6. The Great Reset

The “Great Reset”, the COVID-19 pandemic and the subsequent Russia Ukraine invasion initiated a new era of geopolitics and thereby a new economic landscape. It is necessary to be aware of these forces to utilize a different approach when it comes to constructing our portfolios in 2022 and beyond.

What makes 2022 so different from previous market cycles and recessions?

As of mid-2022, we can simultaneously see:

• Uneven supply constraints
• Higher level of interest rates
• Elevated geopolitical risks
• Slower economic growth
• Sticky inflation.

These structural forces have not been seen in this combination before. We entered a new era. This makes it dangerous to simply do what worked previously. Instead, we must adapt.

As I have looked in my study at the returns of value stocks during the global financial crisis 2007-2008 and the European debt crisis, it is important to note how remarkably different governments and central banks have responded in 2020 and beyond.

While in 2008, politicians and central bankers stimulated the economy with very little direct cash injections into the average consumer wallet, in 2020 the approach was entirely different.

For the last two years, the financial system has been overstimulated with a massive amount of quantitative easing. Especially in the U.S., cash was handed out directly to consumers, totaling > $1.5 trillion in stimulus payments, unemployment insurance, and tax credits. In 2020 more than 3.5x the amount of the 2008 stimulus was spent to rescue the economy. This kind of active engagement in the economy was previously unknown to investors.

Besides more stimulus than ever before, we are also experiencing supply side constraints and heightened geopolitical risks – which are here to stay for the foreseeable future.

Risks

The unprecedented situation also brings certain risks investors have to be aware of, especially:

1. Risk of a severe recession
2. Risk of stagflation
3. Geopolitical risks
4. Risk of high commodity prices

Risk #1: Recession

Presently, we are experiencing an unprecedented situation. Over the past two years, the economy has been rescued with massive quantitative easing. Now see a situation where low unemployment meets record high inflation which central banks already try to tackle with an aggressive tightening policy which poses a heightened risk of policy error.

The question is: can the FED and the ECB, in such a challenging macroeconomic environment, cool down inflation without disrupting the labor- or housing market? Or will they instead – accidentally or on purpose – trigger a recession, as it was the case in the 1970s?

Hedges Against a Recession

The most difficult task for investors is to time the market – especially during inflationary periods. As it is hard to predict when the recession really hits rock bottom, there is no easy strategy for investors to hedge against it. One way for value investors to prepare for an approaching correction is to follow the general advice derived from the study: hold cash or at least rebalance towards a conservative value stock portfolio.

In the past active value investors in the United States were able to reduce their losses during a recession and outperform the market by holding significantly dividend paying value stocks and simultaneously re-investing the dividends. Especially during the current period of high inflation, this seems to be an interesting way to hedge against an approaching recession.

However, the best way seems to be to hold cash until the bottom of the market has been reached. As soon the market is recovering, rebalancing towards non-dividend paying low price-to-book value stocks promises handsome returns later on. The only problem: timing the market is hard.

Risk #2: Stagflation

So far, the heightened inflation was accompanied by relatively high productivity and slight growth. As KKR puts it in their mid-year update: “it could have actually been worse, if productivity had not been booming.”

Stagflation describes the scenario where high inflation meets a stagnating economy. The risk of this happening has risen especially in Europe, where on top of the pandemic-induced supply shock comes a supply shock caused its dependency on Russian energy. Ergo, we see one supply shock on top of another supply shock. In sum, this will likely result in higher and more persistent inflation. 

As this new supply shock is based on energy, not only will inflation rise but also growth within Europe will take a massive hit.

Even based on the actual state without taking into account a further escalation in the Russia-Ukraine conflict, Philipp Hildebrand, Vice Chairman of BlackRock and former Chairman of the Governing Board of the Swiss National Bank, describes the situation as “uncomfortably close to a zone where stagflation is a real risk in the Euro area.” If the geopolitical situation deteriorates further, this “could easily tip the Euro area into a stagflation scenario of very low or even negative growth and high inflation.”

Hedges Against Stagflation

For the investor, stagflation generally results in lower profits as a result of higher input prices – such as energy – and lower sales. This overall impacts investors returns as companies experience decreased or even negative growth which impact stock prices. This in turn will lead companies to reduce or suspend their dividends. Growth companies – on the other hand – can see significant losses as their stock prices are based on growth targets which become impossible to meet in an era of stagflation.

A recent market update from Bridgewater Associates ((An Update from our CIOs: Transitioning to Stagflation (25.07.2022). Bob Prince. Retrieved on August 29, 2022, from: https://www.bridgewater.com/_document/an-update-from-our-cios-transitioning-to-stagflation?id=00000182-4bc0-d72c-a3eb-cfdb80630002)) compared global asset performances in periods of stagflation.

During periods of stagflation, equities performed worst with an annualized loss of 10.2% (Sharpe ratio -0,72) followed by a global 60/40 portfolio (-6.6% with a Sharpe ratio of -0,7), and real estate (-13.8% with a Sharpe ratio of -0.68).

The best hedges against stagflation were Gold, with an annualized excess return of 17.6% (Sharpe ratio 0.67), Inflation-Linked Bonds (ILBs) with an excess return of 4.5% (Sharpe ratio 1.02), and a broad basket of commodities with an excess return of 10.5% (Sharpe ratio 0.58).

How about dividend or non-dividend paying value stocks? As my study didn’t look at a phase of economic stagflation, I cannot tell how well a value dividend strategy historically performed as a hedge against it.

Overall, during stagflation, stock prices fall, and as the market corrects, more stocks will fit the loose definition of “value stocks”. It is therefore important to check twice if the stocks that appear to be undervalued actually really are undervalued.

However, what we can say is that especially significantly dividend paying value stocks are – at least in theory – a good hedge against stagflation. First, they are undervalued. Second, they return an extraordinary high dividend which helps to hedge against inflation.

Risk #3: Geopolitical Conflicts

The geopolitical landscape is complex. With an already present Russia-Ukraine war, we see a brewing conflict in Taiwan and other uprising conflicts in Greece/Turkey, Iran, the Baltics, and more, which all have the potential to turn into a real military conflicts or even a new world war.

The United States play in two of these conflicts a major role. First, the U.S. is heavily funding Ukraine with weapons and other military aid. As I am writing this, the White House is finalizing its next assistance package for Ukraine which is announced to be $1 billion USD. This adds up to approximately $8.8 billion USD in aid the US has given Ukraine since Russia’s invasion on Feb. 24.

In my opinion, the unspoken truth is that the United States are leading a proxy war against Russia which – as a strategic byproduct – harms the economic powerhouse Germany.

With careless rhetoric, an unfortunate accident, or a false flag attack, the conflict in Ukraine could well result in a direct military conflict between Russia and NATO – or in other words a new world war.

Then there’s the conflict between Taiwan and China, in which the United States is willing to “confront [China] when necessary” as Secretary of State Antony Blinken said. How much the U.S. is willing to stand up against China was shown in a recent Taiwan visit by Nancy Pelosi. Despite harsh warnings from Beijing that a visit would result in serious consequences, she nevertheless landed in Taiwan to meet state officials. The consequences of this “face off” will be seen in the coming months.

For the United States, the Taiwan conflict is not only about Taiwan itself. It is about China, which emerged as a competitor who is capable of threatening the United States’ status as a superpower. That’s why from an economic and geopolitical power perspective, we will see the United States trying to do the best they can to stagger China’s influence – in a pinch also militarily.

It is not only the United States which is reexamining political and economic partnerships and cooperations. Moreover, Australia, Japan, India, and the European Union are positioning themselves in an attempt to navigate the changing world order.

Economically and politically, we will see previously mentioned power blocs which will preferably trade with each other. Especially key areas such as telecommunication, data, semiconductors, and healthcare will move home or be sourced from an aligned partner. In other areas, such as low–cost production, we will see trade-offs.

Hedges Against Geopolitical Risks

How can we hedge against these geopolitical risks? For now, it is likely wise advice to stay out of Chinese and Taiwanese stocks. It appears to be clear that the United States and European Union desire to bring industries of strategic importance home. Thus, I expect there will be a variety of companies which will profit from this geopolitical reorientation. For example: domestic manufacturers of 5G equipment, semiconductors, and healthcare equipment. Furthermore, independently of intensifying military conflicts, we will see countries increase their military spending. Thus, investors can look for fairly or undervalued armaments companies – as long one has no ethical dilemma with it.

Risk #4: Instabilities due to high commodity prices

I see a significant risk in commodity prices which stay heightened not only over several weeks or months, but on an above comfortable level for several years to come.

I point to Lyn Alden, who anticipates ((Energy: The Area under the Curve (07.2022). Lyn Alden. Retrieved on August 29, 2022, from: https://www.lynalden.com/the-area-under-the-curve/)) that oil and gas prices will likely be higher than they are being currently priced by future markets or predicted by many analysts. It is not about the peak of the oil and gas price but how long the commodity prices stay high – thus the time variable is critical. If oil and gas prices stay high over not only weeks or months, but years, it will not only pull Europe into a deep recession, but also lead to the destruction of savings and thus poverty for the average people. In this scenario, I am talking about high gas prices and high oil prices which partially will destroy entire industries who are dependent on cheap gas. This again leads to unemployment. At the same time, heating costs, fuel prices, and even food prices surge. I don’t know how long people will put up with this impoverishment, before we will see violent mass protests on the streets.

Not only energy prices have exploded since the beginning of 2022, also food prices are at record highs. What started with the loss of agriculture exports from Russia and Ukraine, has been intensified with massive climate-related droughts in sub-Saharan Africa and – as I am writing this – throughout Europe. We are in a situation where everything must go right, to avoid a real food crisis. If things go wrong, we will see a catastrophic human toll and economic impact, and political uprisings  – not limited to emerging countries.

Hedges Against High Commodity Prices

The first approach to hedge against high energy prices seems rather simple: investing in energy stocks. With oil and gas prices heightened for a longer time, oil and gas companies finally entered an incredibly profitable period. However, with the energy transition in mind, we have to pay attention in how far the current valuation of oil and gas companies are still attractive.

A second approach to hedge against high commodity prices – which is quite contrary to the value investment approach – is to seek companies who likely won’t survive this cycle and to build short positions against them. There are many companies – especially in Europe – whose entire business model is only working with cheap Russian gas. Finding these businesses who can impossibly survive with continuously high energy prices is a commonsense approach to hedge against the unavoidable havoc.

Furthermore, investors should look out for attractively valued food companies which are essential to feed people. It must not be the large Nestlé conglomerate, but maybe the value investor still finds undervalued and crucially important food producers in whatever global market.

Trends

The End of Globalization

The supply chain issues experienced as a result of Covid-19 lockdowns as well as the Ukraine-Russia war have fundamentally changed how CEOs and political leaders view our globalized economy.

While in the past, the economy was built around the notion of globalization, the future will instead be characterized by a global power competition where like-minded blocs of companies trade preferably and more with each other. Many nations will overgo the globalized economic efficiencies by prioritizing trade based on geopolitical alliances.

Like-minded blocs we know today are for example:

• The West
• NATO
• BRICS 
• AfTFCA (African Continental Free Trade Area)
• Mercosur

Even within these alliances, I expected changes in the near future. For example, in 2022 Iran and Argentina applied to join BRICS as full members and many other countries – including Saudi Arabia, Pakistan, Mexico, and Egypt – are interested in joining.

But this all doesn’t mean that these power blocs – which essentially compete with each other – stop trading altogether. Instead, we will likely see that certain countries will trade less with each other and prefer to trade with neutral or nonaligned countries.

In addition, governments and people realized that certain industries such as energy, communications, healthcare, and data are not only of economic importance but a strategic national priority as well. Going forward we will see further industries become “strategic” from a national security perspective.

What does this shift mean for the investor?

First, there will be certain companies which will profit from the strategic re-allocation. For example, while the majority of semiconductors and telecommunication hardware was previously manufactured in Asia, we will likely see a large trend to bring the manufacturing of crucial telecommunications hardware and semiconductors back to the own territory.

Furthermore, there are entire industries which will profit from a strategic re-allocation which means that some industries are most likely better picks than others.

Pay attention to stocks within the security industry, companies which have pricing power, companies delivering solutions or raw materials needed for decarbonization, stocks with collateral-based cash flows, innovative companies, and companies which profit from the strategic realignment towards domestic manufacturing.

Second, the shift from globalization – which itself is disinflationary – towards a more regulated economy of competing economic power blocs will result in inflation. Overall, the economies today are less efficient than before. 

Investors shouldn’t underestimate how higher inflation will affect corporate profits.

What does this mean for investors? All recent trends – such as inflation, supply chain disruptions, concerns over violent crime, political and social divisions, cyberattacks – will reinforce populism, accelerate distrust in institutions, cause political uprisings and thus have a significant long-term and not to be underestimated economic and social impact. The extent of which is currently impossible to predict. Instead of being fully invested – the value investor should stay calm and invest carefully.

The Energy Transition

When we look into the future – next to the shift from globalization to power competition – we will see one major trend: the energy transition. 

KKR estimates in their Mid-Year Update 2022 ((Walk, Don’t Run: Mid-Year Update 2022. Henry H. Mcvey (16.06.2022). Retrieved on August 29, 2022, from: https://www.kkr.com/global-perspectives/publications/walk-dont-run-mid-year-update-2022)), that the energy transition will be a $1.5 – $2.0 trillion opportunity per year – with half of that spending going directly to decarbonization.

This opens a very interesting investment horizon, which KKR put into two categories: climate action and energy transportation.

Climate action:

• Solar
• Wind
• Batteries
• Storage
• Electric Vehicles
• Distributed Generation
• Energy Efficiency

Energy Transportation:

• Pipelines
• Power Grids
• Supply Chains
• etc.

Massive investments and capital re-allocations into the energy transition will most certainly also translate to an accelerated material demand and thus a large capex super cycle for raw materials and metals such as:

• Graphite, 
• Nickel, 
• Copper, 
• Zinc,
• Silicon, 
• Lithium,
• and Cobalt.

This demand could – in the current situation of multiple geopolitical conflicts – also turn into the weaponizations of critical components which are crucial for the energy transition.

For example: while Europe expressed their intention to replace Russian gas with green energy, they will see themselves in a similar dependence shortly. The bulk of mineral resources which are needed for the energy transition are currently sourced from Russia and China. 

The Fossil Fuel Dilemma

Overall, the energy transition is a massive re-allocation of capital which creates a dilemma for the fossil fuel industry.

Even though prices for fossil fuels are already high and expected to rise even further, the expected transition towards renewable energy is already massively limiting investments into fossil fuels. Investments in oil and gas are currently at only 60-70% of their historic norms. This in turn might well lead to a historic supply shock of fossil fuels – and thereby even more inflation in the energy sector.

With energy inflation in mind, it is not that important how high energy prices will go, but rather how long they will stay at heightened levels – as investment analyst Lyn Alden eloquently points out.

Why? Let’s assume that for whatever reason energy prices will double tomorrow, stay high for several weeks, and then quickly come down to previous levels. In this scenario, consumers would have a couple of unusually high energy bills but then get over it. However, if we assume that energy prices go up by 50% and then stay there for several years, this will have a compounding negative effect on the economy and household budgets.

The question we should ask ourselves is: What is – for our current economy – the “comfortable price” for oil and gas. Then, how high will oil and gas prices go – and for how long will they stay that high?

Lyn Alden used $60 as an historic “comfortable” price for a barrel of WTI crude oil. Many analysts – such as Morningstar – actually expect that we will return to low prices, and they expect them to remain low. These low figures are then used not only in the analysis of energy companies themselves (to project their revenues) but seemingly also in the analysis of non-energy companies which rely on oil and gas a resource – and thus as an expense.

As I am writing this, WTI crude oil is at $88 per barrel. This is even though the United States are actively selling oil from their strategic petroleum reserve into the market to stamp down prices, China still doing partial lockdowns, and the airline industry still consuming unusually low amounts of jet fuel. If we go into a severe recession, oil might indeed drop to $60 a barrel. But as a result of the above-mentioned decrease in oil and gas investment over the recent years, we are already seeing evidence that OPEC+ ((OPEC+ Spare Capacity is Insufficient Amid Global Energy Crisis. Bisn Interests. (15.10.2021). Retrieved on August 29, 2022, from: https://bisoninterests.com/content/f/opec-spare-capacity-is-insufficient-amid-global-energy-crisis)) does not have a lot of spare capacity left. With an insufficient oil supply, we might see much higher oil prices which will stay high.

Without trying to predict the peak of the oil price, investors should consider the real possibility of high oil prices which stay high for several years. This will have massive effects on all businesses which rely on energy and thus have energy as an expense.

Let’s also look at the natural gas prices in Europe. If we define 27 EUR / MWh as a comfortable price for the European economy. As I’m writing this, the price is at 199 EUR/ MWh. What happens to the European economy if the price declines to 50 or 75 EUR per MWh and stays there for many years?

High natural gas prices also have an impact on electricity price. Above comfortable gas and electricity prices would massively affect the competitiveness of European companies and thus most likely lead to a severe recession in Europe.

With this in mind, we must pay special attention to businesses which consume a lot of oil or gas as an energy resource for their production process.

Ask yourself:

• Can this business still compete in the world market, if the energy prices not only stay high for several months in 2022, but in fact stay above comfortably high throughout the next five years?
• How price elastic is the demand when the costs of higher energy input prices are passed on entirely to the customer?
• If the entire costs cannot be passed on entirely but only partially, what will the effect be on the profits, share price, and dividends of the business?

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Value or Growth?

In the current climate, choosing between value stocks and growth stocks is a two-edged sword. While the macro environment – we elaborated on inflation, recession, and stagflation risks – would predict that prices of growth stocks will unavoidably correct downwards, still we urgently need innovation to avoid a protracted stagflation.
In normal circumstances, repositioning one’s portfolio into value stocks would be the default option. However, due to the existing energy supply shock in Europe, investors have to check twice whether an undervalued European business is capable of surviving at all or a candidate for short selling.

Growth Stocks

On the one hand, innovation is the only way out of this extremely messy geopolitical situation. Western countries will bring back home all industries which they deem of importance for their national security. By the way, the same is true for Russia and China, who need to create their own intellectual property in critical areas such as semiconductors – fast. With an already existing labor shortage, these ambitions can only be realized with increased productivity and efficiency through innovation, automation, and also decentralization. There will be growth stocks profiting from this trend and by doing so, perform greatly.

The same applies to the ongoing energy transformation. Growth companies offering solutions and infrastructure for the energy transition, will continue to do good. The question we have to ask ourselves, to what extent this future outlook has already been priced into the stock price today.

On the other hand, the majority of growth stocks are currently valued based on ambitious growth targets. The problem is that should we enter a phase of stagflation, these growth targets can impossibly be met, which will lead to significant losses as the markets corrects the valuations of these growth stocks. Generally, big cap technology stocks will underperform in an era of rising interest rates.

Value Stocks

Value stocks have commonly the notion of being boring. While boring companies might not create the future, they do, however, produce what we need to live comfortably and safely today. This includes food, energy, housing, security, and even commodities which are required for food and energy production and the great energy transition.

It is best to pick among these companies those, which have pricing power or collateral-based cash flow.

But value investors must be aware as well:

• Companies with a large lower-wage workforce and limited pricing power,
• Companies which might have trouble passing on higher input costs (i.e., energy) to a small but powerful customer base
• Non-premium non-essential consumer goods and premium consumer goods. Inflation will force households to cut spending on nice-to-have goods.

5% Growth and 95% Value

Times are different. The stock portfolio of an active investor should – in my best judgment – contain majorly carefully analyzed and selected value stocks with a few handpicked growth companies which undoubtedly serve the market with crucial technology while being in a monopoly market position.

United States or Europe?

The short answer is: United States. While this has been the case historically everything looks like the U.S. economy is this time – again – better positioned for the future.

Would we solely use historic data and would we have to choose between one of the two markets to invest in, we would certainly choose the United States. Furthermore, this study has shown, historically the U.S. has been the better choice for the investors. The S&P 500 index outperformed the STOXX 600 Europe index with the average yearly returns of the S&P 500 index for holding periods between 1 and 11 years being on average more than twice as large when compared to the STOXX 600.

An old saying tells: it is hard to spot a recession in real time. I’d add that it is even harder to predict future recessions. However, when it comes to picking the U.S. economy over the European economy – or vice versa – there is one main factor which is so prominent that I’m confident to pick the U.S. over the European economy. This factor is energy.

Energy dependency and availability is the largest differentiator between the U.S. and the European economy. While the West (including the United States) commonly decided to wean itself off Russian oil and gas, it is mainly Europe who is carrying the consequences on its shoulder, given its reliance on Russia for roundabout 40% of its gas supplies.

What started as a self-imposed measure initiated by the West, with the intention to transition away from Russian gas and towards net-zero carbon emissions, turned by mid-2022 into the weaponizations of gas supplies by Russia. As I am writing this, both Nord Stream pipelines are destroyed and deliver no gas to Germany. Other pipelines deliver either nothing or a tiny fraction of previous levels. As I see it now, Europe is at an outright risk of a serious stagflation.

Three main factors are negatively impacting the growth perspective of European companies:

1. High energy prices reduce real incomes → Consumers spend less on other things
2. Uncertainty and reduced confidence over energy availability and long-term prices → Consumers reduce spending and businesses postpone or cancel investments into the European industry
3. Financial stress → Higher financing costs for businesses, households, and governments

In a scenario where Russian gas is no longer available to the EU, it will be pushed into a strong recession. If the mentioned factors lead to a significant loss of growth, the EU risks of entering an ugly phase of stagflation. Considering the substantial international economic relationships, a recession, or even stagflation would not stay in Europe but most likely spread out to the global economy. 

This is not as much the case in the United States. Even in a prolonged standoff scenario between the West and Russia, BlackRock estimated the impact on the U.S. at “still less than half the 1970s oil supply shock.” Consumers and companies will feel the economic impact of the energy shock, but it will be smaller than in the past and less dreadful than in Europe. The U.S. is a primary energy exporter and the U.S. economy is – in contrast to the European economy – starting with a strong growth momentum which originated before the oil and gas supply shock began.

As addressed earlier, the U.S. will still feel ripple effects should the European economy be pushed into recession as nearly 15% of U.S. exports went to the European Union (just over 270 billion USD in 2021) (( United States Census Bureau: Trade in Goods with European Union. (2022). Retrieved on August 29, 2022, from: https://www.census.gov/foreign-trade/balance/c0003.html)).

Now or Later?

An old lesson may still hold true: recessions are hard to spot in real time. Timing the market correctly is unbelievable hard, if not impossible. I think it is best to get rid of the idea that we can predict the best time to buy or sell. And don’t get frustrated by it. Even professional investors and “experts” are wishy-washy: some believe the United Stats is already in a recession, others think it’s heading there. Then there are other experts who state the United States will avoid a recession altogether.

The question therefore is not whether we can time the market, but rather if we should hold cash at all.

Given the difficulty of timing the market, the Schwab Center for Financial Research analyzed ((Does Market Timing Work? Schwab Center for Financial Research. (15.06.2021). Retrieved on August 29, 2022, from: https://www.schwab.com/learn/story/does-market-timing-work)) different investing styles to find out whether it is worth trying. It compared five different investment styles in a hypothetical portfolio with $2,000 invested annually from 2001-2020:

• Perfect Timing: investing each year at the lowest closing price,
• Investing Immediately: no strategy, simply investing on the first trading day of each year,
• Dollar Cost Averaging: investing the total sum in 12 equal portions at the beginning of each month, regardless of the stock price,
• Bad Timing: investing each year at the market peak,
• Staying in Cash: leaving money in cash, in the hope for better opportunities to get into the market.

The results speak for themselves. Staying in cash and delaying investing with the hope that there will come a better time to enter the market was – over time – worse than bad timing. Given how difficult it is to time the market, the best strategy is to simply invest straightaway or use a cost-averaging strategy.

But isn’t 2022 different? As we learned, things are indeed different today. While there are major risks which might trigger a recession or stagflation at one point or another, it is uncertain when exactly this is going to happen, if at all.

It is best to define one’s own strategy, for example:

• Investing 40% immediately in an index, a value portfolio, or attractive stock picks or portfolios according to the Value Dividend strategy,
• Investing 30% over the upcoming 12-months via dollar cost-averaging,
• Investing 30% as soon the market drops (i.e., >20%) or latest by a defined date (i.e., by the end of a quarter)

This way you get the best out of the different approaches with enough cash to average down.

One last point: cash does not equal cash. Especially with a potential stagflation in the Eurozone in mind, investors might consider holding foreign currencies, or as a hedge against stagflation gold. For example, one might prefer holding USD or Swiss franc instead of Euros. If one wants to stay liquid, one can also invest in digital gold, which can quickly be converted back to cash and then be invested in stocks.

Furthermore: if one would like to hedge against stagflation with gold, there are companies who allow you to cost-average with a gold savings plan. For example, in Germany Degussa is offering different gold saving plans.

Stock Picking?

Hopefully, towards the end of this book, you’re motivated to actively approach and design your own Value Dividend strategy to make the best out of this chaotic market environment.

The question is now whether you should invest in an index mutual fund or ETF, an actively managed fund, mimic a portfolio, or build your own Value Dividend portfolio by picking individual promising stocks.

As easy as it sounds, beating the market is harder than it sounds. The choice probably comes down to how much risk you’re willing to take to achieve a higher performance.

Let’s first take a look at the differences between these investment approaches.

1. Index Mutual Fund or Exchange-Traded Fund (ETF)

Index funds are designed to track and mimic the performance of a specific market benchmark – or “index” – as closely as possible. Instead of selecting which stocks or bonds the fund will hold, the fund’s manager simply buys all the stocks or bonds in the index it tracks. Overall, index funds have lower expenses and fees than actively managed funds.

2. Actively Managed Fund

While index funds mimic the market, actively managed funds try to actually beat the market with specific hand-selected stocks by a professional money manager who has access to deep research and expertise. However, as Vanguard calculated, over the past 15 years only 37% of actively managed funds outperformed their corresponding index – in other words 63% of all actively managed funds underperformed the market!

3. Mimicking a Portfolio

Instead of investing in a fund, it is possible to mimic the investment strategies of other individual or professional investors by tracking their investments and replicating the portfolios of these individuals by individually buying stocks held by the investor.

4. Creating a Portfolio

It is also possible to create your own portfolio either by screening the market according to pre-defined criteria and using the results as a portfolio, or by selecting the most promising stocks manually. For example, my study created three distinct portfolios by screening the market according to defined criteria such as a low price-to-book ratio and a high dividend yield or a dividend yield of zero.

From a cost perspective, it is the cheapest to invest in an index fund. Actively managed funds come with higher fees, which they use to pay for research, compensate the management, and of course expensive suits. As the name suggests, actively managed also means the portfolio managers may trade more often, which could lead to more taxable capital gains and thus making an actively managed fund less tax efficient. ETFs on the contrast don’t require much trading which make them more tax efficient. All three, ETFs, index funds, and actively managed funds come with fees which are oriented according to the total value of your holdings. Some passive ETFs charge less than 0.05% (some even 0.00%) while, according to a Morningstar Fund Fee Study published in 2020, the average actively managed fund charges an average of 0.66%.

If you create your own portfolio, you don’t pay a management fee. At least not directly. Indirectly the hypothetical management fee of your portfolios equals your invested time, possible subscription fees to research products, etcetera. Other than that, when you create your own portfolio you’ll mostly only pay commissions per trade – depending on the broker platform these could be $0, $10 or even $25 per trade. So, depending on your invested amount, the fees of your broker, and the frequency of your trades, picking and individually investing may be cheaper or in rare cases pricier than investing in a fund.

If you are reading this book, something within you might have sparked your interest to outperform and beat the market. However, be careful of overconfidence and all other human biases. If you have not the time nor expertise to actively create a value-dividend portfolio, I still believe that the best choice for most investors is a very low-cost S&P 500 or S&P 1500 index fund. In fact, this is precisely what Warren Buffett recommended when he wrote his 2013 annual letter in which re describes his instructions on how the trustee of his inheritance should invest the money: “My advice […]could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund”.

For me, investing is not an either or decision. Just because you invest in an index fund, it doesn’t mean you can also invest in individual stocks you like. Just because you follow a value strategy, it doesn’t mean you cannot also invest in selected growth stocks.

For example: One can invest, i.e., 90% of one’s portfolio into an index fund, and use the remaining 10% to invest in carefully selected value-dividend or growth stocks. It is up to you to decide the risk you are willing to take, how much time you want to invest, etcetera.