Its Not Harry

Comment and opinion for retail investors in the UK

Mark Potter

Is the UK in Europe for investors? Depends where you are sitting!

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Rant time:

I read a short article from a respected (US based but strong in the UK) research firm this morning suggesting European stocks were cheap, relatively (to what? the US as it turned out).  This is the sort of new item that gets recycled into the finance sections of the national media without too much, if any, further research.

I was curious to check out a specific fund listed as a good way of exploiting this apparent opportunity.  The fund (which I will not name as I don’t see it as being in any way useful to my readers) is effectively US run, although based notionally in Dublin.  It has 30% of its holdings in the UK and incidentally a surprisingly big block of supermarket stocks.

You need to know the perspective of your analysts and fund managers:  to a US investor, the UK is just part of the European investment universe.  You don’t need telling why that might not be the viewpoint of a Brit!

Have no doubt:  geographically filtered funds are best managed by people who come from, or who have at least absorbed over many years the culture of the market they are investing in.

Yes! It does work!

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NotHarry’s approach to portfolio design is backed up by observations in very elevated places!

Below is an extract from Morningstar’s website, published yesterday.  I have read and highly recommend Daniel Kahneman’s (and his colleague’s)  book ‘Thinking Fast and Slow’.  It will go down in history as a seminal publication and be used in all sorts of university courses in the future. 

I certainly bear in mind his analysis and research now.  But I am very pleased to say that my articles on this web site and my recommended use of multiple portfolios to meet client objectives long pre-date my reading of the Nobel Laureate’s work.  It confused compliance people no end as they like to think that a client with risk score ‘x’ gets portfolio ‘y’, not that people are complex psychological units who want multiple things, sometimes in conflict, and don’t like disappointment.  Here is the article:

‘Finding out how people tick is a vital part of the investment process, Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, told the 30th annual Morningstar Investment Conference in Chicago.

He had this advice for financial advisers hoping to steer clients towards reaching their investment goals: “You need to find out what the client’s dreams are, what their fears are. And when bad things happen, you need to be there to help people stay on course.”

Kahneman, speaking with Morningstar behavioural scientist Sarah Newcomb, said that in in investing, research on behavioural biases can be used for good or evil. In the worst case, these biases could be used to exploit clients. In the best case, they could help a client develop and implement their financial plan and potentially improve their outcome

The first step is to decide what’s in the client’s best interest, Kahneman said. Then the adviser needs to find some way to develop a “regret proof” policy – a policy someone can live with when things go badly. This reduces the chance that a client will capitulate at the wrong time and possibly move to another adviser.

Kahneman described a practice he had developed with colleagues to improve investor outcomes. First, the adviser would try to determine the client’s loss aversion to create a measure of projected regret.

“We try to have people imagine various scenarios. We ask them, at what point do you think you would want to bail out?” There are some differences, Kahneman says, but he has found that even extremely wealthy people are loss-averse.

Two-Part Portolios to Manage Risk

The next step was to run client portfolios in two parts. One portfolio holds the assets the client is willing to risk, and the other is a much more conservative portfolio comprising what the client wants to protect. The portfolios are managed separately and clients get the reports individually.

This is helpful for clients because no matter the market environment, one of the portfolios is likely doing well. Of course, financially, it’s one portfolio, but framing it as two separate accounts helps clients understand and tolerate the risks better, he explained.

Asset allocation, in many ways, is the easy part. Helping clients set reasonable goals and adhere to their plan is the difficult part; it requires having in-depth, sometimes personal conversations with client. One element of the process taking a comprehensive look at the client’s present and desired future outcome.

“Individuals tend to do very poorly guessing what stocks will do. Admitting you don’t know is a very healthy step, but this admission leaves you with a great deal to do,” he said.’

 

Going to extremes or sensible hedging?

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Introduction

I am working on constructing a low volatility example portfolio for the members’ part of the web site and this is taking a long time.  The reason is that it is currently very hard to find assets that are cheap and likely to be steady low volatility earners.  Updating my knowledge of what the big fund management groups are doing to get returns on their fixed income (bond) and absolute returns fund confirms that more and more ‘innovative’ methods are being used – not  a good sign!

A gloat

Over a period starting about 18 months and lasting 6 months until mid 2017 I was fighting a lone corner as the senior member of my then employer’s investment committee, resisting inclusion of the M&G Global Macro Bond fund as a heavy weighting in the firm’s lower risk portfolio models.  The advice to include it was coming from the form’s external investment advisers and was based on the recent strong performance and the undoubted reputation of the lead manager.  They produced vast amounts of backward looking data showing how it would have  done better than what I proposed, had what I proposed now been included 3 years ago (not very logical, you will realise).

My objections were several but basically that the fund was a straight bet on the ongoing appreciation of the US dollar versus Sterling.  The big negative impact that strong US growth and possibly inflation would represent made the fund high risk in my view.

I was persistent and ultimately no doubt rather unpopular but in fairness to the committee and its chairperson, they declined to used the fund.

In 2017 the fund lost over 4%, fell from 10th to 85th percentile in the sector (Source: Morningstar) and the current top 10 holdings are now rather different.

What’s to learn and where are the dangers?

I am not suggesting of course that I am any cleverer than the highly regarded manager of the above mentioned fund or that he did something ill advised.  That is not the point.  He may well have never expected any advisers to use his fund as a diversifier in a lower risk growth portfolio.  He only works to his published objectives.  My point is that the people who recommended it did not understand how the recent past performance arose and what the implications of that would be based on what economic and financial conditions were at the time we were reviewing the fund as a possible recommendation.

This is the point missed so often by portfolio designers.  I think it was J M Keynes who said that ‘when the facts change, I change my mind’. If an event that was great for your investment holdings has ended (eg a sharp change in relative currency values), it is naïve to assume that the same performance can be repeated – in fact there is more likely to be some claw back.

The dangers I am currently identifying is that even experienced fund managers with excellent past performance records are struggling to find assets that can make money after the overly long period of value increases in fixed income assets.  I read today that prior to the change of government in Italy, Italian government debt was paying a net negative real yield.  It has now turned positive.  The facts changed – Italy has an anti-euro government.  Some famous fund managers lost very large sums in their bond funds the week of that election result.

It is almost as if, if you invest in bonds, you are being asked to be a bank – lend your money at risk – but unlike a bank, you also pay the borrower a fee for making use of your money!  Bizarre and surely a danger signal?

It seems that fund mangers are, perhaps out of desperation,  investing heavily in derivatives of various sorts.  I looked at a newish Absolute Return Bond fund and the top holdings were ALL CDSs (Credit Default Swaps).  These featured heavily in the 2008 financial crisis, being a major contributor to the insolvency of the huge American insurer AIG.  They are a legitimate insurance element in diversified  portfolios and maybe some people actually want to buy a managed portfolio of CDSs.  But a fund branded as an Absolute Return bond fund will sound to most people like it is very cautious.  I think they would be disturbed to find out how it is constructed.

Not what is says on the label

One of my friend recently posted on Facebook that he had bothered to read the ingredients list in an Activa sugar free yoghurt and found a huge number of ‘unexpected’ additives.  Yet this product is advertised as being for a healthy life style.  What you are led to expect by marketing psychology may be very different to reality.  The Food Standards Agency has just made this point in a report.

The same applies to investments these days.  You often don’t get what you might expect.  If you don’t pay attention, your financial health is at risk!  Read the label, or in this case the fact sheets.

I would suggest people who are not comfortable with investment risk might actually do better not investing at all at the moment, or only a modest proportion of their available assets, but I will keep working on some other options.

Trumping the markets

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I would expect investors to be wondering if the very real negative outcome of the G7 economic summit and the sham positive outcome of the Kim/Trump summit will have any impact on investment markets.

The lightweight answer is that as usual short term reactions are not connected with logic, economics or reality.  Asian markets reportedly went up because the developments in North Korea are ‘positive’, when in fact nothing will change that influences the climate for business in the Far East.  Developed markets, the larger company elements of which are highly dependant on global trade, are treating a potentially serious interference factor in the global trade mechanisms as if it just won’t happen.

As I have commented before, trade tariffs, embargos and sanctions have very unpredictable results because of the complexity of world trade.  If you put petrol in your diesel car, nothing happens to start with.  I know this, because I have done it twice! 

But later on the car reacts and in the end, if you don’t clean out the diesel immediately, you will have a non-functioning engine and at least a damaged diesel injector pump that is very expensive to repair.

I think the lack of impact on global markets of the break down in the free trade consensus may be just as dangerous, even if nothing happens straight away.

As for North Korea – well it may be an exploitation opportunity for a few mainly US corporates at some future date, but I can think of many more interesting investment stories.

Ciao!

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As anyone who has holidayed in Italy knows, this little word can mean hello or goodbye and is widely used in other cultures too.

Recently Italian bond markets made the financial news and it was very much a quick hello and good bye.

The political situation in Italy looked all of a sudden to be very shaky and ‘spreads’ on Italian bonds or loan stocks shot up.  In fact there was moment when global stock markets started speculating about a new Eurozone crisis.

What does it mean when ‘spreads’ move up?  It means that the difference between the interest rate investors expect to be paid to lend to the country of Italy (in this case) and its institutions and businesses, relative to the rate they require to lend to say the UK or US or Germany,  move up to reflect perceived extra risk.

For example, say an Italian bank was offering a 5% return on a fixed term bond the last time it borrowed money from the money markets, but now no-one will buy the bond unless it pays 6%.  In that case the spread has gone up 1% or 100 bps (basis points), assuming all other countries are borrowing at the same price as before.

The change in Italy mattered a lot to some investors running bond funds.   Italy is large industrialised country with some great businesses (not just food, cars and wine!)  but it has not got  a great reputation for security and stable government and so bond fund investors have been happy to own Italian loan stocks and pick up a bit more return that reflects the lower credit quality than say Germany.  But imagine you bought Italian bonds at prices that on average are giving you a 4% return in total if held to maturity.   If spreads shoot up the market might want 6% or even 7% returns over the period during which you are going to have to wait for your bonds to mature.  That makes your bonds very unattractive and in fact their value as a tradeable asset will have fallen very significantly overnight.

In the end a new pro Euro government has been installed, albeit the first really different government in Europe since the Greeks rebelled against austerity.  Markets calmed down, but expect to be hearing more about Italy in the financial as well as the culinary media!