Monday, October 24, 2011

ETFs or direct holdings?

Peter Lynch, the legendary money manager, has called excessive diversification as "diworsification". By this he meant that you should not be afraid of putting a lot of eggs into a single basket. However, unless you happen to devote most of your working time to screen potential investments and looking deep into company files, you are probably not going to have enough confidence to do so. And even if you would, you are probably better off if you diversify (distribute your money over lots of quality companies) anyway. Most money managers don't actually beat their benchmark index.

After reading "Random Walk Down Wall Street" I become believer of investing into index funds. However, after trying it out for a couple of years I noticed some drawbacks in passive-index ETF (exchange traded fund) investing:
  • Some ETFs do not replicate index by directly owning the stocks. They do this by swap-contracts. So you have got some level of counter-party risk (in case the other bank defaults and can't make good on the contract).
  • Most ETFs are expensive (net fees and costs 0,5%-1% per year or more)
  • Most ETFs have very big spreads (difference of buy/sell bid)
    • This is typically tied to size of fund and daily volume of it.
  • You have to trust the company running the fund
    • Even if they claim that the assets are separate, I don't trust any banker 100%.
  • Taxation of dividends
    • Atleast in Finland, there is a difference in directly holding stocks and holding an ETF
    • I get a 30% tax break on dividends from Finland and all countries with whom we have a tax contract. Essentially this means paying capital tax on 70% of received dividends.
Therefore, I mostly invest directly into stocks. Typically I pick big corporations that would anyway be well presented in any passive index. I also diversify over several companies in the same business. Lately, I have noticed that there are several big ETFs (>billion dollars of capital) with very low fees (as in 0,1% or less) and low spreads. Those remove some of my concerns.

Generally I think passive-index unleveraged ETFs are good if you can't diversify otherwise. Also, when investing outside your county and developed markets, it is probably a good idea to use ETFs. However, even with ETFs you need to think about diversification (across multiple funds and money management companies). Don't trust any one money management company too much!

Sunday, October 16, 2011

Who pays the bill?

A group of 97 prominent Europeans published an open letter to eurozone leaders on Wednesday 12th of October 2011. In the letter they called upon the governments of the Eurozone to agree in principle on the need for a legally binding agreement to: 1) establish a common treasury that can raise funds for the Eurozone as a whole and ensure that member-states adhere to fiscal discipline; 2) reinforce common supervision, regulation and deposit insurance within the Eurozone; and 3) develop a strategy that will produce both economic convergence and growth because the debt problem cannot be solved without growth.”

While this proposal could work long term, it will take ages to negotiate and faces opposition in countries like the one I live in (Finland). That’s why they insist that the European Financial Stability Facility (EFSF) and the European Central Bank (ECB) would guarantee and eventually recapitalize the banking system.

Sounds easy – but is not. Otherwise, the crisis would be over by now - right?. It’s still about who pays the bill (accumulated losses). Not all countries behind EFSF and ECB are easily going to guarantee everybody else. A joint recapitalization of the entire European banking system is not too popular in countries (like Finland) that do not have banks with big pile of soon-to-be-rotten debt.

George Soros, one of the 97 people behind the open letter to eurozone leaders, published an essayA routemapthrough the eurozone minefield” the following day. He does not believe banks will be recapitalized by banks themselves or by national governments. Instead Soros believes that the only sensible path is for ECB to solve all problems. He goes actually further than the joint letter and claims that EFSF is actually not even needed short term.

Again: If it would be so easy, why it is not being done?