Best Index Funds for Global Stocks, Part I
Part I - Strategy
(Part II - Setup
Part III -Operations)
Background
Strategy
Tilts
Modern Portfolio Theory
Strategic allocation rules
“Core and satellite” portfolio design
Screen for compliant ETFs
Summary
Background
Without enough knowledge or time to make a sound call, some investors nonetheless try to pin the tail of a stock they hope will outperform, on the donkey of all stocks in the market. The alternative is to find one fund for exposure to all global equities. Why only one fund? Why global? Companies, sectors and country markets go up and down but we do not have the knowledge or time to understand this and we cannot predict the future. So we diversify as broadly as possible to protect our capital and the good investments will cancel out the bad and hopefully we can benefit from rising markets wherever they occur.
Passive investing is a strategy for minimising stock dealings with all its risks and costs. It is a cheaper way to hold a bunch of stocks that represent the overall market. It is a way to build wealth gradually but surely. All the information is already in the market, in the form of the price, so there is no benefit in trying to time the market or identify which stocks will outperform. But we believe that over time, in the long run, markets will rise and because we do not know when or where, it is better to be “in” than ”out”.
https://www.ig.com/uk/trading-strategies/what-are-the-average-returns-of-the-ftse-100--200529
Rather than trading securities, we buy an index to the target market. An index is like a ruler that measures overall market activity. The index is normally worked out by taking the average price of the basket of securities, as they move up and down each day, but weighting by the market-capitalisation of each company (“market cap.” is number of shares times the share price).
A way was found to buy and sell the index and it is called an Exchange Traded Fund or ETF for short. Today, indexes, in the form of ETFs, can be bought and sold like stocks and shares.
Strategy
https://youtu.be/8qLgw4FS6wI
Tilts
On the one hand, we want to cover all risks and opportunities with a global ETF; on the other, we have ideas about which markets will do best. Which markets - developed or emerging? Or which country? Or sectors of the economy - eg Tech or Finance or Basic Materials, favourites at the time of writing. Or even single stocks, why not Tesla or Legal and General?
Maybe we want to filter by company size, as measured by its market capitalisation (=number of shares times share price) – large, mid-cap or small.
Or look for particular types of company. Growth or value, or a blend of the two? This is a Morningstar style classification. Growth stocks are companies that have not yet reached full potential. They are investing a lot, probably in something new, but still producing little in the way of earnings. Value stocks are mature companies typically dishing out at least half their net earnings in dividends as they have nothing better to do with their profits. By discounting those future earnings to a present value (the “intrinsic value”) and comparing that to the share price, we can say if the current share price undervalues the company.
Or screen for “momentum” stocks, where recent share prices are making higher highs.
The idea is to reduce risk through diversification while outperforming a standard benchmark for performance, such as MSCI’s All Country World Index, ACWI. The goal is to achieve above-average returns with below-average risks.
Modern Portfolio Theory
MPT says you could combine asset classes of different risk profiles to obtain above-average returns compared to your benchmark such as the FTSE All-share, all for an average level of risk. So ETFs for emerging and for small-cap indexes with a global large cap ETF, where the sum of the parts is a more efficient use of your capital, in terms of generating higher returns at lower risk, than the three ETFs held individually because you are on “the efficient frontier”.
Pro’s and con’s
• No market timing: of course you can time the markets, but do you have the knowledge, time and emotional distance?
• Easy to implement: MPT can produce a balanced portfolio ready for long-term growth with only occasional rebalancing needed (if you are more trader than buy-and-hold, you may want to consider more tactical approaches involving technical and fundamental analysis as well as market sentiment, eg I am interested in “sector rotation”, holding a certain amount of cash in anticipation of a decennial crash and buying more stocks during the recession to hold till they return to pre-recession levels).
• Lower risk: diversification means spreading investments across assets that are not positively correlated (though this is increasingly hard to find), so protecting from changes in the market.
Strategic allocation rules
An investment selection governed by MPT might be a portfolio of ETFs following these strategic allocation rules:
• 40% large-cap stock (index) for bedrock
• 10% small-cap stock for outperformance
• 15% emerging market stock for outperformance
• 30% intermediate-term bond for shock resistance
• 5% cash/money-market for opportunities.
Though one global equity tracker and one or two satellites that might vary, is enough.
It is still important to periodically rebalance the portfolio to bring it back to its original asset allocation, keeping your holdings in sync with your investment goals, avoid overweighting certain assets and following the maxim “sell high, buy low”.
“Core and satellite” portfolio design
One way to think of a global equity fund strategy based round these characteristics is as a version of “core and satellite” portfolio design. Most of our money is in a core global equity fund, around which can optionally circle more specific funds such as :
• Emerging or Developed market EM or DM ; or country.
•Company capitalisation – Large, Mid-cap or Small.
•ESG or non-ESG because maybe we favour companies with green governance statements in their Mission Vision Values statements – Environment, Social and Governance or ESG.
So, these might be the "tilts" that you specifically wish to give to your portfolio. If that tilt does work out, good for you, and if it doesn't, then that it is not so serious as most of your hard-earned is in the safe (you hope) core.
Fact is, most of us are pretty useless at choosing these tilts and so all the money in a global equity fund would be perfectly OK. You can still make the high-level choice between developed and emerging markets, or developed markets ex-US (EAFE: Europe, Australia, Asia, and Far East), or maybe add a tilt for a covid-free Europe you expect to emerge.
Screen for compliant ETFs
Having developed a strategy for maximising returns over the long term, while respecting our values, we will then be in a position to (1) find compliant ETFs, (2) evaluate their charges, (3) consider their risk-return profiles. (4) Also spot funds all tracking the same index, so here the only differentiator would be the fund’s ongoing management charges.
The advantages of this core-and-satellite strategy are:
• Preserves your capital by stopping you from trying to pick "winning" stocks and instead focusing on winning themes
• Reduces your time and reduces management and commission charges
• Improves risk-returns through portfolio diversification.
Summary of Part 1 and look ahead
In sum, we are going to look at which index and what markets to track. We will consider the risks and returns of each. Then we will identify particular non-correlating ETFs and mutual funds that could meet the chosen strategy and the charges they make - that will be Part II - Setup. And once we are in "run mode", we will look at Maintenance of Operations.
Part I - Strategy
Part II - Setup
Part III -Operations
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