Going to extremes or sensible hedging?

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.