01st Nov 2022 by George Fisk, CFP™

Find the needle or buy the haystack?


Nobel Prize-winning economist Harry Markowitz is famed for the phrase 'diversification is the only free lunch in investing'. During times of market volatility, it is important to revisit the fundamentals of a diversified investment approach. George Fisk, Wealth Manager, discusses the importance of diversification and avoiding the noise created by the mainstream media.

When it comes to the equity allocation within your portfolio, which will vary in size depending on your risk budget, there are two primary methods of buying equities – the single stock approach and the fund based approach, with the latter being divided into active and passive investing.  Active fund investing involves attempting to buy winners whilst endeavouring to avoid losers and can adopt a similar market timing strategy to some single stock approaches.

Over the last 3 years to June 30th 2022, more than 85% of large cap funds underperformed the S&P 500[1]. Over the last 10 years to the same date, this figure is even higher at 90.03%[2]. There are many reasons for this underperformance – fees account for some of this tracking error, but research from S&P Global found that 68.16% of large cap equity funds underperformed the market on a gross-of-fees basis in 2016[3]. That said, starting the performance race significantly behind the market return means the funds have to work that much harder to achieve said market return:

Source of fund costs: Investment Company Institute, Trends in the Expenses and Fees of Funds, 2017.

Other factors include active managers holding funds in cash whilst waiting to buy prospective winners, along with, perhaps most importantly, the fundamental bets fund managers take to try and achieve alpha, and the difficulty associated with choosing the right bets with a degree of consistency.  Choosing alpha contributing geographies/asset classes is hard enough to do year on year, as shown by the varying returns over the last 18 years below, and choosing correct single stocks presents even more difficulties because of their concentration risk:

Asset class returns in USD at 30th September 2022

In buying the haystack, you will never consistently achieve returns in line with the top of the above graphic, but you will also not achieve returns that are consistently at the bottom.  Diversification means that you may always be saying sorry for something, but it means never having to say the BIG sorry when stock picking goes against you.  Even popular companies present significant risk – the highly speculative Peloton stock is down some 91.16% over one year to 17th October 2022[4] and Netflix is down 61.58% over one year to the same date[5].

The difficulty associated with stock picking and active investing is largely down to the efficient market hypothesis, developed by Eugene Fama in the 1960s and often coined as a cornerstone of modern financial theory.  Ahead of his time, Fama was awarded several highly acclaimed Honours over the course of his career, with the most notable being the Nobel Prize in Economic Sciences in 2013.  With asset prices reflecting all publicly known information, it is difficult for fund managers to identify mis-pricings that could help them beat the market – one could compare it to ‘searching for a needle in a hack stack’ of over 9,000 investable companies, as measured by the MSCI All Country World Index[6] - an analogy coined by Jack Doyle; the founder of the world’s largest passive managed fund, Vanguard.

US/UK Tax considerations

Whilst we would not want the tax tail to wag the investment dog, there are some important points to note if you are a US connected person residing in the UK.  Generally, UK funds are not tax efficient for US connected people as they are categorised as Passive Foreign Investment Companies (PFICs). This means that any capital gains are punitively taxed in the US, at the highest rate of income tax (37%), with interest charges typically being applied in years that taxes have not been paid. The UK has a similar rule, where funds that do not report to HMRC have capital gains taxed at the owner’s highest rate of income tax, which can be as high as 45%. Moreover, this tax cannot be offset by losses.

As shown by the below graphic, this can have a meaningful effect on the net of taxes return for investors:

Source: Data: S&P 500 Index , US 5 Year Treasury Note.  Source: DFA Returns 2.0.

At MASECO, for US and UK taxpayers we use US Mutual Funds and Exchange Traded Funds that have obtained UK reporting status, which means that the correct taxes are paid both sides of the Atlantic.

It may be possible to beat the market with a stock picking approach.  There are several examples of how various individual companies have significantly outperformed their indices – Google has returned 436.97% vs an SPDR S&P 500 ETF Trust return of 204.22% over the last 10 years[7].  Benjamin Graham – widely known as the father of value investing, Warren Buffett’s mentor and author of ‘The Intelligent Investor’ wrote in the iconic book that one should only allocate 10% of one’s investment funds to ‘speculation’ – a category into which stock picking could fall.  Whilst there are some upsides to trying to find the needle, we believe that buying the haystack is the better risk adjusted approach for your hard earned savings.

[1] SPIVA | S&P Dow Jones Indices (spglobal.com)
[2] SPIVA | S&P Dow Jones Indices (spglobal.com)
[3] https://www.spglobal.com/spdji/en/documents/spiva/research-spiva-institutional-scorecard-how-much-do-fees-affect-the-active-versus-passive-debate-year-end-2016.pdf+
[4] Google Finance
[5] Google Finance
[6] https://www.spglobal.com/spdji/en/documents/spiva/research-spiva-institutional-scorecard-how-much-do-fees-affect-the-active-versus-passive-debate-year-end-2016.pdf+
[7] GOOGL - Performance (koyfin.com)

The Legal Stuff

The information in this article is provided for information purposes only and does not take into account the specific goals or requirements of any particular individual.

This document does not constitute and should not be construed as investment, tax, accounting, legal or any other type of advice.  The information contained herein is subject to copyright with all rights reserved.  The views expressed herein do not necessarily reflect the views of MASECO as a whole or any part thereof.  This document is intended for the recipient only. It may not be copied, forwarded or otherwise distributed, in whole or in part, to any other party.

All investments involve risk and may lose value.  The value of investments can go down depending upon market conditions and you may not get back the original amount invested.  Your capital is always at risk.  Information about potential tax benefits is based on our understanding of current tax law and practice and may be subject to change. The levels and bases of, and reliefs from, taxation is subject to change. The tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

MASECO LLP (trading as MASECO Private Wealth and MASECO Institutional) is a limited liability partnership registered in England and Wales (Companies House No. OC337650) and has its registered office at Burleigh House, 357 Strand, WC2R 0HS.  The partners are Mr J E Matthews and Mr J R D Sellon; Mr D R B Dorman, Mr H Q A Findlater, Mr T Flonaes, Ms A L Solana and Mr N B Tissot.  Telephone calls are usually recorded for your protection.

MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered in the US with the Securities and Exchange Commission as a Registered Investment Adviser.

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