Portfolio, performance management and XIRR

No, not the sort of performance management that is ruining office jobs by making them paint-by-numbers,  I’m happy to say. What I’m looking at here is how do you know if you should get out of stock picking and become an index investor instead, and I was tickled by the various maxims of John Templeton as listed by Monevator recently.

How do you qualify how well you’re doing at stock market investing?

This isn’t straightfoward, since the value of an investment is a noisy signal with switchbacks. There are a couple of obvious ways:

Wilkins Micawber approach

Take the current value which your ISA provider usually computes from the last market valuation. Add any cash sculling around in the account, subtract what you’ve put into your ISA since opening it. Outcome > 0 result happiness, outcome < 0 result misery. Simple, honest, and automatically tracks your dealing fees. You ought to rescale each year’s input to allow for inflation, though I haven’t done this so far. In my case the result is a 7% increase over the 1.7 years that the first transaction appeared, so result happiness?

This valuation is as of Friday 17 June 2011, so as of the first part of the hit caused by the unfolding Greek tragedy. The Greeks will no doubt be able to switch the result negative over the next year, and if I had a crystal ball I’d sell some stuff and buy later. Trouble is I don’t have one, I don’t know which bit so sell, or when, so I’ll sit tight. and save to buy more, I have been waiting for this rumble, and have switched much of this year’s savings to cash in the meantime.

There’s much to be said for the honesty and simplicity of the WM approach. However, due to the volatility of stock markets, it is more suited to portfolios that have been running for five years or more. It’s also what fundamentally matters for people investing conventionally towards their pension – it is the size of their pension pot that determines their annuity value and thus their retirement income.

Cost of purchased income (how good an annuity is this?) approach

However, that doesn’t really reflect how I plan to use my ISA, which is to use the income to boost my income. I hope to have the intestinal fortitude to be able to focus on the income and leave the fluctuations in capital value alone. Say I take the amount I have put in, minus the amount of cash still lying around in my ISA, and divide that cost by the dividend income over the last year.  That ratio is 4% in my case.

How do I allow for the fact that I haven’t owned some of the companies for a whole year? At the moment intuitively this would seem to underestimate the portfolio’s performance. I target reasonably reliable dividend payers, so if I had had them for a whole year presumably the dividends would have added up to more than 4% of the stake.

Another honest and decent approach, but again more suited to an investment account that has reached steady state (new money contributed < 10% of total invested)

So far so good, we’re still in the elementary-school arithmetic stage. Maybe there’s a better way?

XIRR, PRR and RIT to the rescue

For things arcane and technical I look to Retirement Investment Today who has usually spent some time understanding the intricacies of analysis. RIT introduces us to the Excel function XIRR and the required fixing factor to turn that into a PRR (personal rate of return) to account for sub-year periods. As I’ve been running for more than a year I can use XIRR straight off the bat. For my trusty old copy of Excel2000 I had to go hook out the install CD to add in the analysis toolkit before any of that would happen for me.  XIRR takes the valuation at the end, and the series of times and associated cash inputs that made it, and gives you an annualised rate of return. It allows for the fact that some of the money has only been working for a short while, while the initial stake has been working all the time. Here  is one example, though the illogical American format dates will barf on a non-US date format PC. A more homely explanation of XIRR is available

XIRR% is the answer to the question:
“What constant, annual, bank-like interest am I getting, considering various deposits and withdrawals at arbitrary times?”

Now my current ISA has only been running for 1.7 years since Oct 09. My XIRR is 9% as opposed to the 7% calculated above. Is it really a better estimate of “what constant, annual, bank-like interest am I getting”? Search me, guv. Intuitively since my full stake hasn’t been working for me for the whole time I probably do get more than 7%. 9% sounds reasonable, so I’ll run with that.

Why Stock Picking?

It’s been a while since I had to liquidate my previous index-tracking ISA in 2007 for a life change reason, and it’s been an even longer while since I did any stock selection in the dotcom bust. I’ve come to view the current investment mode de rigeur, index investing, with a jaded eye, as it failed me in the first decade of this century after I cleared out of tech stocks having taken a jolly good hammering.

It takes a while to get back in the investing traces, and I had some things to learn, for which I have much to thank The Investor side of Monevator. For my investment activities in a ISA targeted at UK stocks, I will do stock picking (this is contrary to the general recommendation from TI, BTW). I do income, not growth, because I have no talent for growth stock picking, whereas I can see income track record and other fundamentals. I believe some of the assumptions behind index investment may break down if the mix of what works in the economy starts to skew as a result of oil shortages, and partly because I don’t want another slice of passive sideways tracking over 10 years 😉

However, when I diversify into foreign markets index investing will be my weapon of choice, because these will be smaller amounts of my ISA, I will find it hard to gain domain knowledge and trading non UK shares is more expensive. I also use it for my AVC savings that are larger than my ISA, because I have the option of two pretty decent low cost index funds there – I choose the 50:50 UK/Global.

I did some damn fool things in the first year, particuarly associated with BP Macondo. Not just once, but twice, and it didn’t end well. There’s a case to be made for taking a look at what would have happened if I had been a straight index investor.

How did I do against Index Investing with the FTSE All-Share?

If I were a UK index investor, I would track the FTSE All-share, because I feel the FTSE 100 is highly skewed and more varying in content than, say, the S&P500 – it is more of a top slice by definition. Since I have an Excel file of my cash injections with dates, I can run a what-if on how much I would have in my ISA if I just went and bought the FT all share index each time I lobbed some cash in. The ^FTAS has currently got a yield of about 3% so I have also added a 3%*no of years to date from purchase date* cash injection since I was only able to get a historical price series rather than a total return series for the ^FTAS. It’s not exact, as the yield varies with time and value of the ^FTAS, but for about two years it is hopefully good enough.

The difference is 1.3% in my favour. It isn’t a huge amount of cash, given the ISA is only a little under two years old. I was lucky in being able to compensate using gold and silver ETFs for the rank stupidity of losing £350 on BP, though as a lesson in ‘do not churn’ and ‘do not do what you did in the dotcom boom-bust’ the learning was cheap at the price.In aggregate I’ve lost more than that on some other holdings, but these are stocks I believe in, and some have more than made up in dividends for the loss of capital I have eaten, making the total return positive.

The 1.3% difference doesn’t probably tell me much, other than that an older head than mine in the 2000s can curb some of the excesses. I’m not going to do BP-like things and I will not do PMs in my ISA again.

The yield profile is more suited to my future needs. If I take the arithmetical 4% I need a stake 25 times my desired annual income boost, if I take the 3.1% yield of the ^FTAS I need 32 times the income boost, or I have to start selling down lumps of capital every year. The capital will hopefully have appreciated more with the ^FTAS, but selling chunks usually is a hit on dealing fees.

I’m not going to claim that this is anything other than luck, I’m not a John Templeton. However, I have reminded myself of things not to do, and confirmed so far the validity of seeking income. I hope to take advantage of a damn good stock market crash in the coming months in which to get some good companies at knock-down prices.

It is, of course, perfectly possible that we are in the endgame and that the horsemen of the apocalypse are coming for us from all points as the Greeks stress-test the decaying edifice of Western finance beyond the point of no return. That’s partially why I have non-financial investments, but for the financial investment side I will see if I can make use of the forthcoming white-knuckle ride.

How would I have done with Regular Index Tracking investment?

A chap like The Accumulator would disapprove of both the stock picking part and the irregular lump sum investment process. To evaluate this I took the total amount that I had contributed to the ISA over the time it’s been open, and asked Excel the question

“assuming no dealing fees, what would have happened if I had purchased the ^FTSE index with the same amount of money each month”

The answer was interesting – I would have been 0.7% up on what I managed. I did the same 3% scam as above to simulate the ^FTAS yield.

This shows that for all the sturm und drang of stock picking if I had bought the ^FTAS regularly I would have been 0.7% up (though I would have eaten 1.7* 0.35% TER making it a dead heat IMO). It’s a fair cop, I would have spent less time worrying about BP Macondo and more time living life had I gone this way.

Now for various reasons it would have been difficult for me to do a regular ISA purchase over that time; I started a regular employee expecting to work another 10 years at the same job and had to swing my financial aims to becoming financially independent in three years, and simultaneously investing in several non-financial assets as a hedge against the financial system exploding. That involved lumpy calls on my disposable income so I contributed to my ISA when I could, with the overall aim of achieving the maximum permitted contribution in a tax year.

However, the result is interesting – I am tempted to lob £100 every month into a ^FTAS index fund in my ISA to get a regular index-tracking benchmark. Using a fund such as  HSBC FTSE All Share Index Fund identifier: GB0000438233 which I have brazenly pinched from the Slow & Steady Passive Portfolio rather than an ETF means I minimise dealing charges each month. I can check how many more units I have at the end of a year than I had at the start and the current valuation of that number of units. Ideally the over the long term the value of what else I bought that year should be greater than 8.8 times the tracker, else I am drifting off-course. Instant low-stress benchmarking and it saves me grubbing about with Excel and the handwaving fixing factors to account for the 3% yield.

Greek Farce/Tragedy Ahoy

For all the bull being spouted from the Eurocrats, the Greeks are stuffed within the Euro. They can’t pull the nose up before they hit the ground, and either the French and the Germans are going to sub their lifestyle for ever in return for the Greeks surrendering ther self-determination, or Greece will have to bring back the drachma to live the lifestyle they wish to live.

In Greece they don’t like paying taxes, but with the drachma the government could collect the taxes by taxing capital using inflation. They can’t do that with the Euro. Whatever happens, a nasty whirlwind is going to storm through the financial system again. Ths whirlwind is going to sort the men from the boys, and I’m not sure which camp I belong to!