying power, but ETFs is another great way to do it, the cost on those is generally a fraction of active funds, generally paying 0.2 for fixed interest funds, 0.4/0.5 for equity-style funds.
David:
And of course Vanguard are coming into the UK market now, so what they've actually done is put the cat amongst the pigeons there, haven't they? – because prior to that we had iShares, we had various other exchange traded funds, but Vanguard is really going to open up the market now?
James:
I think the arrival of Vanguard is great, and the UK's been waiting for it for many many years. I think EFTs are great, but if you can access a fund like Vanguard, you're paying 15 basis points for exposure to the UK FTSE All-Share.
David:
That's 0.15%.
James:
That's 0.15%, now compared to the average UK (and that's a total expense ratio), compared to the average actively managed fund, where the annual management charge is 1.5%, that's ten times cheaper. Actually, it's even better than that, because the average actively managed fund has a total expense ratio of nearly 1.65%, so it's about 11 times cheaper. So if you can access something like that, it's great – the cheapest ETF is going to be about double the cost of Vanguard, it's going to be about 0.3/0.4% for the FTSE All-Share. I do think the arrival of Vanguard's great.
David:
Are there any risks associated with passive investing? – I mean, with buying exchange traded funds? Are there any risks? – I mean, people say it's relatively risk-free because you're buying the entire market there, but are there risks?
James:
There are risks, the obvious risk is that you're getting market exposure, so buying passive funds, you take the same risk as buying an active fund – you can lose money, and that's the biggest risk, you can lose money in exactly the same way as you can with an active fund, you will do what the market does, as long as the fund is tracking the index correctly. So that's the obvious risk, but I think passive funds do get criticised sometimes, because they have an inbuilt bias towards growth companies – the way the index reconstitute themselves, their weighting towards companies which have grown rapidly, which share prices have gone up, and that in itself is, I don't think is particularly good; it is a slight weakness of index funds.
However, I think that's particularly the case because there's loads and loads of academic research which has shown that you can outperform the market generally over the long run by investing in specific sectors, so smaller companies tend to do better than the market as a whole, and value companies tend to do better than the market over the long run. Now, that's not going to be true year on year on year, and you could get differences over, small companies may underperform for ten years, but over the long run, over 30, 40, 50, 60, 70 years, value and small cap companies have done much better.
So if you're in an index which has a slight bias towards large cap growth, you are tilting away from the optimal areas of the market. Now, we can get round that, because we have access to specialist trackers which can buy smaller companies, and they can buy value stocks, but I'd say that is a slight weakness. Having said that, I think that weakness is negligible compared to the average active fund where you're paying a lot more.
David:
And what you are hoping for over the long term is to reap the long term benefits of the stock market itself, where we're actually talking about somewhere between seven and 10%, over the long term? - and as long as you buy in the dips and stuff, then you will eliminate some of that volatility?
James:
Absolutely.
David:
Now, there was a story recently, unconfirmed story, that maybe the Government might waive university fees for parents whose children do not take the student loan. Now, there will be parents out there thinking, well, if I can amass a college fund, a university fund, of around, say, £50,000, or maybe £30,000 – somewhere between £30 and £50,000 – I could actually send my child to university without having to pay any university fees. Now, if there was a parent out there, me for one, thinking, how do I accumulate a fund of that amount over ten years – how would you advise me to do it? – apart from eating just sausages and mash all the time for the next ten years?
James:
It's a good question, it comes down to how much risk those parents are prepared to take, and what their income is, and what their timescale is, so what sort of timescale are we talking about?
David:
We're talking about ten years, and maybe total household income of say £60,000, I mean if the average income is somewhere between £20 and £30 per individual, two parents working, that's £60,000.
James:
£60 is a reasonable assumption, yes.
David:
£60,000, and they want to accumulate a fund of about £40,000 in ten years' time – is that achievable?
James:
I think it is achievable; however it depends on what the market return is going to do.
David:
Sure.
James:
For someone who is very very risk-averse, who cannot stomach losses, and there are plenty of those people around, they should literally set up a savings plan, and invest that money in cash month on month on month. The people who are prepared to take a bit more risk, I think it makes sense to put some into equities, because as you said, over the long run, equities have far far far outperformed cash and gilts.
What I would do is, I would, depending on the risk of those individuals, I would probably have a core fund investing in cash, which you know is going to be there, and a certain proportion in equities, via a monthly savings scheme, probably into an ISA, because it's more tax efficient, and particularly if they've got other savings, you want as much sheltered as possible; keep on saving on that basis. But ten years sounds like a long time, it isn't really a long time though, when you look at investments, and you look what the stock market's done over the last ten years …
David:
It's done nothing.
James:
… it's done nothing, exactly.
David:
It's heartbreaking, isn't it, for those people who've been investing for the last ten years.
David:
And for those people advising clients for the last ten years, like myself. It is very very tough; over the last ten years, and I hate to say this, over the last 20 years you probably would have been better off in gilts than in equities, and that is a very very sobering statistic. You should be rewarded for taking equity risk, but that has not happened in major equity markets, the UK and the US, for the last 15 to 20 years.
David:
But here's an interesting point about these parents, who maybe saving money for their children's college fund – they can probably afford to take a little bit more risk, because what is the downside? I mean, let's say the college fund disappears, for whatever reason – the child can still go to university, but the difference is they would have to take out the student loan and pay fees, but the other side is, if the fund is sufficiently large enough, then they don't have to take out the student loan, and avoid paying fees. So for those parents, risk is probably not such a big issue, is it? – having lost the college fund, because it doesn't mean that you're going to be destitute?
James:
No, it's not the end of the world, it isn't a disaster.
David:
But when it does become the end of the world is my next example, where somebody wants to build up a retirement pot of half a million pounds, and they want to do this over the next 30 years – now, how would you advise that particular person to do it? This person wants to retire, at some stage when he's got a pot of about half a million pounds, and he says, "James – show me how I'm going to do it?".
James:
Start saving now.
David:
Right – immediately?
James:
Yeah, you need to start saving now, you need to save more than you think, and you need to do it tax efficiently, so pensions are critical and ISAs are critical, because the tax benefits on those are huge, really really huge.
David:
So ISAs or pensions? – I mean, this is another big thing, because at least with an ISA, you are in control; the pension, the Government can change the rules any time they want to, can't they?
James:
Well, they are changing rules on pensions, but they can change the rules on ISAs any time they want to as well, they're at the whim of the Government. They have actually changed the rules on ISAs, and they've actually made it better for once, in that you can, as of later this year for certain age groups, and next year for everyone, you can invest £10,200, which is the first meaningful increase we've had, but I think the important thing is to start saving aggressively now, because you get the rule of compounding coming in, so you get the growth of your investments now, plus the income they generate reinvesting, and that is very very beneficial over the long run.
What is really really important though is, as those individuals reach retirement age, actually well before retirement age, they start ratcheting down the risk of that retirement fund. Looking back at the stock market in 2000, people coming up to retirement in that period, they had portfolios that were overly aggressive, and they lost vast vast amounts of money at exactly the wrong time.
David:
So similarly now though, I mean people who were going to retire say two years ago, and decided maybe I'll just delay it for two years …
James:
Exactly.
David:
They suddenly found they had a third less in their pension pot?
James:
Exactly the same thing has happened, so I think stock markets are very largely driven by sentiment. Fundamentals underlie it, but short term movements, there's a lot of sentiment, and it's driven by fear and greed, and when things are going well, investors do not want to sell, their human nature is that they do not want to sell, they want to hold on, if things are going well, we can get more; when things are bad, rather than buying more of something that has gone down, they want to sell.
If you're walking down the market, buying some fruit and veg, and you see cherries on special offer, you're not going to think – "Ooh – those are cheap, but I'm not going to buy them today" – you'll buy more of them, but when it comes to stock market investing, clients do the exact opposite; things are down, they get scared, preservation sets in, they want to protect what they've got, so they sell holdings, and it is exactly the wrong thing to do.
David:
OK, we're almost at the end of the podcast now – can I ask you a couple of personal questions?
James:
Yes …?
David:
What are you investing in yourself now? Do you practise what you preach?
James:
I do practise what I preach, in my pension I've got exactly the same portfolio that I hold for all clients for Evolve, it's a different risk, because we have different risk weightings, I'm relatively young, so mine is quite an aggressive portfolio, but they're all in tracker funds. In my ISAs, most of it's in tracker funds, I have one or two slightly more esoteric investments and I've got my holding in Trafficmaster.
David:
What do you mean by "esoteric"?
James:
Esoteric investments – I have got an absolute return style fund.
David:
Have you – a hedge fund?
James:
No, it's not a hedge fund, I confess that I have held hedge funds in the past, but I don't hold them now. An absolute return style fund is one where hopefully, regardless of market direction, it will continue to go up.
David:
And does it do what it says on the tin?
James:
I think absolute return investing is to some degree the Holy Grail, because people want to make money, whatever the market's doing. However, I struggle to find managers who do it consistently. I think it's a fascinating concept, but it is all about market timing, and as I said at the beginning, we don't believe that people can market time consistently, so I do practise what I preach, I have low cost index trackers.
David:
That's good to hear.
James:
It's the way forward.
David:
It is good to hear somebody practising what they preach. Thank you very much for coming in today, James.
James:
You're welcome.
David:
Oh, just one final question before I finished – have we reached the bottom of the market yet?
James:
I don't know, I'm not a market timer.
David:
OK, thank you very much, James. Now, I end each podcast with a quote, and today's quote comes from a guy called Anon, Anon makes an appearance every now and again, and he said, "Prepare and prevent, don't repair and repent" – does that make sense to you?
James:
Sounds very profound.
David:
It does sound very profound for Anon, I think sometimes Anon comes up with the biggest load of rubbish.
So anyway, that was James Norton from Evolve, and this has been MoneyTalk. Now, if you have a comment about today's show, you can post it on the MoneyTalk blog, which you can find at fool.co.uk/podcast, or, if you have a suggestion for future shows, please email me at moneytalk@fool.co.uk.
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