Lars Kroijer joins Owain Bennallack in the Motley Fool studio to talk about “edge”, why you probably haven’t got it, and why that matters. In his former professional life, ex-hedge fund manager Lars hunted for undervalued shares across the globe and devised intricate trades in order to beat the market. But he says most investors should not do anything like that — nor pay managers to try to do so on their behalf. Instead, his new book, Investing Demystified, advocates investing cheaply and effectively through the simplest products available.
The following is an unedited transcript of this Fool podcast:
Owain Bennallack: Hello, and welcome to Money Talk, the investing podcast from The Motley Fool. I’m Owain Bennallack, and my guest today is Lars Kroijer, who is a former hedge fund manager and the author of a brand-new book, Investing Demystified. Lars also sits on the boards of various financial and non-financial firms.
Hello and welcome to Money Talk, Lars.
Lars Kroijer: Thanks for having me.
Bennallack: Now Lars, call me cynical, but when a hedge fund manager talks about “demystifying” investments, they’re often referring to 20 pages of disclaimers about their funds that a would-be client should read, perhaps with the help of a lawyer.
But in your brand-new book, you’re talking about tracker funds and government bonds. Are you ever going to be able to show your face in Mayfair again?
Kroijer: Well I was there yesterday and no-one came chasing me down the street, so …
Bennallack: Maybe they haven’t got to it. They’ve just read the introduction.
Kroijer: They haven’t read it yet.
Well, look. I think what I’m trying to do in the book, really, is to tell people about investing in a way that’s not very technical, in a way that is something that a lot of people that are not in Mayfair should be thinking about; sort of what my Mum should be doing with investing, not necessarily what the people of Mayfair should be doing with investing.
Judging by the cars they drive and the restaurants they go to, they’re doing something right — even if that means that they’re charging too much — so I don’t think that there’s an inconsistency between what I’m suggesting in this book and what a lot of the people in the various hedge funds do.
Bennallack: I read your previous book, Confessions of a Hedge Fund Manager, and I thoroughly enjoyed it. I did think as I was reading that, towards the end, it almost became a sort of “confessions of a secret fan of index funds.”
You did a really good job in that book of explaining how the high fees of hedge funds possibly were not wildly advantageous for the clients of the actual funds. It was almost — and possibly this was the way you wrote it, rather than a reality — but it almost felt like you were having maybe second thoughts, even, as a fund manager. Is that what led you to write this book, that kind of feeling?
Kroijer: It’s been a funny journey for me, personally. When I graduated university many moons ago, I was originally going to do a PhD in portfolio theory and potentially teach one there, and I ended up graduating with a ton of debt and got a job on Wall Street. One thing led to another, and there I found myself in a hedge fund, and subsequently started one.
Where I’m coming from is the fact that you have the ability to beat the market and generate great return for your investors. It doesn’t mean that everyone has it, and in fact what I’m arguing in this book is that the overwhelming majority of investors and private people don’t have that ability.
The book is there for trying to answer the question, “What should you do then?” The first part of the book is really to try to use layman’s terms to explain what does that even mean? What does it mean that you can’t beat the market — or, what I call it is to “not have edge” — and then try to tell you, help you think about what you should do then.
That doesn’t mean that edge doesn’t exist. When I ran a hedge fund I certainly thought I had edge, and I still sit on some boards of some hedge funds today and I think they’re extremely capable and have great products, and therefore I think they have edge. But it’s not something that the wider world is easily able to obtain.
Bennallack: Let me start by saying that I pretty much agree with everything in your new book. I think you’re bang on for how the everyday person should go about setting up the core of their investing strategy and, while we do champion individual stock picking here at The Motley Fool, we also really love index funds for their low costs and their kind of ironically superior returns, compared to the majority of active funds, so no argument there.
However, it is going to be a pretty dull podcast if we agree about everything so I’m going to challenge you on some of your ideas for the sake of us all learning a bit more about them — so don’t think I didn’t read your book, Lars! I did read it.
The key to your argument, as you say, is that most of us don’t have an edge when investing although, as you put it, we don’t “have edge” — which to me sounds a bit like a deodorant.
Kroijer: That’s true!
Bennallack: People have Lynx and the women come flocking.
Kroijer: Yeah. It’s funny, actually, my editor was saying you have to say you don’t have “an edge.”
Bennallack: Yeah.
Kroijer: It’s just, in my many years in finance, I never heard people say that. People would say stuff like, “Does he have edge?” or “Does she have edge?” but never “an edge.” That sounds more odd, so there you go.
Bennallack: It actually sounds odder to you.
Kroijer: Yeah. The way it’s written actually sounds odder to me than the lingo in the industry.
I was actually going to call the book The Edgeless Investor, because that’s what I really think the book is about, but the publisher disagreed and thought that has negative connotations — the idea that you’re without something — so this was our compromise.
Bennallack: I guess we have to immediately get to the point now of what you mean, then, when you say that the investor is “edgeless.” What does it mean not to have an edge?
Kroijer: What it means to not have edge is that you are without the ability to consistently out-perform the financial markets that you invest in.
One example would be that you are unable to consistently pick stocks that outperform the wider index of stocks in the market you operate in. In the U.K. that would mean that you could not put together consistently, after costs, a portfolio that does better than, say, the FTSE 350 — whatever index you’re comparing yourself to.
I argue that most of us don’t have that ability, and the book is therefore about what should you do then?
Bennallack: If I’m an investor listening to this, is that something that I should just assume, that I don’t have an edge, or is it something that I should prove to myself by doing worse than the markets for a few years?
Kroijer: Yeah, that’s a tricky one because it’s not easy to prove or disprove. You could invest in the market for several years and outperform the markets and it could have been luck. Or you could have picked just one stock and that was the one stock that went up a lot.
I think most of us are guilty of selective memories, where we tend to remember our winners and forget about our losers, but that doesn’t mean that you’re consistently able to beat the market going forward.
I think to a certain extent you have to believe the logic that you are unlikely to compete with the thousands and thousands of people that are better informed than you, or have better access to information than you do, and have a long history of doing this, and have better access to the management of the companies, or the wizards of the economy, or whatever have you, than you do.
Then say, is it realistic that even after all the costs that you’re going to incur, that you are able to outperform those people — and those people are, again, consistent. That is the market. We call “the market” this sort of …
Bennallack: Amorphous beast.
Kroijer: Yeah, this sort of thing that’s out there, but in the book I’m trying to make it very tangible and come up with a couple of examples of, who is the market? Think of the person who is selling you that stock.
Bennallack: The average person — or perhaps most people, as you say — might not have “edge” (I’m getting the hang of it), but surely highly-paid fund managers do. Why can’t I go out and find today’s Lars Kroijer, the fund manager, and pay him or her to pick winners for me?
Kroijer: That seems to be the obvious answer, and I’ll tell you why I don’t think it is. If you look at the industry in aggregate, in aggregate they divide between the passive and the active investors.
The passive investors means that you passively follow an index. It could be a FTSE tracker, it could be a broader world equity index. Active investors are people that then go and actively select stocks — select a subset of stocks — and try to out-perform the index as a result of that.
You distinguish between passive and active managers; the active managers are the kind of managers you see ads for on the high street saying, “Our U.K. small cap fund has done exceptionally well over the 10 years. Come buy this.”
Now, I think that if you are able to pick active managers that do better than the index, that is itself an incredibly valuable skill. It’s another form of edge. It’s a form of edge that people wouldn’t typically describe as edge, but it’s certainly that. A lot of people would pay you a ton of money if you were able to do that consistently.
Keep in mind, though, that if you compare passive and active investors, the active investor — the high street advertisement guys — incur a lot of costs that the passive investors don’t. They have to actively buy and sell stocks, and they incur all sorts of fees from that, that I walk through in the book, and they also charge higher fees because these are very highly-paid people that are doing the stock picking for you.
If, in aggregate, you look at all the fees and expenses they incur compared to a passive tracking fund, which is very, very cheap, there’s every likelihood that over time the active manager will not out-perform the index … in fact will, on average — and there’s lots of studies supporting this — on average that active manager will under-perform the index by the fees, which kind of makes sense.
They’re not picking worse stocks. They’re just picking, on average, the stocks that the index consists of and as a result, in aggregate, they’re going to perform worse by the extra fees and expenses they incur.
Bennallack: OK, that’s fair enough, Lars. I have one more shot of my argument against this, and that is that in the book, as you’ve just done again, you suggest we imagine a sort of wizard portfolio manager and all her experience, her contacts, meetings, analysts’ reports, so on; all of that potentially combines to give her an edge and, compared to me on my laptop in my living room, possibly in my underpants if it’s in the afternoon …
Kroijer: You don’t even have to wear those.
Bennallack: Well, you might get some sort of unpleasant burns. You’ve painted a good picture there. I should be fearful.
But I would say, what about the flip side? She is drowning in information, whereas I could look for key things. She’ll be compared to her peers. She’ll be compared to the index certainly quarterly, maybe monthly — maybe, internally, every single day — whereas I can choose to be a long-term investor. I can ignore volatility if I want to.
She has career risk. She does nothing for six months, she says, “This is my portfolio. I’m not going to touch it,” they’re going to go, “Well, why are we paying her half a million a year?” so she’s going to buy and sell a little bit.
Finally, if she is being advertised on the high street as a U.K. small cap fund manager and they have a roaring success for a couple of years, she may well be starting to think, “Well, these are starting to look a bit over-valued.”
I understand this is almost the point, but she might for some reason feel that it’s not a good time to invest in small cap shares, her hands are completely tied. She can’t even go to cash. Enough disadvantages that she has, something that I as a private investor could maybe find my edge.
Kroijer: Yeah, look. It’s entirely possible that someone who is small and nimble has an advantage over someone who is throwing around billions of pounds of other people’s money. Of course that’s possible.
I would question the premise that you are better able to see trends or to analyse companies than she is, because there’s no reason that a person like that — if they’ve generated better returns — she could sit in her underpants and generate better returns for her investors.
I think if you want to take luck out of this, and obviously a big part of this is to eliminate luck, well you want this edge to manifest itself with the best information available and you are at a huge information disadvantage to her. Part of being a skilful investor in her case would be to create the distance, if that was somehow advantageous.
I don’t really buy it. I’m not saying it’s not possible. Anything’s possible, and it’s hard to prove or disprove anything in what is essentially the generalised statement that I’m asking you to question your edge, or her edge, so I don’t buy it, in a word.
Bennallack: I’m going to crack on because you’re breaking my heart here, Lars. For the sake of the podcast I’m going to say I don’t have edge.
As someone who doesn’t have edge and doesn’t know how to pick people who do, how would I go about creating what you call in the book the “rational portfolio?”
Kroijer: The reason I call it the “rational portfolio” is because it’s a portfolio that is rational, based on the premise that you don’t have edge, to just make that clear.
A fair question would be, “If you don’t have edge, or the ability to outperform the markets, why should you even invest?” I think maybe you can turn that on its head a little bit and say, “What else are you going to do with your hard-earned money?” You’re going to put it into the mattress or dig it into the garden.
I’m suggesting that you can create a very, very powerful portfolio, extremely simply. If you don’t want to take any risk you can invest in government bonds, or a series of various government bonds if you don’t believe that the one government bond that’s in your currency is low-risk, and you can combine that portfolio of government bonds with as broad and as cheap a portfolio of equities as you can find.
The broadest — and quite possibly the cheapest — portfolio of equities you can find is the world equity index. What you get in that is you buy one security. You can buy it through an exchange-traded fund or an index tracker, although there’s some evidence to suggest exchange-traded funds are a better bet.
Then you get maximum diversification through one security, so literally you go and you buy one security and that represents an index of many, many underlying equity securities from all over the world. That can be your entire equity exposure.
In their case they’ve been trying to find an optimal equity portfolio, and lots of people selling snake oil have told you that they can create that for you. What I’m saying here is you’re essentially buying the whole market.
Bennallack: The reason that you’re saying that is because you’re saying, effectively, all the millions of decisions that have gone into setting the prices of all those equities around the world, it’s like the ultimate efficient allocator for capital.
Kroijer: That’s right, and because you’re starting with the premise that you don’t have edge, you don’t think you can reallocate capital between those stocks in a way that gives you a better risk/return profile. Buying the whole thing — it’s very important, actually, to be clear what you can get out of that.
You’re buying the whole equity market. Let’s call it the whole world. You’re buying the world, and you are therefore trying to capture the long-term equity returns. That’s not low risk. We all know that the risk of the equity market is potentially massive, even if the world seems a safer place now than it was five years ago.
There are no guarantees what that generates you, but because you’re buying the whole thing, in proportions to the values that the market has set, you can do so extremely cheaply. You’re not asking anyone to be particularly clever. You’re not asking anyone to go through a lot of research reports and then travel the world on first class to see a lot of companies, or you’re not paying anyone a lot. That alone will, over time, do you very, very well.
Now there’s theory to suggest that it is, ignoring the costs, the best portfolio you can create, and I firmly believe that now. But even ignoring that, you’re ahead just on the fees.
Bennallack: We’ll get a bit more deep into equities in a moment, but I just want to rewind slightly to government bonds. You mentioned that, obviously the events of the last few years, at least in theory if not in practice — because none of these government bonds have actually defaulted — there’s been a lot written about it, but people do feel a bit more nervous about calling them “risk free” these days.
It struck me that, as a private investor, not an institution, can I not replace that bond element with cash, where I might be getting 2% on a savings account? Does cash have substantially different qualities?
Kroijer: It’s a very interesting question. Let me start by saying there’s a good reason I refuse to call them “risk free.”
Bennallack: Minimal risk.
Kroijer: I call them “minimal risk.” It’s interesting. All financial theory that I’ve seen or that I grew up with talked about the “riskless asset” or the “risk free asset.” It almost sounds like an oxymoron in the world today.
Even, they were referring to governments that have defaulted many times, sometimes. That’s crazy talk. That’s why I call it the “minimal risk asset.”
Let me ask you. You say, “I want cash.”
I say, “Well, where does that cash actually sit?” It sits in your bank, presumably — or you could have it at home, but I would strongly encourage you not to do that. It sits in a bank on a high street somewhere. Most countries in the world have a deposit insurance, where the government guarantees your deposits in that bank, up to a certain amount.
Therefore you are essentially taking, indirectly, two credit risks. You’re taking the credit risk with the bank, that that bank defaults and you’re therefore relying on the deposit insurance of the government That’s only up to a certain amount, so if you have cash sitting in the bank earning the 2%, above that you’re an unsecured creditor to a bank.
Bennallack: I could spread my cash between lots of banks.
Kroijer: That’s right. You could have, depending on your wealth levels, you could have 10 different bank accounts.
Now, would you actually generate better returns having the cash in the bank than you would in the government bond? And if so, why? Why is that bank able to generate you higher interest than you would from a government bond? Presumably because they’re taking some risk in addition to the government bond.
Bennallack: Well, they might have different motivations to the government. They might feel that if they can get me in for 2% they can sell me a credit card.
Kroijer: Yeah. I would rather say, if you think about cash in the bank, the risks with that cash. Now, it’s not always a bad idea because the alternative may be a government bond that’s, itself, not riskless or terribly low-risk.
It’s less an issue in the U.K. than it is in certain other countries. If you looked in Brazil and Pakistan, you might find that your local bank is lower risk than your local government, so therefore there are slightly perverse incentives there, but generally speaking I think it’s the case that the cash in the bank is not as safe as …
People say “cash in the bank,” and they assume it’s the safest thing in the world. It may not be. In 2008, lots of banks were defaulting. Keep in mind that when banks default it’ll typically be at the same time as the local government, so domestic governments are in for an incredibly rough ride.
That means that your deposit insurance is the least valuable insurance when you need it the most.
Bennallack: How much is it, also, that government bonds might move and invest directly into equities?
Kroijer: The thing about government bonds is also, think of your time horizon. If you need the money next year, you should take one-year bonds. If you need the money in 30 years you can still buy short-term bonds, yes, but that means … let’s say you buy one-year bonds. You get your money back in one year and you have to reinvest it, so you’re continuously taking risks for the next 30 years.
You might actually be better off buying longer-term bonds because there are fewer transaction costs and, also, longer-term bonds historically gives you a higher yield, so higher interest. Now, that doesn’t mean you’re not taking any risk. Certainly you’re taking risk.
You take interest rate risk, so even if there’s no change in the risk of a default of the bond, the interest rate environment might change and as a result the value of the bond might change, but I encourage you, when you look at a bond portfolio, you look at the time horizon you expect to need the money in, and then you try to roughly match that with the government bond portfolio.
Bennallack: OK, so the idea is that you effectively have your minimal risk asset; we won’t say “risk free.” Then you add more riskier assets, essentially equities — world equities in your suggestion. That’s where you get your return from equities.
Kroijer: Yes. On a very basic level, to keep things extremely simple, you can create a portfolio of two securities. One is an index tracker of world equities. That is slightly misleading, because it’s one security, yes, but it represents thousands of underlying securities of equities all over the world, and that’s where you’re trying to get your returns from.
Then the other is you’re trying to figure out, “What is the lowest-risk asset I can find?” Let’s say that you think your domestic government — we’re in the U.K. today — so you think your U.K. government is of a high enough credit quality that you’re happy that that’s it.
Then you find a grouping of those securities in the time horizon where you roughly think you’ll need the asset. You can, again, buy an exchange-traded fund, which basically tracks those government bonds; let’s say 7-9 year or 7-10 year horizon.
That’s, again, one security that represents multiple underlying government bonds, so now you have a portfolio of two securities; one that represents the government bonds, and one that represents the equity index. You can combine those two according to the level of risk you’re seeking.
Bennallack: I think it’s key for us to say that this isn’t something that you have come up on your own.
Kroijer: Oh, no. God, no.
Bennallack: In the book you have a really excellent, simple description of portfolio theory, which is what we’re talking about, where you condense down months of those economics lectures you took, into three or four pages.
Kroijer: I do want to emphasise that point. I’m not claiming to have invented something brilliant here.
Bennallack: Is it possible to explain in two minutes, tops, portfolio theory and how — because there’s theoretically a particular point where your risk and reward is most optimised. Should people just take it on faith that that’s the case?
Kroijer: Yeah. I’d almost ask you, “Let’s think of a market.” Just for argument’s sake, we’re talking about the FTSE. Let’s say that we think that that market is optimised, so you want to buy the market. The reason you want to buy the market is because you don’t think you can reallocate capital between those stocks from what the market has done, in a way such that you will generate superior returns.
Now, portfolio theory, what it says — and no, you cannot do it in two minutes!
Bennallack: Come back next week.
Kroijer: I think we’re going to need more than a week.
What portfolio theory says is that, suppose you have a risk-free asset — so already there, there are some issues — but you have a choice of having your money invested in one asset that generates a certain return, the risk free return, and has no risk so the standard deviation is zero.
An alternative to that, you have one stock. Let’s say you have a stock with an expected return of 10 and a risk of 15% standard deviation — I’ll assume the listeners know that, but that’s probably an unfair assumption in some cases — but think of it as risk.
Now you can choose to add another stock that has a risk of 20% but a return of 12%. The question is then how much should you add of the two equity alternatives, the one with 10 and the one with 12, such that you are optimised?
Bennallack: The key is that they don’t move in the same direction always, do they?
Kroijer: The key is the correlation between the stocks, as you say. How do they move, relative to each other? Portfolio theory will make these beautiful charts that assume that risk and returns are constant, and correlations are constant, which they’re obviously not in the real world.
But the lower correlation between the stocks kind of makes sense. The less they move dependent on each other, the better it is to diversify between the two. If they move in exactly the same way, there isn’t much benefit from having two instead of just one.
To make a very, very long story very, very short, you can correctly assume, if you’re not able to beat the market, that the market allocation incorporates all those expected returns, all those expected risks, and all the correlations between the stocks into the market. That’s why you are essentially, theoretically, buying an optimised product.
Bennallack: I can see that in terms of the market for my equity money, but in terms of how much money I put into equities versus my minimal risk asset, have we not replaced the impossible task of beating the market now with the impossible task of me picking the exact proportion of equities that I should hold? Do I put 50%? 70?
Kroijer: This is where I think a book like mine stops, essentially. That is an extremely individual choice and it depends on your risk tolerances. If you have 100 pounds today, and you need 95 pounds for heart surgery 12 months from now, you would be absolutely idiotic to invest in equities, obviously. You have very low risk tolerance.
Whereas if you have 100 pounds today and you’d like to have 130 pounds in 30 years, well, you can afford the risk of nearer-term draw-downs that the equity market will probably give you. It really depends on your life and your circumstances.
Bennallack: But in your book you do give some rules of thumb.
Kroijer: I give them because I think it’s important to help people think about their personal risks. But a lot of it depends on what stage of life you’re at. The older you are, the less you should invest in equities because you’re unable to be able to handle the risk of the equity market or a huge draw-down.
There are some rules of thumb I list there then I, in the very next paragraph, outline that they are exactly that — they’re rules of thumb, so they don’t apply to everyone — but that if you’re younger you can afford more risk. In fact, I encourage people that are young to invest in equities because the long-term return on equities is highly likely to be vastly higher than a minimal risk asset.
Not only that, but I think by investing in riskier assets you get a better sense, while you’re young, of your risk tolerances. How do you handle losing money? How does it impact your life?
Bennallack: That’s really something you can’t understand until you go through it, in my experience.
Kroijer: That’s my feeling, at least.
The other thing that I touch on in the book, which I think is often overlooked in the financial world, is what about the rest of your life? Your investment portfolio is one component, but it’s not your entire life. What about your job? Where do you live? What kind of opportunities for other jobs do you have if this job doesn’t do well?
It seems to me that a lot of people take, already, a lot of concentration risk in their economic lives. In the book I bring up an example of someone who works in the real estate sector in the U.K. and they have a house or a flat in London. If they were also to invest their savings in the real estate sector in London, they might be setting themselves up for a perfect storm.
By diversifying their investments across a lot of industries and a lot of geographies, which is what the world equity index does, you’re at least mitigating that perfect local storm. I think in investing in general, you need to think of your whole economic life, instead of just your investment portfolio. That’s another point in the book, and I think one that’s often overlooked in the industry.
Bennallack: You mentioned different geographies there. We get people in this very podcast room who tell us, for instance, that emerging markets are the future. That’s where the growth is going to be.
Is there room in the rational portfolio to say, “I’m going to follow Lars’ advice up to this point, but then I’m going to put in an ETF that follows an emerging market so I have an extra 10% of that,” or is that effectively claiming edge, again?
Kroijer: It’s effectively claiming edge. I don’t disagree that there’s going to be a higher level of growth in the emerging markets than there is in the U.K. and the U.S., nor do the people that are currently shareholders of the Indian and Chinese stock exchanges. They also know that.
My argument to you would be, what do you know that they don’t? That’s already in the price. That’s already in the numbers. If you allocate more than you would if you just invested in the world equity index, you’re essentially claiming to know something that the wider world does not; namely that the emerging markets are going to out-perform the wider world.
Now some people would say, “The real reason I’m doing it is because I want more risk.”
My argument to them is, “Don’t do it that way.” Simply allocate more to equities, rather than your minimal risk asset, and achieve the higher risk levels that way.
Bennallack: Portfolio theory, you would even theoretically do it by borrowing, wouldn’t you?
Kroijer: Yeah.
Bennallack: But probably not recommended …
Kroijer: That’s right. I do bring that up as something people can do, and there are levered products that are cheap, but I would strongly encourage people to think very, very hard about applying leverage in their personal portfolio, and think back that the levers tend to work until it really, really doesn’t work, and when it doesn’t work is when you least can afford for it not to work. That’s probably when everything else in your life is going in the crapper. Your house, your job …
Bennallack: I was wondering which technical term you would reach for there.
Kroijer: I’m sure there is a technical term out there.
Bennallack: So we will just stick to world equities for the equity portion of the rational portfolio, but there are a few other assets that you don’t really talk about as having a role, some of which have got a lot of media attention the last few years.
You’re going to have the gold bugs on your back. You’re going to have commodity fund managers, property guys. You don’t think people should take explicit exposure to property. Why are you throwing all those commodities out?
Kroijer: Let me start by saying, if you invest in a broad equity index, it’s not like you don’t have commodity exposure or property exposure. I think 2/3 of commercial real estate in the U.S. — that’s the way I have the data — is owned by listed companies, so it’s not like you don’t have that exposure.
When you are buying the U.K. index you have lots of commodity businesses in there, so it’s not like you don’t have that exposure. Let’s take the example of commodities. Where I really start is to say, “Do you, over the very long-term horizon, have reason to believe that commodities are going to do better than the minimal risk asset, or than inflation?”
It’s not actually clear that these asset classes have. They are incredibly in vogue when they’ve done well over the last five years. I think the first draft of the book, gold had been flying up and up and up and up, and it seemed like heresy to not have it in there. Then it collapsed and it was no longer a question why it wasn’t in there.
Bennallack: I’ve seen graphs showing that the real price of commodities for the whole of the 20th century, the real returns were negative, because we got better at digging stuff up.
Kroijer: Yeah, that could make sense to me. I think that’s the first premise.
The next one is, which commodities? Are you really saying you can pick the commodities that do better than other commodities? Even within commodities, are you saying you can do better? I doubt it. Most people can’t.
If you buy a commodity index, that hasn’t actually done that well. Is there real reason to think that it should do well over the next 30-40 years? I’m not sure that there is, whereas you know the equities will tend to outperform the inflation rate by, call it 4-5%, or that’s what it has over the last several hundred years.
Bonds are really your store of value. You’re not expecting to make a lot of money on them. There are two asset classes, also, in the book that I think are worth looking at for people that can accept slightly more complexity. One is corporate bonds, and the other is government bonds that are not in your home country.
Again, here in the U.K. a lot of people are probably saying, “Well, I don’t think the U.K. government bond is very, very low risk.”
I say, “Well, that’s perfectly reasonable to think, particularly as it’s your store of value.” You can then combine that with other highly-rated government bonds, but keep in mind you’re taking currency risk, so if you buy German bonds because you feel that a great store of value that’s fine, but you’re now on euros.
Bennallack: Which you do with the world equities of course.
Kroijer: Which in fact you want, because you want the diversification of the multiple currencies. That’s another way of being exposed to many different places.
Bennallack: I guess some people would say, though, that you’re going to ultimately spend your money in your home currency, so is there an argument for biasing your home country for that reason?
Kroijer: I think for most people that would happen naturally, because when you ultimately spend your money is when you’re closer to retirement or when you’re closer to the lower-risk asset, which will tend to be in your home currency.
In our case it would be sterling. If we’re a German investor it would be the euro. Well, we’ll see if it’s the euro when everyone retires. You come from Denmark originally so it would be the Danish krone. The world equity is not where I’m trying to hoard my cash. It’s where I’m trying to generate the returns.
Now I want to touch a little bit on where do other riskier government bonds and corporate bonds fit in. I think they are interesting because there’s reason to think that they generate returns, and it’s a further diversifier.
You don’t strictly need them in a portfolio, and that’s why I have a chapter saying, “If you can accept the complexity of adding these, please do,” and then explain why. But it’s also worth noting that a lot of this stuff you’ve actually got to go buy the stuff. You’ve got to go implement it.
It’s very, very easy to buy these world equity indices. There are several providers of them, and they’re very cheap. They’re much cheaper than they were a decade or two decades ago, and they will be cheaper yet in the decade to come.
The same way it is with government bonds through tracker products. Some of the corporate bond products and other government bond products are less widely available, but in the book I illustrate a couple of places where those can be gotten.
Bennallack: We’re still cracking on, then, with a very simple portfolio. Really we could set it in the morning and retire, I think.
Kroijer: You couldn’t retire. You could retire from actively …
Bennallack: Absolutely. I’d be out of a job.
Kroijer: You wouldn’t be the only one out of a job.
Bennallack: Yeah, you’re going to be a wanted man, Lars.
You celebrate liquidity because the portfolio is so simple and literally at a touch of a button you could sell all the world equities and sell your government bonds. That obviously seems a very attractive trait of a portfolio and obviously in theoretical terms it is.
But is it really something that a private investor has to think about? The reason I say that is because if I could take 10-20%, if I could take lock-ups of a few months for a higher return in 20 or 30 years, that would seem rational.
As an example, one reason I think people tend to do well with property is because they go and buy a house; very hard to buy and sell, so they sit in it, they pay their mortgage, and in fact the lack of liquidity helps them.
Kroijer: Let me talk about the house a little. I’m not saying you shouldn’t own a house. I own a house. I think there are a lot of benefits, not all of which are economic, from owning a house.
But the reason I’m saying, “Think very long and hard about adding that to your portfolio,” is because you already have a lot of it. It’s very hard to make that house into cash if you really badly need it. I think it’s likely to be a geared product, because you have a mortgage on your house.
Adding to that, you’re talking a large concentration of wealth in an area where — you live there, so you probably work there — and to then further add to that concentration I’d just be very cautious.
Is there anything to suggest that there is a liquidity premium in other asset classes? Well yeah, but it’s not necessarily … you can look at something like private equity. It’s not clear to me that in the private equity industry, that you’re getting paid for that lack of liquidity.
You have your money locked up for six to eight years. First of all, most private investors are not able to invest in those funds because you need minimum investment sizes that are significant, but even if you were, your capital’s tied up for a very long time.
Not only that, but the liquidity of those investments are likely to be even less when you need it to be the most, because the liquidity depends on the private equity funds being able to sell their investments, which they’re less able to do in crap markets, which is when you need the cash.
My point is that if you add to extremely high fees that private equity funds charge you — both management fee and performance fee — and you add to that the fact that they’re illiquid, you add to that the fact that their returns are generated by investing in assets or companies that are highly tied to the economy, which means that their returns are largely dependent on the economy, which you already have exposure to through a varied equity portfolio. I don’t think it makes sense for most people.
This is not a book written for the Abu Dhabi investment authority that diversify across an extremely broad array of assets.
Bennallack: You’re losing a sale there. They were probably hovering over the Amazon button.
Kroijer: No, but any of these big endowments should either figure out and be able to explain extremely well, “Why do you have edge?” or at least in something like the equity markets, they should buy the world equity index.
I certainly think it applies to all those guys, and if they’re doing anything other, then I think they should explain to themselves at least why they’re able to beat the markets.
What I am saying with them is they’re obviously going to be able to invest in very large projects that most private people can’t invest in. Therefore their portfolio will look less liquid, and different from the portfolio of most private investors.
Bennallack: Lars, you’re making a very compelling case, and this podcast does go out to quite a lot of people. What if this is the start, and in five years everyone is a rational investor? At that point, does the market stop being efficient? Are the seeds of the destruction of the rational investor contained in Investing Demystified?
Kroijer: I’d be surprised if, in five years, the world would have gone that direction entirely. Well, OK, backing up. Depending on what statistics you believe, around 15% or so of the world equities are following a broad index tracking product and a broad index.
I think that number could triple, and you would still be way, way away from where the markets were inefficient. I think it’s a theoretical point rather than a real one.
It’s clear that if everyone was an index tracker there would be no traded stocks, and therefore the stocks would not have a fluctuating price, and therefore they would not reflect the underlying economics of the companies that they represent.
Imagine the scenario where the gold mining company hasn’t traded for 30 years and now it holds cash worth 10 times the value of the stock.
Bennallack: I’m going to go and buy it.
Kroijer: Yeah, you would go buy it, right, and that would be the beginning of a market, so obviously there is an equilibrium.
I think the point is we are miles and miles away from that. I think we could triple the amount of index tracking investment and still be miles away from it, so I don’t think it’s a real issue but clearly there’s a limit to index tracking only. Well, there’d be no market.
Bennallack: OK. One last and potentially cheeky question, Lars. You’re an ex hedge fund manager. You know all the tricks, and you mention in the book that, amongst your various activities, you’re still running your own money. You’re still flexing the old hedge fund muscles. Or are you?
Do you invest your money according to the principles you outlined in this book, or are you still looking for pairs trades where you sell kumquat plantations, buy …
Kroijer: No, all my assets are invested along the lines in this book. I own some properties. I do have some private investments that are mainly in companies that I’m involved with through board membership, but no. I believe this stuff.
Bennallack: But does that imply that you feel you’ve lost the edge you had?
Kroijer: I think beating the market is very, very hard to do half-time. I think a lot of incredibly talented people I know spend 80 hours a week trying to do it, and still fail. I think it would be presumptuous of me to say, “I can just look over the Financial Times and magically see the ability to outperform the market.” I can’t.
Bennallack: The key is you don’t need to beat the market to have a good outcome.
Kroijer: No. You would obviously rather be able to pick the best performing stock each day because you would soon be richer than Bill Gates, but you can’t. Nobody can. Most people are unable to beat the markets, and that’s why you should buy index tracking equities because over time you will do better because of fees, because you have a broadly diversified portfolio. That’s how you should be investing your money.
Bennallack: So you’re eating your own cooking.
Kroijer: Yeah. I’m not that hypocritical.
Bennallack: OK Lars, thanks. It’s really been insightful. Your book, Investing Demystified, is just out now on Amazon so people can go and buy it right now. Thanks very much for coming in.
Kroijer: Thanks for having me.
Bennallack: Hopefully we’ll have you in in a few more years with another iconoclastic …
Kroijer: I’m all out of stuff I know about.
Bennallack: I’m sure you have a hobby that you haven’t revealed yet. OK, thanks Lars.
