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Investors in stock markets share a common ambition to generate additional returns from taking the risk of parting with their hard-earned capital to purchase company shares, usually with specific financial goals in mind that justify taking such a risk. Motivations aside, the challenge for any equity investor is to identify the most efficient way of buying shares in company stocks. Following the advent of modern technology and trading platforms, the options available to an equity investor have increased and long-since gone are the days when share ownership would be obtained through the issuance of individual share certificates. With new opportunities come fresh decisions and it is important for investors to consider the most efficient way of deploying their capital in the markets to achieve their financial goals.
For several decades the norm for equity investors was to purchase shares in a relatively small selection of companies in which they had personal faith, hoping that any capital losses as a result of companies performing badly or going bankrupt would be offset by the upside of the ‘winners’ in their portfolio, and that over time excess returns above investing in Government bonds would be achieved. A variation of this approach continues to exist today; analysts sit on the trading floors in Wall Street and Canary Wharf to pour over volumes of data collected about thousands of companies across the globe, with the aim that the portfolio of stocks that they design as a result of digesting public information will hopefully provide a higher return than their peers across the street. Some of the most successful investors in history have employed this method, succeeded to outperform their peers and their benchmarks, and as a result made their clients happy.
Perhaps unsurprisingly, however, statistics tell us that the majority fail to achieve this – the Dow Jones annual report on active manager performance released in March of this year highlighted that in 2018 for the ninth consecutive year the majority of active large cap funds (64.49 percent) failed to beat their benchmark (the S&P 500 index) during the previous one-year period. The same data over a 10-year period increases the failure percentage to over 85 percent and, over the previous 15 years, 91.6 percent of active managers have failed to provide their clients with returns that outperform the index. Given the risk-reward dynamics of actively investing to try to beat the return of the market as a whole, most active managers are likely to be running portfolios that carry more volatility risk than the index itself, and so clients in active stock-selection strategies are most likely exposed to higher levels of risk than if they had simply invested to track the comparable market index, with the event that the active strategy generates higher returns than the equivalent index proving to be statistically unlikely.
Modern investors that remain attracted to stock-selection strategies often have understandable reasons for doing so; it is human nature to feel trust for the familiar, to have confidence in our own judgement and to be competitive in our efforts to overachieve. That said, investors should generally take a step back and consider why they are investing in the first place and what there is to lose as well as gain from taking risks. Are the potential returns worth the risks being taken or is the investor able to satisfy their long-term planning targets by capturing the annual returns of the market as a whole? How well-suited is the portfolio to withstand a significant market downturn? Can the investor bear capital loss and, if so, by how much?
In the Journal of Financial Economics (JFE) Hendrik Bessimbinder, from his office at Arizona State University in 2017, studied the chance of outperformance through a different lens – how many US companies have stocks that outperform Government Treasury bills over the long-term? He analysed the returns of over 25,000 company stocks between 1926 and 2016 to work out whether an investor for the period would have had higher returns by holding the company stock or by holding a US one-month treasury bill, which sit at the lowest end of the risk and volatility spectrum. Overall, only 4 percent of the stocks he analysed (under 2,000) accounted for all of the net wealth creation beyond holding a one-month T-Bill. More staggering still, only five companies of the 25,300 accounted for 10 percent of the total wealth created by the stock market sample over the 90-year period. Firstly, this tells us that the stock market can reward us for taking additional risk beyond holding cash or short-term government debt, but secondly and importantly that the rewards are being generated by a small subsection of the market, the outliers if you will. So, for an equity investor to reap the full rewards of the market, they must either try their hand at selecting the very best companies or capture the returns of a very wide sample of company stocks to maximise their chances of holding outliers like Apple, IBM or Exxon when their stock prices go through the roof.
It is a common misconception that a modern, widely diversified approach to stock market investing must be entirely ‘passive’, whereby an investor looks to replicate a given index such as the S&P 500 or FTSE 100 as closely as possible by purchasing shares that are included in the index. In recent years, with the advent of algorithmic trading, the ongoing cost of running funds that employ passive strategies has become relatively inexpensive in many cases. It can sometimes make sense to invest by passively tracking an index, particularly in the most liquid markets, but there are also a wealth of strategies that follow the same principle of investing in a diverse range of company stocks within a given market without mimicking the holdings within the index entirely. These strategies are often referred to as ‘smart beta’ as they combine some of the advantages of active strategies including a level of discretion over when to buy and sell a given stock, or having a bias towards relatively cheap stocks that are small or those that are trading below value, with the overall benefit of a diversified approach that seeks to capture the return of a stock market as a whole.
Americans living in the UK that are looking to invest in any types of collective investment funds, regardless of the strategy, must be conscious of the treatment of their investments from a tax perspective. It is important to avoid Passive Foreign Investment Companies (PFICs) from an IRS perspective as well as to avoid collective investment schemes that attract Offshore Income Gains (OIG) treatment from an HMRC perspective. This makes it important to seek proper advice from a qualified tax professional that understands the US-UK tax treaty, and also to ensure that the investments that you hold are appropriate for you. Even for the simplest of investment strategies, it usually makes sense to take professional advice as an American in the UK.
Well thought through financial planning can provide opportunities to take advantage of the latest thinking in academic research, such as Bessembinder’s study, and allow investors to build a more efficient strategy than they might otherwise develop on their own. As an American, you might understandably believe that your investment options are limited to single stock strategies because you have heard about the complex rules around holding collective investment schemes overseas, however, with the correct portfolio oversight Americans can benefit from access to tax-efficient fund solutions.
With the appropriate advice you can invest in a globally diversified portfolio of collective investment schemes that are tax efficient from a US and UK perspective. These funds should be closely monitored to make sure that they remain efficient from a tax perspective and continue to drive long-term returns for each unit of risk being taken in the portfolio.
If you would like a full copy of MASECO’s ‘39 Steps to Smart Living in the UK’ or more information about MASECO’s services please visit www.masecoprivatewealth.com/the39steps or contact firstname.lastname@example.org. 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.