Ex-Hedgie Now On Index Crusade

November 05, 2013

No one’s incentivized to sell investors what they really need, says ex-hedge fund manager turned author Lars Kroijer.

[This article previously appeared on our sister site, IndexUniverse.eu.]

 

Hedge funds and index trackers are polar opposites: the highest- and lowest-fee ends of the investment product scale.

And yet a surprising number of hedge funders are fans of indexing. Reportedly, many are closet admirers, buying ETFs and index funds for their own portfolios—as though stepping out of a Ferrari and into a well-used family diesel when away from the public gaze.

Others have switched career to embrace tracker funds. Alan Miller, manager of a fund of ETFs at SCM Private, was once a hedge fund investor at New Star. Victor Haghani, partner at Long Term Capital Management in the 1990s, now looks after a $200 million portfolio of index funds and ETFs, Elm Partners.

Lars Kroijer, who ran an equity hedge fund, Holte Capital, between 2002 and 2008, is another convert. But the Dane no longer manages client money himself (though he sits on several fund boards). Instead, he’s turned author.

Following a well-received account of his hedge fund experiences (“Confessions of a Hedge Fund Manager”), published three years ago, Kroijer has written a new book, “Investing Demystified”, with the objective of explaining why index investing is the rational approach for almost all of us.

Kroijer’s book is serious but accessible, combining investment theory with practical advice on how to construct a rational portfolio. His book also covers financial planning, pensions and insurance and how and when to ask for specialist help.

The author says he wants to help the rest of us to manage our money without losing a fortune to intermediaries. “Your life savings are not a spectator sport,” he told me recently in London.

We should all face a simple truth, Kroijer argues: that we don’t have an “edge” in financial markets, and we should select cheaper, indexed investment products instead. His book is written “for my Mum, and for Mr. and Mrs. Smith,” Kroijer says.

“It’s very unlikely that you have the ability to beat the market,” he explains. “And once you admit that you don’t have an edge, you can move on from the conventional wisdom of buying expensive, active products that imply skill in investing. You don’t need to pay more for something that isn’t better.”

The Dane is aware of the irony inherent in his new role.

“A one-time hedge fund manager writing a book about investments without edge may seem like a priest writing the guide to atheism,” he writes in the introductory section of his book.

The theme of faith recurs during our conversation. At one point Kroijer says, “I’m religious about this stuff. If you keep fees down you can do extremely well.”

But Kroijer is self-deprecating and doesn’t come across as the type of indexing evangelist one might meet at a US fund conference. All the same, his tone intrigues me. I ask him if he ever reached a point where he lost belief in the hedge fund model.

His reasons for closing his hedge fund and returning money to investors were personal, Kroijer responds. But he adds that he doesn’t regard his past professional life and the theme of his current book as contradictory.

“I’m not anti-hedge funds and active management,” he says. “Some people do have edge. But the onus is on people who want to give money to active managers to prove that the managers have skill. And having an edge is a full-time occupation.”

If you want to place bets on individual companies, Kroijer says, at the very least you should recognise who you’re up against.

 

When managing his hedge fund, Kroijer says, he always tried to visualise a well-connected competitor, a hypothetical portfolio manager, who was armed with the latest research reports, industry expertise, access to companies’ management, and knowledge of the latest market flows in the shares concerned.

“I would convince myself that we should not be involved in a trade unless we had an edge over them,” Kroijer writes.

And if a full-time hedge fund manager, backed by a team of well-trained and well-connected analysts, had such concerns, what chances do the rest of us have to outperform?

“If you want to have an edge, you can’t do it as a part-time job,” Kroijer says. “This is not something you can spend an hour a day on.”

When it comes to indexing, Kroijer is a firm believer in sticking to the traditional method of weighting stocks by their market capitalisation. For him, alternative methods of constructing indices are akin to the active management methods he cautions the rest of us against.

“I’m not at all keen on smart beta,” Kroijer tells me. “If you have an edge—good luck, you’ll get rich. But the vast majority of us don’t have it.”

But for all the conviction of the pro-indexing arguments, isn’t there an inherent paradox here? After all, someone needs to set the price of Microsoft, Google and Vodafone shares. Aren’t index fund investors free riders, benefiting from the decisions of those who do apply judgement to pricing stocks?

“Yes, index investors are piggy-backing off the idea that there is an efficient market, and that securities’ prices are set fairly,” Kroijer concedes. “For the same reason I only advise using indices in active, liquid markets.”

But we’re far from the point at which index-following funds stop working, he says.

“There’s clearly a saturation point after which indexing can’t work. But only around 15 percent of global equities are currently owned by index funds and ETFs, so I think indexing could still grow by three or four times before markets become inefficient.”

Kroijer says investors should shop around for the cheapest indexing option, but adds that ETFs may offer the widest choice.

“Giving individual investors access to the stock market in a cheap, diversified way has been a huge, positive development. I’m agnostic about whether that’s done by an index fund, ETF or some new vehicle that’s yet to be invented. But ETFs may give you exposure to a broader range of markets than retail index funds. ETFs are also easy to trade.”

And investors should welcome the increasing competition between the major providers of tracker funds, he argues.

“Should you choose BlackRock, State Street, Vanguard, Deutsche? It doesn’t really matter. Go with the cheapest. I’m glad they compete on price and this is going to leave people better off. The providers make a lot of their money on the more esoteric products and I advise sticking to the main indices. It doesn’t even matter which index is involved—you do need an index but you don’t need it to be expensive.”

Switching to a cheaper, index-based investment approach requires both self-awareness and a change of mindset, Kroijer reiterates throughout the book. But though indexing sounds simple, it’s easy to forget how revolutionary the concept really is and how much of a challenge it presents to the finance industry’s traditional commercial model, he tells me as our conversation comes to an end.

“You can create a diversified portfolio using just two securities: a government bond ETF to suit your maturity profile, and a world equity ETF. You then mix them according to your risk appetite. That’s a really simple, powerful combination and you’ll end up doing better than 99 percent of the world’s investors. But no one is going to get rich selling that product mix to you and so you probably won’t see it advertised.”

 

 

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