Tuesday, 5 June 2018

Equities Outperform Bonds?

As I now invest directly with Baillie Gifford, I received my glossy version of the Scottish Mortgage annual report which thumped on the doormat last week. SMT are one of the best performing investment trusts having grown net assets by 269% over the past decade compared to 150% for the FTSE All-World Index. Share price return is even more impressive and had I invested £10,000 of my pension fund in SMT when I retired 10 years back, it would now be worth £43,000.

SMT 10 Yr Chart

I am always fascinated to learn some insight into the approach of the managers and how they go about achieving this performance. One thing that caught my attention was their focus on the search for great companies and the methodology behind this search.

The joint managers, Anderson and Slater outline their core beliefs and how these have evolved over the past five years.

The fundamental attraction of investing in equities is the asymetric payoff structure - you can make far more if you're right about a stock than you can lose if you are wrong. The managers have long believed in the impact of holding a small number of exceptional companies. However they were surprised by how narrowly returns have been shown to extend within the market.

Recent research shows that over 50% of the excess return (over bonds) from equities came from a small percentage of the total market. The outsized return from less than 1 in 20 exceptional stocks dominate the payoff structure.

These exceptional performers include the likes of Apple, Microsoft, General Motors, Procter & Gamble, Coca Cola and Amazon

The core task of the managers therefore is to identify such companies at an early stage and then hold for an extended period. All of SMTs top ten holdings have been held for at least 5 years and two for more than a decade - Amazon & Kering.

The Research

I have dug a little deeper and see the research (pdf link) in question is Henrik Bessembinder's "Do Stocks Outperform Treasury Bills?"

The question may appear  nonsensical - every novice investor knows that equities provide a much better return than bonds over time. However the research established that 58% of stocks listed on the US market returned less than one-month Treasuries (equivalent to UK government bonds) and the entire outperformance over the 90 year period of 1926 to 2015 can be attributed to the best 4% of listed stocks.

Just 86 top performing stocks which together account for 0.3% of the total have delivered over half of the wealth creation. The top 1,000 stocks - just under 4% - account for all of the wealth creation and the other 96% have together generated a return which matches the one-month Treasury Bills.


The research helps us to understand why non-diversified portfolio are prone to the risk they will not contain the few stocks which generate the large returns. Active strategies which tend to be poorly diversified most often lead to underperformance.

So whilst overall stocks outperform Treasuries (bonds), most individual stocks don't. The positive stockmarket outperformance is down to a small percentage of stocks.

My Take

This research conducted in 2017 is based on the US markets but the principles will no doubt apply worldwide. Therefore to be sure to capture the returns provided by these handful of exceptional companies you need to hold the whole market i.e. index fund.

The alternative would be to engage a managed fund such as Scottish Mortgage which has the potential to identify these companies with some accuracy. If successful, this should be a winning strategy as the returns will not be held back by holding stocks which underperform.

I will continue to hedge my bets by holding my core Lifestrategy global index and also my actively managed satellites such as Scottish Mortgage.

Leave a comment below if you have any thoughts or suggestions relating to this research.


  1. Hi John, great food for thought.

    I remember listening to a Value Investing podcast where a PE firm talked about hearing from Google early on (if I recall the episode I'll let you know). There were literally thousands of companies near enough to identical to Google. Only Google became ... Google. So it seems to ensure we own the next GOOG then index level diversification is essential, unless we have some outlier skill to pick stocks. Looking at my own portfolio, most profitable stocks return between 0 and 30%. Most losses are between 0 and 30%. Probably 1 in 10 return 100% + and make most of the difference to the total return. Over time, I expect it might get even slimmer!

    1. Thanks Wf30...yes, a broadly diversified global index fund will be the only way to be sure of holding the small percentage of companies that will do the business over time. However this only applies when they become listed on the markets and I think what SMT (for example) try to do is provide support and funding for start-ups which they believe have potential. Seems their strategy is working so far. Of course the small private investor does not have access to invest directly before they are listed unless they are a wealthy business angel. So SMT is one way of doing this.

  2. That's a very interesting paper....
    One thing that does concern me about the "stick it all in the Vanguard World etf" approach proposed by some FI bloggers is that (apart from the massive downside risk, of course), you're only very slowly building a meaningful holding in these "Winner" companies as their market cap. and hence their index weighting increases; possibly great for skewing your returns a bit to the right but wouldn't it be better if you could try to overweight some of the big "Winners" at an earlier stage?
    I can really see the point of a whole market "core" to a portfolio's equity holdings, complemented by a fund like SMT (which you suggest in your post) to try to capture some of those early-stage Winners.

    1. Thanks Jo. The problem with active funds is they seem to have their time in the sun, attract more investors and at some point seem to fade away...the star manager leaves or loses his/her mojo etc. I have seen this several times over the past 25 yrs. I hope SMT can keep things going with the strategy they have employed so far to good effect.

      The index fund has no star manager and lower costs...and you are guaranteed to hold the outperformers which make up less than 5% of the market. You also hold the 95% of average holdings which apparently deliver no more than safer bonds.

      Plenty of food for thought for us small investors to mull over...