Comment and opinion for retail investors in the UK
Many elements of global stock markets are in genuine ‘correction’ territory (usually a definition of a 10% or greater set back from the last peak). Is that something we should worry about and do we need to take any immediate actions to re-organise our portfolios?
Spoiler alert, as they say, – no.
Not long back, I mentioned that Vanguard had announced that they would be offering multi-asset ESG (environment, social, governance) portfolios built using an actively managed approach, not something one would have expected, although I was aware that they were being criticised for the lack of ESG filtering of their main best sellers.
I initially and incorrecty assumed from the press release information that the products would be managed collections of ETFs (exchange traded index tracking shares), not direct holdings in individual businesses. That is the way the Vanguard Lifestrategy funds work.
I have now read a little more and the following may be of interest to readers who have ESG priorities when making investment calls. I have already written that there is indisputable evidence that more money is flowing into ESG filtered funds than the rest, and so all investors ought to take account of the obvious boost to the momentum factor.
A piece in today’s FT refers to investors suffering the 60/40 blues. It comments that the expected diversification benefit of adding a large chunk of fixed income securities to an equity portfolio just did not work in September and 60/40 porfolio investors suffered from both an equity sell off and rapidly rising gilt yields.
There is more of that today as the market focuses on rising energy prices. It would be a surprise, but not improbable, if the much anticipated end of cycle market sell off was driven by oil and gas prices. People of my age were used to talking about the energy crisis constantly in that late 70s (I had my moped fuel ration book in 1973/4) and we note the re-emergence of those two little words in media coverage.
As I have pointed out before, an increase in bond yields of 1% is not too dramatic if the rise is from 10%, but a rise from 0.5% to 2% is very dramatic for longer maturities. We are now witnessing the process live.
I have been writing for quite a while that owning a general mix of fixed income securities was not necessarily going to be useful in the next part of the global economic cycle. Some bond fund managers (tactical or speciality funds come to mind) may well still be able to offer some volatility control and even make a little money, but index trackers heavy on long dated gilts and US treasuries are going see their performance hammered.
Readers who have known me for a long time will know that I am sceptical of using fully invested multi-asset funds or portfolios to provide risk mitigation in the event of an unexpected (or even planned) large withdrawal from the investor’s capital base. I prefer reserving cash and accepting the negligible or even zero return on that money and compensating with more aggressive investment of the money that is highly unlikly to be needed after allowing for all contingencies.
Like all investment strategies, my proposition needs checking from time to time and I have been doing that.
For purposes of testing the assumption, I used the Vanguard Lifestrategy funds to represent the invested portfolio. In the first situation, I have assumed all the actually invested capital was in the Lifestrategy 100% equity option, but only 80% was invested, leaving 20% in cash (Option 1). In the alternative option, all of the money is invested but in the Vanguard 80% Lifestrategy fund (Option 2).
For simplicity, the total capital available is taken to be 100,000 Pounds. So for option one 80,000 Pounds is in the Vanguard fund and for option two it is the full 100,000 Pounds.
Using these funds allows me to extract real world rates of long term investment returns after fees and to get a widely accepted measure of potential losses, the 3 year standard deviation.
I have assumed returns continue on average at the same rate as over the last 5 years and that a major market setback sees losses equal to 2 standard deviations.
Of course, this is not going to predict the future or any actual set of events, but I think it is a valid base for modelling some scenarios. All the scenarios below look at the situation 3 years down the line.
The data extracted from Morningstar gives 5 year annualised returns and 3 year standard deviation numbers (doubled) of 11%/9.3% and 29%/24% for the Lifestrategy 100% and 80% funds respectively.
The capital remaining for Option 1 would be about GBP98000 but slightly more for Option 2 at about GBP99000
In this situation the higher returns on the 100% fund have not yet compensated for the sharper loss right at the start. After a couple more years of recovery, Option 1 would possibly be more profitable.
The capital remaining for Option 1 would be about GBP78000 but rather less for Option 2 at about GBP73000
In this case, the option to take the cash reserved as a contingency and leave the equities fully invested to recover is very beneficial. Option 2 sees the capital base severely depleted by the market loss and the simulatneous withdrawal
The capital remaining for Option 1 would be similar to the first scenario at about GBP98000 and also for Option 2 at about GBP99000. This is not surprising given that the main elements of the arithmetic are the same, just the order of events is different.
You may note that the returns from the 80% equity fund are more than 80% of the wholly equity fund, over the last 5 years. As cash has been assumed to have a zero yield in this case, that leaves Option 1 at a disdavantage from the start. The multi-asset fund has benefited from historic returns on its fixed income holding (the other 20%) while interest rates have been at record lows. That may not be the case in the near future – in fact I would think the fixed income holdings will be a drag on returns.
I accept of course that one would expect different outcomes with different cash proportions and amounts and timing of withdrawals but I see no point in running endless hypothestic scenarios. My objective was to see if there were any new reasons to stop holding cash to fund anticipated withdrawals and leave my invested portfolio with an aggressive market exposure. I have not discovered anything new.
In reality, I prefer the ‘three pots‘ strategy for people who, like me, need to take an income from their capital base but who know that you only make really good money by investing in global equities. The missing element in the simplified examples above is a portfolio allocation to low volatility assets that sit between deposit funds and the plain equity funds.
Mixing up the elements of the 3 ‘pots’ is a bit of an acquired skill! I do my best to pass it on to those who take my training sessions.
I have written before about my judgement that equity markets were overvalued at the end of 2019 never really getting tested because the advent of Covid-19 and the response of global governments (ie a huge stimulus of ‘free’ money) created a set of conditions that were way beyond the normal market cycle.
I have argued since that the flow of cheap money and one other factor that I have repeatedly mentioned, the arrival of novice retail traders with new technology at their disposal, has been propelling valuations along for equity shares and some new asset classes like crypto ‘currencies’ and their plethora of proxies.
I think we have seen enough since March 2020 to come to some new conclusions.
As inflation rears its head and there is talk of rising interest rates – see next article for some analysis of the direct impact of this – and the Covid crisis is becoming normalised in Western economies, perhaps we should consider the Covid deflection almost fully worked through? Certainly, we must be close to the end of ‘spend, invest and be merry for tomorrow never comes’ era for governments.
CFA UK is the professional body for investment managers – your scribe was awarded one of its qualifications in his younger life. It recently expressed some concerns about the impact on portfolio diversification of a long period of negative interest rates. It suggested advisers might want to look through the following checklist. If we take out the references to clients, it would be a good one for do-it-yourself investors to work through on their own account.
Are my client’s return expectations reasonable given the low expected future returns offered on many assets?
In light of the above, are my client’s current contributions (or savings) sufficient to meet their objectives?
Conversely, are some clients assuming too much risk in order to hunt for yield in a low return world? For example, are risks now higher than they were for traditional portfolios with high government bond weightings (my emphasis)?
When considering risk, what are the limitations of my risk model(s) in relation to the assets in which the portfolio is invested? Do they, for example, rely completely on historic correlation, volatility and drawdown data which may not hold in the future? How have I addressed those limitations, even if only qualitatively?
How long would it take to liquidate the client’s entire portfolio? How much would it cost do so? How do those figures compare with the past and is the level of exposure to illiquid assets still appropriate for the client’s needs?
As the hunt for yield continues, are my client advice and investment decisions accounting equally as much for the risk characteristics of a product/asset as its return potential?
I think the third paragraph is particularly relevant to those investors with passive multi-asset portfolios that are biased to fixed income stocks, like a Vanguard Lifestrategy 20% or 40% equity fund. The conventional risk control offered by owning long dated government bonds may well not hold good in the next few years