"Returns Come From Taking Risks, Not From Following Gurus"

MyPrivateBanking: You are the author of the „Buy-and-Hold-Bible”, a very popular investment guide in Germany. But, given the overall zero performance of stocks since 2000, many private bankers and wealth managers declare buy-and-hold dead. What is your response?

Gerd Kommer: Frankly, that statement is nonsense. It's nonsense for several reasons. First of all it confuses buy-and-hold with asset allocation – two very different things. You can practice buy-and-hold with stocks, bonds, real estate or gold. The very people making this statement you quoted are effectively trying to prove that buy-and-hold is dead by pointing out that a buy-and-hold portfolio of bonds outperformed a buy-and-hold-portfolio of stocks in the last 10 years. That's obviously a silly chain of reasoning. If these people were intellectually clear, they would have to say "Stocks are dead". That, on the other hand, they don't want to say.

Now let's look at the data. What really happened is that large cap developed market stocks have just ended an unusually bad decade while government bonds and gold had – relative to the last 100 years – an extraordinarily good decade. This again says absolutely nothing about whether or not buy-and-hold makes sense for private investors. The data only say that a decade with below average stock returns coincided with a decade of above average bond returns. Has happened many times before in the last 200 years and yet stocks continue to outperform bonds in the long run because they have to. They are riskier. And virtually all the long run data for the 20 largest economies confirm this point.

Over the last ten years a globally diversified equity portfolio, including value, small cap and emerging market stocks performed at the same level as, for example, German government bonds, that is, this stock portfolio had a positive return in the range of 4% annually. So the statement that “stocks” as an asset class had a zero return over the last 10 years is not even factually true. It’s only true if you selectively look at one sub segment of the stock market. Furthermore, what is so important about the time window of 10 years anyway? Is "10" a magic number? If you look, for example, at the last three, five, twelve or twenty years, then you will see that stocks matched or beat government bonds because for most long term periods that’s the case and for most but not all long term periods that will continue to be the case.

I think the equity fund industry came up with this nonsense about buy-and-hold being dead in the first half of 2009 when they realized that more than 90% of stock funds had just underperformed their benchmarks over the first decade of the 21st century. In a sort of marketing panic attack they looked for a new sales gimmick that allowed them to blow smoke over this disaster and hey, presto, they came up with “Buy-and-hold does not work anymore – only we, the active managers, can protect you in these high volatility, low return times” . The media immediately began parroting this baloney. Now, you could ask why the media fell for this and it is probably because they lean toward active management anyway, in whatever form and shape it comes, as that helps them to sell their own market noise and fashion-driven wares. Also bear in mind that the media rely on advertising cash from the wealth management industry which is 95% non-buy-and-hold, i.e. actively managed.

Now, let’s focus on the two really important questions: who did better over the last decade – the buy-and-holders or the active investors? And to the degree some active investors did better than buy-and-holders, did you have a more than even chance to pick these in advance? The answer to the first question is simple: The average passive, low cost buy-and-hold-portfolio outperformed the average active portfolio in all important asset classes if you do the benchmarking correctly, by which I mean like an academic which in turn means taking into consideration things that critically matter to a real world investor such as costs, taxes, risk, risk factors, fund flows, fund size, and survivorship bias in the data. Unfortunately, most benchmarking in the media don't do that and so the results they produce can be deceptive and often are. The answer to my second question: could you pick the few true outperformers in advance with more than an even chance? No, you couldn’t. I personally regret this as much as anyone because I also fantasize about consistently beating the market but science tells us that the small group of long term outperformers changes randomly from period to period. You cannot reliably predict them. You will rarely read that in the media and you will never hear it from your wealth manager.

So from every possible perspective, the “death of buy-and-hold” statement contradicts the facts. It’s a publicity stunt of the active wealth manager crowd.

MyPrivateBanking: Why then is almost every bank and every wealth manager playing the game of active investment in the form of market timing or stock picking?

Gerd Kommer: Very simply because they make five to ten times more money with active investing than with passive. So, it should not surprise anyone that today 95 percent of the industry is active in spite of the fact that basically the entire academia advocates passive, buy and hold investing – at least for retail investors. A 95 percent market share of active wealth managers translates into millions of people in the asset management and banking industry that make a good living out of betting against the market with other people’s money. A large share of these 95 percent not only doesn’t add value to their clients’ portfolios; worse, they actually destroy value because they underperform the market. In finance lingo they have negative alphas. Basically, these active managers are a dead weight on global wealth creation. I am not the first one to point out that the financial industry needs to shrink in order to become useful again across all its segments, not just in payment transactions.

Granted, we need some amount of active investment in the industry. However, the market share of the active industry that we actually have is way too large and therefore a drag on their clients’ economic well being. In the US John Bogle and others have written brilliantly about this. Long before the current crisis Paul Samuelson, a great economist and Nobel price winner, wrote: “A respect for evidence compels me to incline toward the hypothesis that most active portfolio managers should go out of business — take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate officers. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.” Samuelson was right.

MyPrivateBanking: What are the most important things a client should demand from his wealth adviser with regard to a good investment strategy?

Gerd Kommer: The following ten things come to my mind but I am not sure whether the list is conclusive.

1. First and foremost the advisor should focus on “doing no harm”, a kind of Hippocratic Oath like that of a doctor. This means the advisor should focus on avoiding big mistakes as a portfolio can rarely recover from these completely. If you bet against the market as active managers do, you are likely to violate this principle.
   

2. The advisor should be brutally honest about the risks return trade-off investing entails: no pain no gain, no free lunch. There is no such thing as a risk free investment - and certainly not government bonds or gold. Whoever claims there is a way of making a lot of money without taking a lot of risk is a charlatan. Returns come from taking risks, not from following gurus. Risk is called risk because it will materialize from time to time.
   

3. The advisor needs to make clear that historical returns over the last 12 months or 5 years of any product or asset class mean virtually nothing, other than if these returns were unusually high, you should be careful about jumping in. The only historical returns that count are those for periods of 30+ years. Shorter periods are meaningless in the best case and misleading in the worst case.
   

4. The advisor needs to illustrate to the client that costs -- hidden and visible ones -- have an incredibly huge impact on terminal value in the long run.
   

5. The advisor needs to be entirely free of conflicts of interests as to the products recommended. This is only possible for a true fee-only-advisor who gets paid by his client in cash and not through some form of - typically hidden - product commission. Complete neutrality also entails complete transparency about costs to prove this neutrality.
   

6. The advisor needs to pursue a rigorously scientific or academic approach, i.e. an approach that is not product driven but science driven – just like doctors, lawyers, architects and accountants pursue an ultimately scientific or academic approach in their practice and if they don’t they will be sacked sooner or later.
   

7. The advisor needs to pursue a holistic approach, that is, one that takes into consideration all the client’s assets including, most importantly, his "human capital" but also real estate, other family members’ assets and the like.
   

8. The advisor needs to pursue an approach that aims at making the client understand the investment process as opposed to treating him as a sheep that cannot be expected to comprehend what's going on in the advisor's magic black box. An investor who knows what’s going on will be a more successful investor in the long run, irrespective of the advisor’s specific approach.
   

9. The advisor should completely ignore fashions, fads and flavors of the day. The current flavor of the day is gold. The previous ones were hedge funds, private equity and residential property and before that there were others. A simple but effective definition of a dangerous fad is any investment product or asset class that suddenly surges in popularity.
   

10. If the advisor’s investment approach is active, which I personally believe is the wrong idea for retail investors, the manager should invest his own money alongside that of the client and the manager would have to prove this at regular intervals with audited evidence. Of course, I have never seen this happening in the real world, outside maybe a few hedge funds and there you can’t typically verify it on an ongoing basis.

MyPrivateBanking: What is your opinion on alternative investments such as hedge funds?

Gerd Kommer: Hedge funds are great – for their managers. For retail investors they are a fundamentally bad idea. Hedge funds, by the way, are not an asset class but actively managed investment products. Hedge funds as a group underperform long term government bonds once you consider all benchmarking factors that I pointed out above. In particular you need to consider all open and hidden costs including performance fees, which are extraordinarily high with hedge funds as well as survivorship bias and other data distortions that aren't fully reflected in the hedge fund data indices shown in newspapers.

A further downside of hedge funds is their illiquidity. Comparing a hedge fund that has a multiyear minimum holding period with some liquid investment like a regular investment fund or government bonds is bogus. You would have to subtract an illiquidity discount – which would be easy to compute - before you do this. On top of all of this their secrecy and black box character mean you never know what you are actually invested in and thus you cannot use a hedge fund for proper asset class diversification. Finally, even if hedge fund performance was as great as some people allow themselves to be told, you would still face the problem of having to choose a future outperformer ex ante. Using past performance to do this does not work since there is no performance consistency beyond random chance. Yes, some hedge funds will outperform in some future time window but today you cannot reliable know who they will be. The only thing we know is that they will be a minority.

MyPrivateBanking: Are there differences between index funds - not traded on an exchange - and ETFs that are important to investors?

Gerd Kommer: From a legal perspective ETFs and traditional index funds are - in those aspects that really matter to a retail investor - essentially identical which is to say they both represent “trust assets”. A potential bankruptcy of the ETF issuer or fund manager has no negative implications for the investor.

Still for a short term, trading-oriented investor there are large differences. You can trade ETFs daily or even intraday just like any liquid stock or bond. Most ETFs have fairly slim bid-ask spreads of less than 80 basis points. You can also short ETFs and you can leverage them by trading on margin. Most of these things you cannot do at all with a conventional index fund or it is too slow or too costly.
On the other hand, for a long term investor and in particular a buy and hold investor the differences between the two types of products are a much smaller and in some respects basically nil.

Assuming you are a long term investor, how do you pick the right product? You first indentify the asset class, i.e. the index, you want to get exposure to and then you chose the product that delivers that exposure at the lowest overall costs. Given that in Europe – as opposed to the US – most conventional index funds still have substantial upfront loads and given that their total expense ratios are in the majority of cases higher than those of an equivalent ETF, the choice will more often than not be an ETF. In the US conventional index funds, for instance those of Vanguard, are a lot more competitive to ETFs than their counterparts in Europe.

In order to lower ETF expense ratios further roughly half of the several hundred ETFs in Europe make some use of total return swaps, a specific type of derivative. The remaining ETFs do without swaps and are termed full replication ETFs. While the risk associated with the swap structure in my opinion is reasonably small some investors will not want to take it. They should confine themselves to full replication ETFs even if these have minimally higher total expense ratios.

MyPrivateBanking: Thank you very much for sharing your insights.

Gerd Kommer is a director in the structured finance division of a German bank in London. Over the last couple of years he has published a number of investment books directed at retail investors in the German speaking countries among them “Souverän investieren mit Indexfonds, Indexzertifikaten und ETFs" (2002/2007), "Die Buy-and-Hold-Bibel. Was Anleger für langfristigen Erfolg wissen müssen" (2009) and "Kaufen oder Mieten? Wie Sie für sich die richtige Entscheidung treffen" (to be released in September 2010, Campus Verlag Frankfurt). He can be contacted at gerd_kommer@hotmail.com.