A fabulously articulate and doubtless physically attractive Monevator reader (yes, I’m a fan of all our readers!) emailed to ask why invest in bonds, given the superior returns from shares.
He spoke thus:
It’s financial orthodoxy that bonds should form part of everyone’s portfolio. Equations abound, such as “hold a percentage of equities equal to 100 minus your age”.
I do understand that bonds are crucial for people forced to live off income, such as retirees.
However the other reason frequently given for holding bonds is to ‘reduce volatility’.
I’ve always failed to understand the logic of this argument. As long as you have a long investment horizon, then volatility should not affect your investment. Prices rise and fall, and the value of portfolios do likewise.
As long as there is no need to sell, however, then it makes no difference.
Given that equities have historically outperformed bonds, I wonder why anyone in their 20s or 30s would hold any bonds whatsoever?
Or am I missing something?
This blog has the smartest readers. You guys ask all the right questions.
I can’t reply in detail to the many emails we get each week – and I can’t give personal advice at all – but it’s always great to hear from you. As also shown in your comments on the site, you’re an above averagely clever cohort. (Heck, we even know what “cohort” means around here. Go us!)
Onto this query, which I’ve heard quite a lot recently, especially with the rise of Vanguard’s automatically rebalancing LifeStrategy equity/bond funds.
I should first say that asking me why invest in bonds is a bit like asking Worzel Gummidge why shower. I’m skeptical about corporate bonds, and while I do think government bonds have a role to play for most people, I usually hold none myself.
I do understand though why nearly all model portfolios include a slug of government bonds. So hopefully I can give a rounded answer without spouting too much ‘financial orthodoxy’, as our reader puts it.
Below are seven reasons why bonds – UK government bonds – might earn a place in a portfolio, despite the superior prospects of a 100% equity portfolio.
Note that I’m not debating here whether bonds look good or bad value right now. We’ve covered that elsewhere. (Executive summary: They look expensive to me).
Government bonds are the safest asset class after cash
Ignore the ranting of the lunatic fringe 1 – for the UK investor, UK government bonds (aka gilts) are the closest thing to a risk-free asset class, after cash.
Safe here means “return of capital” not “return on capital”.
Since 1950, UK bonds have delivered an after-inflation return of 2%, versus about 7% for UK equities. 2 2% is not a huge margin of safety. If inflation is higher than expected, the real return from bonds could be closer to zero, or even negative.
But no investment is entirely risk free, and inflation aside, gilts are safe.
There is a near-zero chance of the UK not honoring its bond commitments, because it can print the money to do so. When you buy gilts, therefore, you can be extremely confident of the return you’ll get from the interest paid plus the return of capital. That’s attractive compared to the uncertainty of every other asset class.
You can even sidestep the inflation risk if you buy index-linked government bonds or TIPS in the US. (Like other government bonds, they’re currently priced for very little return though).
Volatility can be scarier than you think
Most people believe they can cope with volatility. However when confronted with their net worth plunging 5% in a day, 20% in a month, or 50% in a decade, they often change their tune.
The speed with which a bear market can slash the value of shares is proof positive that many investors panic when times turn tough – because their dumping of shares is exactly what drives the prices down.
Government bonds tend to go up – or at least better hold their value – when share prices fall. They also pay an income. Both factors curb the decline in your portfolio’s value when shares plunge. This silver lining can make stock market falls less terrifying. There’s nothing irrational about wanting some security.
By all means steel yourself to ride out volatility. That’s what I do. It’s easier if you’re young, and much easier if you’ve got substantial new money coming in from savings.
But you won’t know for sure how you’ll cope with extreme market falls until you’ve lived through them. Even after that, you might react differently at 60 when most of your lifetime savings are at risk, compared to how you did at 30.
Most people are much more risk-averse than they think. Why be a hero?
Diversification with a slug of bonds is cheap and effective
If shares do better than bonds – and they always have in the UK market over two decades or more – then a 100% equity portfolio will beat the returns of a portfolio that includes bonds alongside shares.
However adding in even a small allocation of bonds can reduce the maximum losses you’ll suffer in a bad year without significantly decreasing your overall return.
Without getting bogged down in financial theory, it’s all about the ‘efficient frontier’, which is the point where diversification is actually reducing risk while maintaining returns.
The following graph shows how portfolio theory suggests risk (volatility) and return will change as you shift your allocation between equities and bonds.
Of course, you can’t eat theory. What about real world results?
Well, you can use different time periods to make pretty much any point in investing. However this example data covering a 20-year period in the US markets between 1988 and 2008 is pretty typical:
- A 100% US equity portfolio returned on average 11.59% a year over the 20 years. The worst year saw a decline of 20.25%.
- A portfolio with a 55% allocation to bonds and the rest in shares returned on average 9.95% a year. It fell a mere 3.35% in the worst year.
Many people would have lost sleep and hair enduring the 20% decline in the all-equity portfolio, even if they managed to stay invested.
In contrast, I think even the flightiest saver could stomach the minus 3% worst-case year of the bond heavy portfolio.
Yet despite the massive allocation of bonds required to produce that low downside risk, the ultimate price paid – the reduction in return – was less than 2% per year. Painful when compounded for sure, but not fatal.
Now, get pinching your salt. This particular 20-year period saw a boom for bonds. Their returns were unusually high, due to a collapse in yields that cannot be repeated.
But we only know this from hindsight. Also, if your shares do much better than bonds in the future, then you probably won’t care too much, as long as you’re not too bond heavy. Even the worst case for bonds – a full-on bond market crash – will likely be milder than a stock market crash.
For the avoidance of doubt, I’m not advocating a 55% allocation to bonds. This is just example data; personally I’d lean to less is more. Check out these model passive portfolios for some expert ideas on asset allocation.
But remember, sensible investing is not about aiming for the maximum return that’s possible over the period you happen to be invested. That’s the siren call of City promoters. It’s the thinking that got people loading up on tech shares in 1999, and giving up in the depths of 2008.
Your aim when investing is to devise a strategy that works for you, and that you can stick with.
Lower than maximum returns is a price worth paying if it keeps you happily investing for your lifetime.
The outperformance of shares in the past may not continue
This brings us to returns, and the implicit assumption that shares will always do much better than bonds over the long-term.
In the UK and US that’s been true. But a look at the long-term returns from other stock markets around the world shows the degree of outperformance of shares over bonds has varied, even over the extremely long-term.
Over the short to medium term, anything can happen.
Japanese investors in the Tokyo stock market – who are still down 75% from the Nikkei’s peak of the late 1980s – might offer an especially salty rebuttal to anyone urging an all-equity portfolio.
There are strong theoretical reasons why shares should do better than bonds (it’s all about risk and reward). And I’m literally betting my own asset allocation on it, with bonds seeming to me to be at the end of a bull market and the returns of the past three decades mathematically unrepeatable from here.
But there are no guarantees.
A holding of bonds enables you to rebalance effectively
We know from Warren Buffett that we should “be greedy when others are fearful” when faced with bombed-out stock markets.
But where are you meant to get the cash to go on a buying spree?
Buffett himself urges investors to stay invested in great companies through thick and thin.
Sage advice no doubt, but if you’re 100% invested in shares when the market crashes, you’ll have to limit your being greedy to going to pizza joints in the City to scoff at worried bankers.
In contrast, if you’ve got a slug of bonds you can sell them down to stock up on cheap shares, either haphazardly or through a more formal rebalancing strategy.
As you age, you’ve less time to recover from crashes
Like many things, the answer to our reader’s query is in his question. He says we’re assuming a long-term horizon, but the fact is not everyone has that – and none of us have an infinite one.
As mentioned, the Japanese market peaked in 1989. Even the FTSE 100’s peak was 13 long years ago. If you were 60 in 1999 and you were 100% invested in shares, you took a big gamble.
Focusing on income can offset some of the risk of volatile share prices. Dividends are much less variable, and the UK’s best income investment trusts have not cut their payouts in the bad times, while handily beating inflation over the long-term. A high yield portfolio might deliver something similar for a DIY stock picker.
Reinvesting dividends while you’re saving improves the picture, too.
But I still believe that a 100% equity portfolio is a young man or woman’s game, given how long a crash could endure. As we age, we should take less risk when investing, not because our heart can’t take it but because our time horizon can’t.
(Our questioner acknowledges this. Again, the answer is in the question!)
Finally, I never want to be a forced seller of shares
In the US, where dividend yields are lower, it’s normal to plan to run down a share portfolio by selling some proportion each year to create an income.
Indeed, the various studies you’ll see on the 4% withdrawal rule are based on this. So it’s not true that even a pensioner needs an income from bonds – theoretically they could sell their shares for spending money instead.
However I’d hope to live off the income from my portfolio in retirement, rather than actively selling – again because capital values are far more volatile than dividends.
The last thing I’d want to be doing if I was 75-years old would be to flog my marked-down equities in a bear market just to pay the heating bill / Majestic Wine tab / chorus girls.
I fully expect that at 75 I’ll have a slug of bonds as part of a diversified income portfolio. This should give me a good shot at living off my investment income, without having to touch my capital unless I choose to.
The bottom line on investing in bonds
While holding some percentage of bonds relative to your age might be a good rule of thumb, there’s no law that says you have to.
Also, I think private investors (as opposed to institutions) can often substitute cash in high interest deposit accounts for at least some of our bond holdings. While cash and bonds are not the same, cash will do a similar job in cushioning your portfolio. (Given where bonds are currently, this is the approach I’m taking).
I think a 100% equity portfolio can make sense for some, especially when you’re young or your portfolio is relatively small compared to your other assets or your potential lifetime savings.
But bonds are an important asset class, and they’re not to be lightly dismissed in pursuit of an extra percent or two of annual return.
The times when a decent allocation of bonds (or cash) will prove its worth are the dark times when you could be very glad you kept them in the mix.
Good reads from around the Web.
Regular readers will know I’ve long warned people not to get scared out of equities over the past few years.
With the emblematic US Dow Index touching the “psychologically important” (i.e. headline spouting) 14,000 level on Friday, I can’t help remembering some of my own articles:
- Why I buy in bear markets (January 2008)
- Who isn’t buying the market right now? (March 2009)
- Why shares could be set for a decade of 20% returns (May 2009)
- Steep yield curve means equities could fly (December 2009)
- Greeks gift us a buying opportunity (May 2010)
- Five things to remember after the market’s latest fall (September 2011)
- Reasons to be optimistic about stock market returns (November 2012)
Today everyone claims to have predicted the rally, despite the fact that tens of thousands of hours of interviews on CNBC and Bloomberg say otherwise.
Indeed I wish I had some sort of comparison machine to prove how unusual my take was compared to the prevailing comment of the era.
So am I a market timing guru?
Hardly.
I don’t expect anyone to go back and read those articles, but if you do you’ll discover I didn’t predict that shares would be at five-year highs by February 2013.
My point was for most of the past 3-4 years, shares have looked like fine investments for the long term. So if that was your investment horizon – and for most of us it should be – then it was time to be a buyer.
All you can do is balance the risks and rewards on offer.
You’re on your own
Another point I’ve tried to get across is that commentators have continually made bold and gloomy predictions over the past few years not because of any certain insight, but because of a combination of recency bias (i.e. fighting the last war) and because, in the case of the media, bad news sells.
If I’d been spouting terrible warnings about imminent European meltdown, gold heading to $5,000, and rampant financial chicanery, this blog would have a lot more readers – and it would be much more useless to you.
So I won’t blow my own trumpet any more. Firstly, because my joints aren’t as flexible as they were (guffaw!) and secondly because Ermine over at Simple Living in Suffolk has done a too-generous job for me this week. (I’m incredibly flattered and also chuffed to think Monevator has made a difference).
More to the point, this blog is about you taking control of your finances and making your own mind up – not blindly listening to anyone.
Some of the risks of the past few years were very real, and the markets could now be at half the level where they stand. Equally, they could begin to slide tomorrow. Nobody knows, and it’s up to you to judge whether they look good value when it comes to meeting your own needs.
You’re accountable to nobody else – and nobody cares as much as you do.
Memento mori
Finally, I’m also in the fortunate position of knowing how utterly wrong I can be.
Like the servant employed to follow the all-conquering Roman general and whisper “Memento Mori” into his ear to remind him he was mortal, I have the London property market to remind me daily of my own buffoonery.
Again, long suffering readers will remember that I am short one house in London. I have been renting since 2004 expecting a property crash.
How wrong can you be?
Very. From the FT today (search result, the article is listed at the top):
Houses in London’s 10 most expensive boroughs are now worth as much as the property markets of Wales, Scotland and Northern Ireland combined, underlining the extent of Britain’s growing wealth divide.
Update: There are some concerns about the reliability or our reading of the data source we’ve used to compile this feature, which it’s being suggested does not always take account of dividends in its returns. We have modified this copy to reflect this, and will investigate further.
Despite claims that the Total Expense Ratio (TER) 1 is the best predictor of returns from passive index funds, it often only does half a job when pinpointing the real costs of a tracker.
Just as nature selects for big brains, sharp teeth, and the ability to waggle your dangly bits in an amusing fashion, smart passive investors look for low tracking error as a highly desirable trait when choosing the fittest index funds in the investment jungle.
But reliable tracking error data is devilishly hard to find. And summoning the will to trawl the internet can be harder still for investors of the couch potato kind.
Help is at hand
Never fear, the alarm has been sounded. Monevator’s sleeper agents have once again been activated and prodded into action to fill the yawning gaps on the ‘to do’ lists of Britain’s passive investors.
Our plan this time is to host a regular performance review of the main FTSE All Share trackers versus their index.
Hopefully this survey will:
- Highlight that TER or the Ongoing Charge Figure (OCF) isn’t automatically the best guide to your fund’s peer group performance.
- Expose shoddy tracker construction – we want to find out which funds are more costly than they look.
- Demonstrate how you can build up a better picture of the available index trackers with just a little extra effort.
Tracking error comparison table
The following table shows the returns from a variety of All Share index tracker funds, plus the index itself, marked in blue.
I’ve ranked the entries by order of their 3-year returns. Funds placed higher than the All Share index returned slightly more than it over three years. Funds placed below it lagged the returns from the index over that period.
| Fund name | 1 yr | 3 yr | 5 yr | 10 yr | OCF |
| DFA UK Core Equity | 17.7% | 10.9% | 5.5% | – | 0.36% |
| Edinburgh UK Tracker Trust | 17.2% | 10.8% | 5.8% | 9.5% | 0.30% |
| FTSE All Share index | 15.9% | 10.7% | 5.8% | 10.3% | – |
| Vanguard FTSE UK Equity Index | 15.2% | 10.4% | – | – | 0.15% 2 |
| Royal London FTSE 350 Tracker | 14.8% | 9.8% | 5.3% | – | 0.12% 3 |
| HSBC FTSE All Share Index Ret | 15.3% | 9.8% | 5.0% | – | 0.28% |
| F&C FTSE All Share Tracker 1 | 15.2% | 9.7% | 5.1% | – | 0.43% |
| M&G Index Tracker A | 15.4% | 9.6% | 5.0% | 9.7% | 0.46% |
| Virgin UK Index Tracking | 14.5% | 9.6% | 4.9% | 9.4% | 1.00% |
| Henderson UK Index A | 15.0% | 9.5% | 4.9% | 9.4% | 0.70% |
| Fidelity Moneybuilder UK Index | 14.9% | 9.5% | 4.8% | 9.5% | 0.30% |
| L&G UK Index Ret | 14.9% | 9.3% | 4.9% | 9.5% | 0.56% |
| db X-trackers FTSE All Share ETF (See note) | 11.7% | 9.0% | 4.7% | – | 0.40% |
Note: The db X-trackers data may not be representative — we’re investigating. Annualised performance figures
The tracking error calculation is simple. Just subtract the fund’s performance figure from the return of the index. (Some call this tracking difference).
For example, the tracking error figure for the M&G Index Tracker A fund over one year is:
Tracking error = (15.9-15.4) = 0.5%
The science bit
There are a few technicalities to note if you want a fully rounded picture of what I’m doing to get my table. (This section is eminently skippable if you just want to get straight to the point).
- The performance figures shown are annualised returns. They are brought to you by Trustnet’s excellent charting tool, which also shows discrete annual returns and cumulative returns.
- The OCF is the explicit cost of owning the fund now. The tracking error reveals the total cost including hidden charges such as turnover, taxes, and index replication deviancy.
- The OCF will have been higher for many funds in previous years.
- All funds are index trackers with the exception of the Dimensional Fund Advisors’ (DFA) UK Core Equity. It is formulated according to Fama and French’s special preparation H and is designed for passive investors.
- Most of the funds are accumulation flavour index funds with the exception of the db X-tracker ETF, and the Edinburgh investment trust tracker.
- All funds track the FTSE All Share index with the exception of the DFA fund and Royal London FTSE 350 tracker. There is a Royal London FTSE All Share fund, but Trustnet’s charting tool refused to recognise it. The 350 fund is very similar.
- Certain funds were excluded because they haven’t collected at least three years of data, namely: the BlackRock CIF UK Equity Tracker, new clean class funds, the SPDR FTSE UK All Share ETF, and SWIP Foundation Growth B.
- Chart options chosen: income reinvested and offer-to-bid. If you take advantage of Trustnet’s tool, beware the quirk: every time I added a fund, the numbers for the index went loopy. Just change your radio button selection to fix it e.g. % return to £ return and back again.
Analysis
The most important point this table makes is that time is a great leveller. The chart-topping DFA fund shoots the lights out over one year, but over five it’s settling back into the pack. Which is especially important to know as you have to pay expensive advisor fees to access DFA funds.
The same goes for the Edinburgh Tracker Trust that’s in a photo-finish with the index over five years but is deeply average over ten. If this fund was on my hotlist then my next step would be to find out whether its TER had been slashed, which may account for its recent rocketry, or whether there is some peculiarity in its index replication recipe.
On the face of it the stark underperformer amongst this lot is the db-X tracker ETF, though its OCF is reasonably competitive. (Update: This may be due to inaccurate or misread source data. We’re looking into this).
The Virgin tracker looks nowhere near as bad as its market-lagging OCF would suggest. Fidelity has a headline grabbing 0.3% charge but has somehow conspired to underperform Virgin’s 1% fund over the last three years.
Over ten years the best-performing fund we have data for is the M&G Index Tracker. Although, in the last three years it’s fallen behind the HSBC fund which aggressively cut its price in 2009 to combat Vanguard.
Intriguingly, Vanguard is flattered by a tracking error comparison because it charges a 0.5% initial fee to cover stamp duty. That means stamp duty doesn’t swell Vanguard’s tracking error whereas the other funds excrete the share-dealing tax directly via this route.
You can account for all these nuances by squaring up your favourite funds against each other using a fund cost comparison calculator. Use your tracking error figures as the annual charge to find out the real cost of the fund.
Perfect is the enemy of good
Over 10 years I wouldn’t worry about the differences between the funds in the table we have data for. The gap between top and bottom is a piffling 0.3%.
But I’d want to avoid the gulf that’s opened up between a very poorly performing fund and the top funds over five years. I’d worry that a fund that can miss its benchmark by over 4% isn’t doing its job properly, and would dig deeper into the data to try to find an explanation.
Avoiding a straggly bottom shouldn’t find its mirror in an obsession to own the top. Don’t waste time hunting down the very best fund and then lash yourself with the cat if it doesn’t ‘win’ one year.
Look for a fund that habitually hugs its index tight, has a low OCF, and check that its tracking error is reasonably low and consistent with its peer group over as many years as possible. That should do you nicely.
Take it steady,
The Accumulator
Good reads from around the Web.
When I was growing up, Margaret Thatcher and Ronald Reagan championed the power of capitalism to change the world.
There was a clear alternative back then – making tractors in some Soviet gulag wearing ill-fitting overalls while being lorded over by sanctified hypocrites who hunted bears from private lodges on the Kamchatka peninsula before stuffing their faces with Beluga caviar.
I was happy to sides with Thatcher and Reagan over a Labour party that risked taking us one step in that direction.
But by the 1990s, the communist threat had gone. Plenty of us, including me, indulged our more socialist side – both in our thinking, and at the ballot box. Dotcom moguls made money almost as a by-product of their desire to change the world, and before long even Bill Gates had pledged to give away his fortune.
Now, today, we’re shaking off the credit crisis, inequality is rising out of control, and old arguments of Left Vs Right are being reborn in new guises.
So far I’ve come down on the side of the 99%. I think extremes of wealth need curbing – especially because the threat of the Siberian tractor factory is no longer there to encourage the richest to keep everyone on side.
But I don’t think we should do that simply by taxing and redistributing more money. I think the incentives can begin to act in perverse ways, locking some of the poor in dependency and dead-end thinking.
Instead I think we should boost pre-university training, give massive tax breaks to companies for taking on young and unskilled workers, create more start-up funds for new entrepreneurs, raise the income tax personal allowance to at least £10,000, think of innovative new ways to bring childcare to single mothers who want to work, and much more.
What did a rich man ever do for you?
In the midst of this debate, it’s refreshing to watch a video like the following (via Objective Wealth) that reminds me of the ultra-Libertarian other side.
It’s not often you hear Bill Gates chastised for giving billions to charity:
The guy is clearly extreme in his views (I’m sure his moguls are comforted by their billions when society overlooks their achievements) but maybe you have to be to get a view like this across. I’ve just embedded the video, haven’t I?
So what do you think? Is it time to bring back Greed is Good?
It’s hard to stomach the thought, given what those who never surrendered money as the ultimate scorecard – the bankers – did under that flag in the last decade.
It’s easy for passive investors to get wound up by the arrival of cheaper funds. We’re all about cost management, but should we leap like a lizard every time a new fund turns up with a slimmer Ongoing Charge Figure (OCF)?
We’ve previously looked at how to calculate whether the cost savings are worth the hassle of switching funds. But an even bigger consideration is the chances of wild and dangerous Mr Market moving against us.
If you trade from one index fund to another then you’re likely to spend a significant amount of time out of the market due to the way the system works.
If you swap between two index funds that track the same index, this delay means:
- You will lose if the market – and so your new fund – rises in value between trades. The money you raised from selling your old fund will buy fewer units in the new fund.
- You will gain if the market – and so your old fund’s price – drops after you sell. Now the money you cashed out of your old fund buys more of the new fund’s cheaper units.
How long will you be out the market?
This depends on your chosen platform. Here’s TD Direct’s turnaround schedule:
- Submit your sell order in time to meet the fund’s valuation point that day. That’s anytime from 9.30am – 12pm, depending on your fund provider. Your old fund is flogged and you will receive cash in line with that day’s valuation.
- Orders that come in too late will be executed the following day.
- Now we’re in business, no? No. It takes up to four days for the fund to settle. In other words, it’ll be four days before the money goes all the way down the chain from the buyer to you. If you sold on Monday, it’s now Friday.
- Submit your buy order. If you missed the Friday morning deadline then your trade won’t go through until Monday. You’re out of the market for a week. Empires have fallen in less time.
Happily the dance doesn’t have to take that long. If you ring up TD Direct on the second day after the sale, it can tell you how much you raked in and will buy the next fund. Move quickly and you could get your buy order off that day. Your time out the market is reduced to two days.
Check with your broker for its own timetable.
Worst case scenario
Popping champagne corks at City trading desks are a fearful sign for us when we’re switching funds. A good day for the markets is a bad day for us if we’re not in the game.
The FTSE 100’s best day ever was a 9.84% rise on 24 November 2008. The second best day saw an 8.84% boost. I’ll use these movements to model our worst case two-day scenario: where the first rise was followed by the second. In reality that didn’t happen and no fund-hopping passive investor will have had a comeuppance quite this bad. Yet.
You can simulate these movements well enough by using Candid Money’s investment charges impact calculator to work out the effect of asymmetrical costs on each fund.
We’ll take a look at the impact of such an adverse market movement using the Salami Slicer example from our previous fund switching post. In this instance, our new fund is only a sliver cheaper than the old – it’s OCF is 0.2% versus 0.3%.
In this example, we have £1o,000 after we cashed out of the first fund. While we’re waiting for our money to go into the new fund, the market rises by that nightmare 9.84% on day one, followed by a “Why me!?” 8.84% on day two.
Our old fund would have been worth £11,954.99 1 if we’d just left well alone. Instead, we have a paltry £10,000 to put into the new fund, which has experienced the same accursed good fortune over the two days.
Still, we’ve got 20 years of cheaper OCFs to look forward to in the new fund. Let’s see what the trade-off has brought us:
Old fund OCF 0.3%
Fund worth £11,954.99
New fund OCF 0.2%
Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund value after 20 years of cost savings:
Old fund = £80,281
New fund = £75,432
You lose £4,849 or -6.04%.
The market swing against us – in just those two days – is something we never recovered from in this Doomsday scenario. That’s despite 20 years laughing it up with a slightly cheaper fund.
In contrast, an investor with all the dynamism of a cabbage ended up nearly £5,000 better off than us, because they did nothing. Our move proved to be the financial equivalent of blasting our own feet off.
So much for knowing all about the funky new funds.
Average case scenario
Okay, so far so ill-advised, but that was an extreme case. What might the markets do to us on a more average day?
To give us a rough idea 2, I’ve had a grapple with daily pricing data for the FTSE All-Share index. Thanks Yahoo Finance!
Daily prices are available from 4 January 2000 to 11 January 2013, which is long enough for our purposes.
The average daily rise in the market was 0.658% during this period. The average daily fall was -0.603% and if you average out the gains and losses then the market moves a pitiful 0.004% per day.
Back to our example. We sold our fund for £1o,000, but this time the market carried on rising without us at 0.658% per day for two days before we were able to buy back in.
So our old fund was worth £10,132 3 by the time we bought £10,000 worth of the new fund.
Old fund OCF 0.3%
Fund worth £10,132 (after two days average gain)
New fund OCF 0.2%
Fund worth £10,000 (no gain while in cash)
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £74,757
New fund = £75,432
You gain £675 or 0.9%
Well, at least we’re up. After 20 years baking our investment pie with a lower OCF, we cash out slightly ahead.
In fact, after merely 10 years we’re up £19. Sound the vuvuzelas.
Whether such a (potential) gain is worth the risk and effort depends on how devil-may-care you are, how long you invest for, the actual difference in fund costs, how much you invest, and the return you get.
It’s pretty obvious though that there’s no need to sweat small stuff like this. Especially as keeping things simple is the essence of passive investing.
Hey, wouldn’t we profit more if the market fell?
Okay, calm down Gordon Gecko. To round out the picture, you’d indeed be £1,500 up if the market took an average dive (-0.603%) on both days.
Oh, and you’d be a smidge over £1,000 up if you averaged out the daily gains and losses to creep ahead 0.004% each day.
Intriguingly there was a 51.7% chance of a rise on any given day and a 47.8% chance of a fall. The market stayed flat 0.5% of the time.
Exchange Traded Fund (ETF) scenario
The ability to trade ETFs all day long makes them less risky than index funds when it comes to a quick switcheroo. You’ll lose a bit on the bid-offer spread, you’ll pay a dealing fee to buy and sell, but you need only be out of the market for a few minutes thanks to real-time online trading.
In the example below, I assume a bid-offer spread of 0.1% between my two funds. This is the cost of having to sell shares for slightly less than they’re worth and buy for slightly more than they’re worth so that the men in the middle can make a living. Think buying and selling foreign currency when you go abroad.
Our £10,000 holding is whittled down to £9,990.02 after deducting the cost of this 0.1% spread. That becomes £9,980.02 after subtracting £2o of dealing fees (one sell and one buy order).
I’m not going to worry about any change in price between the two trades. It would amount to pennies either way in a reasonably liquid ETF, assuming we’re not in the middle of a flash crash.
Old fund OCF 0.3%
Fund worth £10,000 (value if we’d just left things alone)
New fund OCF 0.2%
Fund worth £9,970.02 (after trading cost deductions)
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £74,357
New fund = £75,340
You gain £983 or 1.32%
Well worth making the change, even considering the trading costs. (We’d only be a bit further ahead at £1,075 after 20 years if ETF trading costs were zero).
I’d definitely be more sanguine about switching liquid ETFs with tight-bid offer spreads, assuming I didn’t mind the bother and that I was trading at least £2,000 a pop. Remember ETF dealing fees can take big bites out of small trades.
Keep It Simple, Stupid
My two posts on this subject have definitely failed the KISS test.
The first post demonstrated that it’s definitely worth the trouble to switch from high-fee active funds to reasonably priced index trackers, but we knew that anyway.
The benefits of switching out of a tracker with a sub 0.5% OCF are far more debatable and taper away the less money you have, as well as exposing you to the risk of the market moving against you.
There quickly comes a point where jumping ship isn’t worth worrying about.
That said, even if two trackers seem similar in cost, it’s always worth comparing their tracking error. That’s the true measure of an index tracker’s cost and can betray some hidden truths that don’t show up in the OCF.
Take it steady,
The Accumulator
