The importance of deep time
Geologists took years to fully appreciate just how important time was in moulding our landscape. Darwin too was a pioneer in understanding the significance of deep time in allowing life forms to evolve and adapt to their environments.
There is another arena where deep time is important and that is in the world of investing.
In the short term people focus on changes in capital values, whether these are shares, indices, bonds or foreign currencies. Yet what is clear from all studies of investing over the long term by researchers such as Professor Dimson of LBS, Professor Siegel of Wharton and the team at Barclays is that the single most important factor is dividends. A simple demonstration of that comes from this yearís Barclays Equity Gilt Study. It quotes the example of a mythical investor who invested £100 into UK equities in 1945. If he had taken and spent all the dividends he had received over that period his investment would have grown to £7,401 in capital terms alone by the end of 2011. Alternatively, if this investor had been sagacious enough to reinvest those dividends his pot would have risen to £131,469 in the same period.
Despite this many investors still try and capture the volatile returns from the oscillations in capital values of shares as they dance tantalisingly on our screens. Some do very well over short periods of time, usually when the whole asset class is rising and the incoming tide of valuations lifts all ships.
Chasing these capital values is time consuming and hard work. Moreover, the more managers chase these ethereal returns the more it increases the volatility of the fund. In a piece of research that seems counter-intuitive Haugen and Baker demonstrate that in fact high volatility funds, high beta in the jargon, actually generate lower returns than low volatility funds. In contrast to accepted wisdom it seems that boring low beta stocks that donít bounce around much give higher returns than the high beta stocks that leap about in the style of Tigger in the 100 Acre Wood chasing every morsel of news.
The problem of course is that holding low beta stocks and waiting for the dividends to roll in is rather boring. It doesnít satisfy the desire for managers to react to each piece of news that comes down the wire and do something.
Clearly, the message from these studies is that managers should do as little as possible. That means a low portfolio turnover ratio. Despite all the research no one is really sure which stocks will suddenly pay a special dividend like Johnson Matthey. So it makes sense to hold most of the stocks in the selected universe. If cash flow is more important than capital values the weightings of each holding should be determined by reference to the size of the dividends that companies pay out.
Finally, the fund should be structured so that it can take advantage of volatility. That way it can benefit when traders see profit warnings from large retailers or other news flow that impacts capital values in the short term. Adding to holdings when prices are depressed by sentiment is an excellent way of exploiting the volatility created by others and using it to reduce your own.
Deep time is a difficult concept for intermediaries to sell because it implies inactivity. In practice the less a manager interacts with stock he owns the better. A fund should be the cleanest, simplest conduit between the investor and the assets it holds. As long as the fund holds those stocks according to these principles deep time and dividends should do the rest of the work for it.
(The S & W Munro UK Fund is a physical long-only smart-beta fund that invests in the FTSE 350 Index and complies with The Stewardship Code.)