Last Updated May 25, 2012
My current investing goal is to outperform an ETF tracking the FTSE 100 total return over any given five year period. However, after reading some more about expected returns and the various sources of those returns I think that goal needs some adjustment.
Whilst I don’t believe the market is completely efficient, I do think that the market is efficient enough so that for most people the odds of adding value via stock picking are virtually zero. This doesn’t mean that you have to settle for the returns of the FTSE 100 or All Share indices though, or even an international mix of indices.
The CAPM Three Factor Model says that the returns from a diversified portfolio come almost exclusively from Market Risk, Size Risk and Value Risk. What constitutes a diversified portfolio is somewhat subjective, but according to Elton and Gruber’s paper “Risk Reduction and Portfolio Size: An Analytic Solution” a portfolio of 10 holdings will have about half the volatility of annual returns of a single holding. More holdings reduce volatility by an ever reducing amount. If you hold fewer companies then you are exposed to Concentration Risk, which according to the theory doesn’t have any associated return.
Instead the returns come from the market return multiplied by the percentage of stocks in your portfolio (the stock/bond split) and the weighted average beta of those stocks, the weighted average market cap and the weighted average price/book ratio (and a few extra bits about the risk free rate which I won’t go into here). The lower the average size and price/book, the higher the expected returns. Given that my benchmark is a tracker of the FTSE 100 which is full of large companies and many growth companies and that my portfolio consists exclusively of small value companies, it doesn’t seem fair to just beat that benchmark and claim myself victorious since the model says a dart throwing chimp could do the same.
As yet I don’t have figures for the UK, but there are a number of sources that have figures for the expected return from holding small value companies in the US. For example, in Mark T. Hebner’s active investor bludgeoning “Index Funds, The 12 Step Program for Active Investors” (available for free at his rather excellent site), he cites the return in the US from 1927 to 2006 from holding the smallest 30% of companies relative to the largest 30% of companies as 3.13% per year, and the return from holding the 30% of companies with the lowest price/book relative to the 30% with the highest price/book as 5.11% per year.
My holdings have a weighted average market cap of about 25 million pounds, which puts them in the bottom 20% of the All Share index in terms of size, so I should expect the full size premium over the FTSE 100 (which by definition is full of the largest companies). The weighted average price/book of my holdings is 49%, which puts them in the bottom 10% in terms of ‘value’ (ignoring negative book value companies). The FTSE 100 actually has a fair spread of price/book ratios, so on that basis I think I can reasonably expect to see half the value premium which would be about 2.5%.
Putting that lot together I think a more appropriate target is to produce returns equal to the FTSE 100 total return multiplied by the UKVI fund’s weighted average beta, plus an annual 3% size premium and 2.5% value premium over the long term. That’s a bit of a mouthful, and given that the UKVI beta is currently very close to 1 and I’m virtually 100% in stocks, I could simplify it and say:
I expect to beat the FTSE 100 total return by about 5% annually over the long term.
Given that the FTSE All Share has returned about 7% capital gains plus about 3% from dividends and the FTSE 100 is likely to be similar, I would expect a total annual return in the region of 15% with somewhat more volatility than the benchmark due to the additional risk I’ve taken on in order to get the extra returns.
Remember that even if I match this performance it does not show any proof of skill since the assumption is that by throwing darts at a board of small value companies (or hiring a chimpanzee to do it) I could achieve the same results. Only by beating that target can I claim some semblance of an apparently ‘socially useless’ skill.
Finally, to aid in the general excitement I’ve added a discrete period performance table, showing monthly performances for me and the benchmark, as well as year to date figures to the about page. Discrete yearly figures will appear when I’ve been around long enough to gather them.
As you will see, despite underperforming the benchmark by about 5% this past 6 months I’m still in the lead for the year by over 6%, but there’s plenty of time to fall behind yet.