23rd May, 2017

Many people choose the passive approach to investing – they put their long-term money into index ETFs or index funds which mirror the standard share market indices, such as the S&P500 in the USA or the S&P/ASX200 in Australia. This is perfectly reasonable. After all, one of the greatest active investors of all time has recommended the passive approach. In 2014 Warren Buffett told his wife that, after he died, she should put 90% of her money into an index ETF which tracked the S&P500, and the other 10% into a high-quality US government bond ETF.

Arminius also makes extensive use of passive index ETFs in our hedge fund and in constructing portfolios for clients, because this is a cost-effective way to gain exposure to large numbers of stocks quickly. But index ETFs should be used with caution. The index that you choose as benchmark needs to suit your investment objectives. You need to understand the components of that index. You need to choose an ETF which is liquid. You need to avoid ETFs which are leveraged or have other exotic features.

One of the biggest problems with the standard indices is that companies are included in proportion to their market capitalization – that is, the biggest stocks make up most of the index. Consequently, market capitalization weighted indices tell you where the share market has been, not where it is going. The reason is that the largest companies in an index are the companies whose share prices have risen the most in the recent past. If these companies’ share prices start to fall, the index will steadily reduce their weightings again.

The spectacular growth of the Japanese economy from 1950 to 1990 propelled Japanese shares to an ever-increasing percentage of world share markets. By the late 1980s Japan accounted for 44% of the widely used MSCI World Index. Many well-informed people believed that Japan would one day overtake the USA as the world’s largest economy and share market. One distinguished scholar even published a book entitled Japan as Number One: Lessons for America.

Needless to say, Japan not only failed to overtake the USA but has spent the last two decades in intermittent recessions and deflations, with the result that China is the world’s second largest economy (but by no means the second largest share market). The point we are making is that our assumptions about economies and markets are often fragile and short-lived. A look at history is a good way of shaking up our preconceptions.

To demonstrate how much stock market indices change over time, we have used a chart from the Credit Suisse Global Investment Returns Yearbook 2017, which is a highly authoritative document on long term returns. It is based on research published in 2002 by three academics, Elroy Dimson, Paul Marsh and Mike Staunton (“DMS”), and progressively updated since then. DMS assembled investment return data from 1900 onwards for as many countries as they could, checking and cleaning all the data in order to ensure that it was accurate and consistent. Credit Suisse now fund and publish the annual update of this data, which now covers 23 countries.

Chart 1 below shows the world’s largest stock markets in 1899 and 2016. In 1899, the world’s leading economies were European, headed by the UK. Between them, the European countries accounted for two-thirds of global stock market capitalization in 1899. By 2016 they accounted for only one sixth. Europe didn’t shrink – the USA and Asia grew faster than Europe did.

By the time of the First World War, the USA was the world’s largest economy, and soon after it became the world’s largest stock market as well. Anyone who tracked the US index from 1900 to 2016 made 6.1% per year, one of the best returns in the world.

By contrast, an investor who invested in the Japanese share market index in 1900 had made only 2.0% per year by 2016, thanks to two World Wars and a bear market that began in 1989. The Nikkei 225 index is still trading around half its 1989 record level. (But that Japanese investor did have a very good run between 1950 and 1989.)

Although China’s GDP is second only to the USA, its stock market is a tiny 2.2% of global equity value (less than Australia), and its equity returns since 1900 were depressed by a 100% loss in 1949 thanks to the arrival of the Chinese Communist Party. The Shanghai Stock Exchange did re-open in 1990, followed by other exchanges, but their exposure to the Chinese economy remains small and erratic. Chinese stock market performance is highly volatile, and the main index, the Shanghai Composite, is still trading at little more than half of its 2007 peak.

What we want to emphasize is that the big countries and big companies which we see around us at present are the result of long term trends in economies and stock markets. These trends may continue, or they may reverse. Monitoring them and predicting their direction is fundamental to Arminius’ business, because it is one of the foundations of our investment performance.