What could possibly bring together art dealers of the 19th and 20th centuries and equity buy-and-hold index investors?
The research work “Art Dealers: The Other Vincent van Gogh” by the Horizon Research Group answers the question.
The art of dealing with art
The Horizon team noticed that great art dealers, like Vincent Van Gogh, the uncle of the painter Vincent Van Gogh, tended to amass enormous fortunes. They did it despite the high unpredictability of their activity and their residual position in the art world.
How can art dealers choose so wisely to buy the paintings that will be considered good art 50 years or 100 years later? They don't. They just have good portfolio structuring.
They do not buy the individual paintings that turn into big successes. They buy portfolios of paintings (read the paper for examples of this). In the past, they did, in fact, index to the life and work of the painter. Monet, Picasso, Matisse, Cézanne themselves didn’t have any idea which of their paintings would turn out to be huge successes. The dealers also didn’t have to know that. They could buy an "index" of the painter.
The art of buying and holding
The other key point of their strategy is that they hold on to their investments.
Although today indexing is an in vogue idea, holding on to investments is not. In fact, it is common in the world of portfolio management that portfolios have 100% or more turnover ratios per year. But why is holding on to investments so important?
Horizon provides an example to illustrate this. Consider two portfolios, each divided in quintiles composed of n securities. The five quintiles for both portfolios will register the following rates of return: “20% will appreciate in a given year by 25%, 20% will appreciate by 15%, 20% will appreciate by 10%, 20% won’t appreciate at all, and 20% will decline by 10%. Let’s assume there’s a 10% stop-loss.”
The difference between portfolios is that in the first one, all securities are sold at the end of the years, and new ones are bought in the beginning of the next one. This registers the same rates of return as described above. The second portfolio holds on to all the securities purchased and also registers the same rates of return each year.
For the first portfolio:
“If one invested $200,000 in each quintile of this portfolio, and it were continued every year in the manner described, at the end of 25 years it would be worth $6,848,475.20. Over the course of 25 years, it would have an 8% compound annual rate of return, not counting taxes and assuming zero transaction costs.”
The authors call this “conventional compounding.”
For the second portfolio:
“Having the same quintile structure as the former, (…) will produce a value of $61,904,648. (…) would have a compound annual rate of return of 17.94% per year.”
The authors call this “static compounding." Even if one takes the 25% return quintile and turns it into a 9% rate-of-return quintile, the overall return for the 25 years is 9.94%, better that the 8% return from conventional compounding.
The much higher performance of the second portfolio comes from holding on to the investments, and specifically to its best performing quintile. As a result, over the years, that quintile will consistently increase its weight in the portfolio and contribute even more to the global return of the portfolio. In fact, over the long term the return of the portfolio will tend to converge to the highest performing individual constituent of the portfolio.
Conclusion
The authors concluded:
“The lesson for portfolio structuring, and I think for indexation and ETF structuring, is that you want to create an ETF that will have minimal turnover in time, and therefore will have the highest degree of probability of convergence on the best elements of that portfolio.”
