Watching and waiting – December 2015
FundCalibre director Clive Hale assesses the progress and effectiveness of the respective monetary easing programmes on either side of the Atlantic
There may be the beginnings of a musical in the title of this month’s column but there is no doubt that watching and waiting upon the US Federal Reserve is a whole song and a dance routine in itself. After all, it is widely accepted that there is very little doubt that almost everybody knows that the world’s major central banks are not going to let anything untoward happen to the markets.
This ‘belief’ began with the Greenspan ‘put’, which morphed seamlessly into the Bernanke ‘put’ and, until recently, was the Yellen ‘put’. The present chairwoman has had her work cut out to maintain the Fed’s credibility as Master of the Universe, but it does seem that, at long last, she is about to lay an egg and accede to the clamour to raise rates. Buried in the latest Federal Open Market Committee minutes was – significantly – the observation that any further delay in raising rates would damage the Fed’s credibility.
|"It would seem unwise to continue with more QE but central banker sagacity is a strange beast"
The recent data on employment – there are nearly 2,000 indices on the FRED (Federal Reserve Economic Data) website covering employment so there should be something there for all tastes – has been “strong” but, despite Rosy Scenario’s appearance, the most recent GDPNow number from the Atlanta Fed shows a decline in the growth rate for the fourth quarter of 2015.
First-quarter GDP in the US has been consistently low in recent years, as seasonal factors drag the number down, so we face the prospect of the Fed having to reduce rates again in the New Year. How embarrassing would that be? Still, at least US policymakers would have something to cut … Maybe that is the only reason to raise now but the belief in central bank omnipotence will be wearing pretty thin should that scenario come to pass.
Over in Europe, Dr Aghi is leaning in the opposite direction. His jawboning is legendary – in July 2012, he uttered the “whatever it takes” phrase, which galvanised the bond markets into believing he had their backs, and that belief is still in evidence. The Italian 10-year yield, which before that statement was standing at 6.5%, is now 1.4%. To put that into perspective US treasuries yield 2.2% and gilts 1.8%.
The ECB’s December meeting saw a further round of monetary easing. One might wonder why this is necessary having already put aside in excess of €1 trillion (£723bn) to buy up European debt. Quite simply, the answer is … QE does not work – or certainly not in the way intended, which was to get the money supply moving again by persuading the banks to lend to businesses and so kick-start the economic growth engine. There has been some tepid growth in issuance but demand has been lukewarm too – mainly as a result of euro austerity as preached by Germany and imposed on the unwilling by the ECB and the EU commission.
It would seem unwise to continue with more QE but central banker sagacity is a strange beast. Draghi has extended the initial QE period by a further six months and reduced interest rates on bank deposits at the ECB to minus 0.3%. Quite why an additional cut of 10 basis points should make the banks keener to lend we find hard to comprehend. What is really needed is an end to austerity. Lower tax rates could very conceivably bring about higher growth rates and, in turn, a higher overall tax take.
The European economy desperately needs a boost with employment across the euro area averaging 10.8% – although it is less than half that in Germany (4.5%) and nearly twice that in Spain (21.2%). In Germany, wage growth has continued unabated for the last 10 years whereas in Spain it has been flat. Any improvement in the Spanish economy has come as a result of ‘labour’ taking a hit.
European markets are not expensive, but we would prefer to see if the fiscal stimulus Draghi is hoping for actually arrives before adding to positions. Still, if you are of a mind to use any further weakness to add to European weightings then the following FundCalibre Elite-rated funds are worth considering – the BlackRock trio of Continental European, European Income and European Dynamic, the Henderson pair of European Focus and European Selected Opportunities, Jupiter European Special Situations and, finally, Threadneedle European Select.
FundCalibre is a direct-to-consumer funds website and ratings business
Oh-oh seven – November 2015
Clive Hale, a partner at Albemarle Street Partners, finds not a quantum of solace in the spectre of what an error by central bankers could mean for market volatility
Bond has been on my mind a lot of late but, unlike many people, it is not the Daniel Craig film but the horror movie – or perhaps the comedy of errors – that is the fixed income sector I have been watching through my fingers. This world is not full of fast cars and vodka martinis – well, perhaps for a few of the fund managers it might be – but the rather more mundane considerations of duration, liquidity and the direction and timing of interest moves.
The numbers of actors who have played 007 on-screen may be growing but it has nothing on the fixed income cast-list. In the three most popular Investment Association bond sectors – Sterling Corporate Bond, Sterling Strategic Bond and Global Bonds – the listed funds align themselves to a total of 70 different indices and benchmarks, with more than a few declining to follow any benchmark at all.
|"With global GDP still anaemic at best, how far can equity multiples be pushed until it is finally spotted the emperor is lacking in the clothing department?"
The huge range of strategies on offer even within those three fund groupings makes it very difficult to say who has done a decent job. Such is the variety of ways to make – and lose – money in bonds, many investors have settled on using ‘strategic’ funds on the heroic assumption their managers will know what is going on at the ECB, BoE, BoJ, SNB and others and position their portfolios accordingly.
And yes, I deliberately omitted the Fed from that list on the basis barely anyone – including most of the FOMC members – has a clue what is going on there. US policymakers seem to be saying rates should be going up and yet, at the ECB, Mario Draghi has threatened they might actually be about to go down …
But why in fact do we need to invest in bonds at all? A lot of them have negative real yields and the attraction of the high-yield sector is on the wane as defaults inevitably start to rise. Yields are also on the up there, of course, but that should be taken as a warning not a magnet.
Over the past 35 years or so, the bond bull market has been the only game in town and, looking at the chart to the right, it may still be. The asset class posted its most recent all-time high in September – so no sign of a bear market … or at least not yet. Over the same time period, portfolio construction has been in thrall to modern portfolio theory and mean variance optimisation. Bonds, based on their historical long-term track record, are deemed to be less volatile and hence less risky than equities so exponents of mean variance optimisation will tell you an allocation of 60% to bonds and 40% to equities will be a nice and cosy low-risk strategy.
Yet that assumes bond and equity returns will behave in the same way they have done for the last 35 years, which seems ever so slightly unlikely, does it not? The current seven-year forecasts for real returns from US large cap equity and US bonds suggested by GMO, for example, are minus 0.6% and minus 1.1%. Stick that in your mean variance optimiser and see what comes out of the sausage machine …
Now, GMO suffers from the same problem as the rest of us – we are all fallible when it comes to forecasting, but the point with modern portfolio theory is that a small change in your assumptions can make a disproportionate difference to the asset allocation you end up with. GMO’s three highest forecasts are for emerging market equity, emerging market debt and timber – an interesting sort of a portfolio that would cause a certain amount of indigestion for the ‘Modernistas’. The long-term historical US equity return may be 6.5% but, in our monetary policy-constrained, experimental world that seems a far-off realisation too.
Liquidity received a mention in the opening paragraph and there is no doubt it could be an almighty problem one fine day. If that comes to pass, it will not be just the bond giants and their investors who will suffer, it will be all the bond funds – large and small. How long would any dislocation last? If it is a ‘flash crash’, high-frequency trading-type event, maybe not very long. If it is based on the perception rates are going up for some time and to levels that only five years ago were deemed ‘normal’, then probably a lot longer than most investors can stay solvent.
Those who were early to eschew bond world used cash as their proxy but, in a negative real rate environment – and one that looks like getting worse before it gets better – we need to look elsewhere. In short, we need ‘alternatives’. Along with ‘hedge fund’ and ‘derivatives, that word does not always receive a good press – ‘Too difficult for the end-investor to understand’, as the refrain often runs. But they will understand all right on the day their 60% allocation to bonds is found wanting …
While we wait for the Fed to make up its mind on whether or not to raise interest rates in December, we also need to contemplate negative nominal rates in Europe, which is one way Draghi could force the banks to use their reserves more effectively. He would hope for them to make more loans to businesses but it is just as likely the money will move into the asset markets.
With global GDP still anaemic at best – the CEO of Danish shipping giant Maersk has said the IMF’s forecasts of growth are far too optimistic – how far can equity multiples be pushed until it is finally spotted the emperor is lacking in the clothing department? A mistake on interest rates either way could usher in the ‘Spectre’ of significant market volatility in both bonds and equities – the scenario that, in their infinite wisdom, the central banks are trying so desperately to avoid.
The tune is familiar
Make a list of all the factors that preceded the last financial crisis and, says FundCalibre director Clive Hale, it is starting to feel like déjà vu all over again
It is not totally clear that Mark Twain ever penned the aphorism so often attributed to him – that history does not repeat itself, although it does rhyme – so let’s kick off with a different well-worn cliché that he definitely did not write. It is starting to feel like déjà vu all over again.
The financial crisis, from which – depending on the talking head who happens to be speaking – either we are recovering or we have recovered, was preceded by increasing levels of corporate malfeasance, an ever-burgeoning level of debt, a laissez-faire attitude to problems of global conflict, stockmarket exuberance, some serious financial complexity and supreme central bank indifference. Remember the then Fed chairman Ben Bernanke averring that “the subprime crisis has been contained” and “there is no bubble in the housing market”?
|"The economic data is all over the place so the bulls and bears practise selective hearing. It was ever thus."
And so today, for example, we have Volkswagen owning up – though only after being prodded with a very sharp stick – to a quite staggering disregard for corporate governance. The company’s now ex-CEO “knew nothing” and, while the EC in Europe and DEFRA in the UK knew something, they did not tell and thus one of the most trusted and revered names in the auto industry is now dust – and dust that is a very long way from settling.
The potential fines, penalties and costs associated with recalling 11 million Passats, Jettas and the rest – let alone the class actions that will be legion – will pale into relative insignificance when set alongside the damage done to the German auto industry and the diesel brigade across the world (are VW really the only culprits?) and the knock-on effects to the economies at large. If US and Japanese manufacturers of – predominantly petrol-powered – cars had had anything to do with pointing the finger, they might now be pondering the wisdom of the admonition ‘Be careful what you wish for’.
If that were not enough, the mining conglomerate Glencore may also be teetering on the brink – if only to judge by the rise in its credit default swap price from €140 (£104) last October to above €700 now and the continuing destruction of its share price. Glencore, a company not wholly unaccustomed to controversy, acquired Xstrata in 2012, becoming one of the world’s largest mining and commodity broking organisations. It controls more than 50% of trading in the global copper market along with similarly strategic positions in many other commodities.
The company’s precarious financial position is of concern given the huge turnover in commodity futures where it performs the counterparty role for a significant proportion of trades. A failure here would have severe financial repercussions and has already been dubbed ‘Lehman 2’ in the making in some of the more excitable corners of the trading floors and the media.
If the financial crisis was caused by too much debt, then the fact there is a lot more debt in issuance globally than back in 2007 is not hugely comforting. The central banks’ penchant for QE has hoovered up a lot of this issuance but over-regulation – to prevent such a financial crisis ever happening again (the regulator’s perpetual refrain) – has reduced bond market liquidity to a fraction of its former self.
That is just fine when everyone wants to buy the latest high-yield tranche – if you remember, we used to call this ‘junk’ – but when it is time to pay the ferryman there will be precious little ‘coin’ to be had as today’s adequately-sized exit door will shrink to the size a cat-flap. With China now exporting deflation that may not happen for a while yet, but it is undoubtedly bubbling away – and not quietly.
And talking of liquidity, there is not much of it in the equity markets either. Since the financial crisis, the S&P index, for one, has risen inexorably on declining volumes – and a major percentage of that volume is in the hands of ‘high-frequency traders’. These are the clever electronic trading platforms that supply lots of additional liquidity to markets – equities as a well as bonds and derivatives – so they must be a jolly good thing, yes?
Well, they certainly think so but then they would, wouldn’t they? The whole high-frequency trading arena is shrouded in mystery as far as most people are concerned, including many investment managers whose attitude is: “If they are shaving the odd penny off price quotes, then that’s the cost of doing business isn’t it?”
But on 24 August, the Monday morning when the recent ‘correction’ began, many exchange-traded funds (ETFs) could not be priced. As stock prices traded outside normal limits, the gyrations caused by the consequent trading halts triggered for high-frequency traders meant that close to half the stocks on the New York Stock Exchange did not have an opening price.
The high-frequency traders helpfully came up with a solution, simply suggesting ETFs should not price on a minute-by-minute basis – one of the major attractions over buying funds that only price daily. A better solution might be to ban high-frequency trading or at least put everyone back on a level playing field – but don’t hold your breath waiting for the regulators to wake up to what is going on. One high-frequency trader proudly announced 24 August was its most profitable trading day ever … now, remind me of the definition of ‘hubris’?
The central banks still believe in divine intervention and, given the number of occasions recently when markets have slumped at the opening only to claw their way back into the green by the close, the Federal Reserve ‘put’ is still very much in play. Much was made of the in/out ‘hokey cokey’ over raising US interest rates and Janet Yellen has not left the dancefloor with her reputation enhanced. To be fair, her job is not an easy one as there have been a number of conflicting comments on the direction of rates from her fellow FOMC members.
Meanwhile, back in the UK, Bank of England governor Mark Carney has appointed himself in charge of the global climate debate – perhaps to take our minds off the fact that he, like Yellen, has not overseen a rate rise since taking office. The economic data is all over the place – for every positive item, there is a negative number to choose from – so the bulls and bears practise selective hearing. It was ever thus.
As for global conflict, there is an abundance of trouble wherever you look. The only reason I am pleased to be back from gloriously warm Cyprus is that it lies a mere 60 miles off the coast of Syria. The building tensions there could beget some serious ‘fallout’. The oil market shenanigans, arguably caused by the Saudis’ desire to blunt the US frackers, have also inconvenienced the Russian bear and Putin is never one to take things lying down. Teaming up with the Iranians, however, was not part of the Washington script.
So what are we to make of the current market gyrations? There is much talk of value being spotted but, unlike previous ‘buy the dip’ episodes where the recovery to new highs was marked in days, we are now some six weeks into new territory. This is a new pattern that could still resolve higher but – to end with a less clichéd cliché than we began – as Chairman Mao’s foreign minister Chou En Lai observed when asked what effect the French revolution had on the development of socialism: “It is much too early to tell.”
FundCalibreis a direct-to-consumer funds website and ratings business
Bear in a China shop
FundCalibre director Clive Hale considers various explanations for the recent market volatility and, looking at where we go from here, suggests bonds may still have one final hurrah left in them
The traditionally quiet month of August, when all good City folk should be sunning themselves on the Riviera, this year exploded into action. Now that we have high-frequency traders running the show, allegedly supplying liquidity – which must be one of the biggest jokes perpetrated on a largely unsuspecting investment community – volatility has been eye-watering.
From 24 to 28 August, for example, the Dow Jones Industrial Average moved up and down by a total of 5,612 points and it has been the same story in commodities – most notably oil, where Brent crude started that week around $46 a barrel, got down as low as $42 and then traded above $50. For their part, bond markets – usually seen as a safe haven when things go a bit ‘awry’ – have also been in the eye of the volatility storm. The 10-year US Treasury yield fell below 2% to 1.9% on the Monday morning, but by Friday it was as high as 2.2%.
What on earth is going on? The explanations are legion – Chinese devaluation, Chinese economy, Chinese stockmarket … though not according to China. Oh no – as far as policymakers there were concerned it was about interest rate speculation in the US and the inability of the Fed to articulate its intentions without the customary obfuscation. Quite so …
The commodity complex has been quietly imploding for some time. Punditry is of the opinion that lower commodity prices – particularly oil and the industrial metals – would be good for increased economic growth, which of course it would be if only there were any. Commodity prices rise as a result of growth, not the other way around – proven in reverse by the continuing decline of prices as news slowly leaks out of a slowing Chinese economy.
Yet all of this is relatively old news so why the mayhem in the equity markets? Well, as ever, it seems it is all down to the inability of homo sapiens to act rationally, which is a huge problem for economists as they assume rationality as a given – otherwise their models do not work. Once the creeping doubt, of which we have had much of late, translates into a ‘significant market move’, the herd mentality kicks in and up and down we go. The press then goes on the rampage searching for ‘the trigger’ when all the time it was ‘us’!
After a sharp fall – in four days the UK index dropped almost 12% from 6,526 to 5,768 – we could expect a rally. And indeed we have had one – a bounce of some 8% since the low. What happens next is crucial. Are there still doubters out there? Or will ‘rationality’ prevail? Is it rational, for example, to insist ‘nothing has changed’ so the bull market can continue?
The topping action of the major indices, in particular the S&P500, suggests otherwise. This distribution pattern when the market transfers stock from strong hands, who have ridden the bull for some time to the latecomers, who are now keen to get on board, is characterised by a rounded pattern that eventually gives way – which it has.
A second bearish signal is that the 50-day moving average has crossed below the 200-day moving average – both of which are now falling. One swallow does not make a summer (even if we could do with one before September is out) but, without some more significant central bank manipulation – capitulation on interest rate rises through to more QE, the efficacy of which is very much open to question – we can, at best, expect markets to go nowhere with regular bouts of volatility to maintain the apprehension. A move below the recent low at 5,768 would suggest a lot more downside – eventually testing 5,000.
Although there was some volatility in sovereign yields, the ‘risk-off’ bond sectors all did pretty well in August as did the Targeted Absolute Return brigade, where only one unfortunate manager in the Investment Association fund grouping performed worse than the UK equity index.
With the Chinese devaluation effectively exporting deflation to the West, bonds may still have one final hurrah. For consideration in this sector are AXA Sterling Credit Short Duration, Baillie Gifford Corporate Bond, Baillie Gifford High Yield Bond, Fidelity Strategic Bond, Jupiter Strategic Bond and Kames Investment Grade Bond, all of which are Elite-rated by FundCalibre.
FundCalibreis a direct-to-consumer funds website and ratings business
It is summer and everyone seems to be out enjoying the sunshine – the trouble is, says FundCalibre director Clive Hale, Greece has not been fixed, the Fed is in a fix and gold is being ‘fixed’
It is August – the month when even the Eurocrats take a break. As such, the illusion that Greece is fixed is maintained but here are some assumptions, dangerous or otherwise, courtesy of Mish Shedlock’s Global Economic Trend Analysis site:
* The current total accumulated bail-out for Greece is €326bn (£233bn);
* Greek GDP will remain at €216bn;
* The interest rate on the bailout will be 0%;
* Greece can immediately achieve a surplus of 3% of GDP;
* Greece will hold that 3% surplus for as long as it takes to pay back €326bn; and
* Every penny of Greek debt surplus will go to pay back creditors.
|"For now, enjoy the sunshine and hope the ECB deploys its €1 trillion treasure chest to good use."
Now let’s allow Shedlock to do the maths: “Three per cent of €216bn is €6.48 bn. At €6.48bn per year, it would take Greece 50 years to pay back €326bn. But none of those assumptions is true. The interest rate will be small, but it likely won't be zero. Greece won't come close to a 3% surplus. 100% of the surplus won't go to the creditors. The only possible favourable condition in the mix is GDP. Greek GDP will eventually rise above €216bn, but that will take years. In the meantime, interest expense accrues, adding to the total amount that needs to be paid back. At 1% of GDP (€2.16 bn per year), it would take 150 years.”
It cannot work, can it? No. But, for now, enjoy the sunshine and hope that the ECB deploys its €1 trillion treasure chest to good use. The chart below shows just how effective goosing the US Federal Reserve’s balance sheet has been for the S&P 500. Could it be the same for euroland? Jupiter European, BlackRock European Dynamic and T. Rowe Price European Smaller Companies have all benefited from taking that view and should be in the vanguard if European equities continue to be favoured.
Note how, as the Fed has tapered and then called a halt to QE, the S&P 500 has followed a similar trajectory. A reduction in the Fed balance sheet would not bode well would it? And if policymakers raise rates any time soon, then that is just another form of tightening with potentially the same result.
On a cyclically-adjusted price/earnings ratio of 26.3x, the US market is higher than it has ever been – other than in 1929 (27.3x) and early 2000 (43.0x). That is not to say it could not go on to emulate the dot com boom, which only got going in 1996 when the price/earnings ratio was the same as it is today – the dénouement, of course, coming four years later. So is there another four years left in this bull market? If you think so – and many do – then have a look at Brown Advisory US Flexible Equity and Legg Mason ClearBridge US Aggressive Growth.
Meanwhile, what is happening to gold? Nobody with any degree of price sensitivity – distressed seller or not – would look to put in an order to sell more than $1bn (£642bn) of gold in the overnight market, and yet that is exactly what happened on 20 July, for example, and there have been similar occurrences every month this year.
There is unprecedented demand for physical gold. The futures market is in ‘backwardation’ – that is, when the spot or cash price of a commodity is higher than the forward price – and yet the paper market keeps getting smashed while short positions are at a record high. The sums involved are breath-taking. Is gold the canary in the coal mine? Maybe the following passage will give pause for thought:
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods.
“The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.”
The author of this passage? Alan Greenspan in 1966. With China accumulating gold as fast as possible and with Shanghai fast becoming the global trading centre for the barbarous relic the “statists” option of making it illegal to hold gold is receding just as fast. As history has repeatedly shown, gold remains the only sensible currency.
FundCalibre is a direct-to-consumer funds website and ratings business
Liquidity is not just an issue for bond managers, says FundCalibre director Clive Hale, but that does not mean advisers are short of potential fund options, particularly from some of the smaller investment houses
Now that markets around the world – both equity and bond – have had a fit of the vapours, liquidity has become a serious talking point rather than an academic issue. It has been compounded by the herd-like instinct of investors to troop into the largest and hitherto best-performing funds. It seems they do so without considering that, by inflating the golden goose, their chances of ‘super profits’ are greatly diminished – especially if they all head for the exit at the first cry of ‘Fire!’
One bond fund manager suggested to me recently that the liquidity analogy about getting out of a burning theatre through a small exit door has taken on a new twist. Should you even get as far as the door, it will not be enough just to walk through it – you still have to convince someone on the outside to swap places with you.
|"If advisers are required to judge the suitability of their investment advice to their clients, is it not incumbent on the fund managers to provide guidance too?"
In that event, he said, he would not be surprised to see some funds ‘gated’ – that is, closed for dealing for a period of time until liquidity returns – as we have see happen with property funds in the past. Let’s not forget either the liquidity issues in that sector too – although at the moment the money is flowing in and the main issue for managers is finding sufficient investable properties to satisfy the demand. That will not always be the case …
If investors were rational – if only – they would let the fund manager make the decision about how to position the bond exposure, but even this gets trickier as the fund grows in size. The larger a bond fund becomes, the more holdings it has to have to maintain even a semblance of liquidity – and so it starts to resemble the market and performance drops off accordingly.
These funds can no longer have as many, if any, high-conviction bets – no matter that this was probably the reason people started investing in them in the first place. Still, there is no need to follow the herd if you are prepared to do your homework. Brown Shipley Corporate Bond, run by the inimitable Kevin Doran, and the relatively new, TwentyFour Corporate Bond, in the very capable hands of Chris Bowie, are well worth a look.
Both are of a size where liquidity is nothing like the issue it is for some of the megaliths in the sector – though that is not to suggest they do not spend a lot of time thinking about it as they construct their portfolios. Meanwhile Baillie Gifford Corporate Bond – Elite-rated by FundCalibre – is another candidate that is still relatively small and does a superb job in evaluating the credit risk of its holdings.
It is not just in bond world that liquidity is an issue – small-cap funds arguably have greater problems and many of the more popular ones are already closed to new business. Liontrust UK Smaller Companies is Elite-rated and has yet to reach a size where liquidity is a significant problem. In bond world, market-making capacity has shrunk dramatically since the change in rules and regulations after the financial crisis, bringing with them many unintended consequences, of which a lack of liquidity is one. With small-caps, the market-makers are still alive and kicking, there is just not enough stock to go around – we are talking small-cap equities after all …
In both sectors, an alternative strategy would be closed-ended funds – that is, investment trusts. From the fund managers’ perspective, they do not have to worry about liquidity in the fund as they will not have redemptions to deal with – meaning they can hold illiquid bond or small-cap positions and let them ride through market cycles. The issues of fund closure and gating go away too. For the buyer, however, liquidity still raises its head. In this case, the issue is being able to acquire sufficient stock in the first place, in the secondary market, without pushing the price to a premium to net asset value – or selling at a large discount, for that matter.
Another ‘thought du jour’ is whether fund managers should make comments about the suitability of their funds – for the retail investor in particular – when market conditions and/or liquidity make their particular style or size of fund ‘unsuitable’. Having been around the block more times than most investors, I am a great fan of ‘caveat emptor’ but, regrettably, that is no longer politically correct.
With my compliance hat on, therefore, I have to ask – if advisers are required to judge the suitability of their investment advice to their clients, is it not incumbent on the fund managers to provide guidance too? If not, why not, I wonder? We cannot depend on risk ratings or volatility numbers or performance, for goodness sake – though that is still the first port of call for many – as these are all backward-looking and will inevitably fail investors just at the time when they would be most needed.
Not surprisingly, some managers who are prepared to wear their hearts on their sleeves include a number of the minnows. Coram, where Martin Gray and James Sullivan have set up shop, is one such and has a range of funds positioned in line with their views that markets are generally very expensive but still offer some pockets of value. Nor are they averse to holding cash if even those attractive valuations go away.
Another newcomer is the VT Price Value Portfolio, run by Tim Price, who sleeps with a copy of Graham and Dodd under his pillow, along with Killian Connolly, who has Warren Buffett’s autobiography under his! They aim to invest 70% of the fund with value managers who meet their criteria of low price-to-book ratios, among other commendable value metrics, with the balance in investment holding companies – again with low price-to-book ratios and high potential earnings growth. That they are able to find such managers and stocks is very encouraging for investors with a timeframe to reap the benefits. After all, as GMO’s Jeremy Grantham is fond of saying: “Value managers are never wrong, just early.”
By no means a minnow any more, Schroder MM Diversity, which is Elite-rated by FundCalibre, is prepared to take defensive positions when the manager deems it appropriate – as is the case currently. And of course there is also the absolute return community, with the FundCalibre Elite-rated Church House Tenax, Premier Defensive and Old Mutual Global Equity Absolute Return funds, along with the newly launched Aviva AIMS Target Return and Income offerings, all playing their part and aiming to preserve investors capital as their main criteria.
FundCalibre is a direct-to-consumer funds website and ratings business
With some bonds starting to look more like speculation than investment, says FundCalibre director Clive Hale, Target Absolute Return funds have an increasingly important part to play in portfolio construction
“We should get used to periods of higher volatility,” ECB boss Mario Draghi observed at a press briefing at the start of June. “At very low levels of interest rates, asset prices tend to show higher volatility.” And the bond market swooned. Well blow me down – I thought they taught this stuff at school. It just goes to show that when momentum is your friend and markets appear to be a one-way bet, all rational thought goes out of the window.
|"It just goes to show that when momentum is your friend and markets appear to be a one-way bet, all rational thought goes out of the window."
Bond maths is baffling for most of us, but it is still fairly obvious that a 100 basis-point move from 1% to 2% is going to cost you a lot more than one from 9% to 10%. 10% bond yields? Oh, those were the days – along, of course, with double-digit inflation …
Draghi is merely pointing out the blindingly obvious and, while it is just as well that someone has, it is a touch ironic it was him. But then bond world hangs onto his every word – all very reminiscent of that past eminence grise Alan Greenspan – another of the central bank bubble blowers.
The move from a low of 0.05% in yield for the German 10-year bund to the current 0.88% represents an 8% loss for bond holders. Such a short-term move in equity prices often comes with the territory, but such is the asymmetric risk for bonds – with repayment at par, the upside recovery is constrained – that this is starting to grow very painful indeed. The longer the duration, the more painful it gets and, as the chart to the right shows, German 30-year losses are around 20%. Ouch!
So far, and especially in the eurozone, the fall-out has in the main been limited to sovereign debt and has not reached out into corporates and high yield – partly because the euphoria following the ECB’s QE announcement did not affect those sectors. However the volatility in bond world is such that the message is ‘Beware!’ – if sovereign yields continue to rise, there will most certainly be a knock-on effect further down the food chain that will be exacerbated by the shrinking of liquidity in these markets.
Ben Graham had this to say about the definition of investment: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” He was in all probability referring to equities but it might give bond ‘investors’ pause for thought if they consider that, by Graham’s definition, what they are currently dealing in is pretty ‘speculative’.
So what is an investor (with no inverted commas) to do? Alternatives abound, but we are not talking about fine wine or works of art where prices are even more ludicrous. The IA Target Absolute Return sector is beginning to throw up some interesting candidates.
Many funds in this sector are targeting equity-like returns with much lower volatility. They do this in the main by employing a number of non-correlating strategies. This does not make them totally immune to sudden changes in market direction but it does help in that all their trades will not be facing the same way. Their losers will in the main be balanced out by their winners.
At the lower end of the volatility scale we have Premier Defensive Growth, managed by Paul Smith, and the Church House Investments Tenax offering managed by James Mahon and Jeremy Wharton. All three managers are acutely aware of the need for preservation of capital and follow a multi-asset approach.
Further up the risk spectrum come Old Mutual Global Equity Absolute Return, managed by Ian Heslop, Smith & Williamson Enterprise, run by Rupert Fleming, and Henderson UK Absolute Return, run by Luke Newman. As their names suggest, these are more equity-oriented funds although managed with an absolute return mind-set. They target higher returns than the multi-asset funds over the longer term and there will be periods of drawdown. All these funds are Elite-rated by FundCalibre.
As an alternative to those ‘speculative’ bonds, Target Absolute Return funds now have an important part to play in portfolio construction.
FundCalibre is a direct-to-consumer funds website and ratings business
Have we lost our way?
It is time to stop putting numbers on portfolios and return instead to understanding what the fund manager is about and explaining that to investors, argues Clive Hale, a director of FundCalibre
As an industry we seem to have forgotten our roots and have instead become obsessed with trying to manage risk by hijacking mathematical models that can never accurately map the emotional investment landscape. Risk is all about losing money and, whether we like it or not, the attributes attached to that outcome are almost entirely emotional.
Just ask investors in a ‘cautious’ fund, with a high weighting to supposedly ‘safe’ low volatility bond funds, populated with alleged triple AAA-rated paper, after the Lehman bust, how they felt. As a result, the regulator embarked on a series of heart-searching exercises that culminated in the Retail Distribution Review and so the quest for suitability and a formula for determining portfolio risk began.
|"Measuring risk using historic volatility can only be used as the most basic of guidelines and should not be the main or only input into constructing a portfolio."
Modern portfolio theory (MPT), on which a great number of ‘risk’-based portfolios are managed, was the brainchild of Harry Markowitz and came into existence over 50 years ago – so perhaps it is not so modern after all Although human emotions have remained the same – and were way before Markowitz’s time – markets have moved on. We now have more asset classes than he could have ever dreamed of and, in theory, more asset classes mean more diversification and hence less risk. In theory …
One of the many spanners in the works of MPT is globalisation. Everything is connected with everything else instantaneously – and in a high-frequency trading world, possibly even quicker. The emotional journey, however, remains the same. A market is unloved and there are few buyers, apart from the canny (uncanny some would have you believe) value investor, who sees an opportunity and knows that – eventually – he will be right. As GMO’s Jeremy Grantham once said: “Value investors are rarely wrong, just early.”
Some of the early adopters will be shaken out in the inevitable corrections that accompany market bottoms, but slowly the pace of buying will increase and we have ourselves a trend. The momentum investors are now in play and the market marches serenely onward and upwards. Retail investors then smell the coffee and join in.
All the while, as the market rises steadily, volatility falls and your ‘suitable’ risk-defined portfolio needs to take on more risk to remain suitably suitable. The value investor at this stage is more than happy to sell to the unwitting band of risk ‘controllers’, who are buying near the top of a market, thus turning rational investment practise – that is, buying low and selling high – on its head.
In days of yore, and perhaps to this very day, this distribution phase in the market could take some time. Then there would be a trigger, which tipped the balance in favour of the sellers, and the market revalued in smart fashion, with many late buyers forlornly holding on for a return to the peak.
Plunging markets mean higher volatility so those risk ‘controllers’ sell near the bottom to ‘reduce risk’ to those canny value buyers and the cycle starts all over again … no doubt to be followed by another regulatory review to make sure that clients in suitably unsuitable portfolios don't suffer the same fate yet again.
Investing comes automatically with the risk of loss of capital. There will be occasions when you will lose money – no ifs or buts – and if you continue to buy high and sell low then disappointment is guaranteed. An application of common sense is required and that discipline is aided in a significant way by adding in a value component to any analysis of risk.
We really do not want to hear any more that, over 15 years, bond volatility is low and therefore a high weighting is the ‘optimum’ strategy for a ‘cautious’ investor. So far this year, the bond ‘rout’ has been confined to sovereign issues and, in the UK, an investor in a gilt tracker has now lost around 5% since the market peak in early February. Long-dated funds, which have done so well for so long, have lost around 10%, which, in both cases, has wiped out the paltry level of income on offer for some considerable time to come.
So far the rapid rise in yields has not been as evident in the corporate bond and high yield sectors – quite possibly because these are home to much retail money in search of an income and it takes them a lot longer to realise a sea-change might be afoot. There is also the ominous question of market liquidity and, should investors decide to sell, they may find that the rather large door marked ‘exit’ has turned into a cat-flap.
We cannot of course rule out an end to this ‘corrective’ phase but, to highlight what volatility in bond world could mean, here is an example of what we might expect if the setting of interest rates were to return to ‘normal. The UK 10-year gilt saw a low in terms of yield of 1.4% on 25 March. It currently stands at 2%.
Were it to rise to 3% where it stood on 30 December 2013, only 15 months ago, the loss of capital would be around 13%, from the low while, if 4% were reached – where it last stood four years ago – the loss could top 20%. If these rate changes were to be translated over into high yield, the losses would be even greater. The typical bond fund may currently have a duration of less than 10 years, but you get my drift.
Regardless of the market direction in the short term, all these sectors remain insanely overvalued and carry a very high risk of capital loss – at best they can be described as speculative investments and not for the risk-intolerant.
Measuring risk using historic volatility can only be used as the most basic of guidelines and should not be the main or only input into constructing a portfolio. Applying a value-based orientation makes much more sense when combined with a reasoned approach to asset allocation, taking into account the current – and anticipated – twists and turns of the global economy. Value will out in the end in direct contrast to paying a high price for assets divined from an archaic mathematical formula.
Fund managers who employ this approach will have periods of underperformance but they also have preservation of capital in mind, which is the real trademark of the risk-aware and you just cannot put a number on it.
Funds that come into this category, having a forte for matching asset selection to the global economic picture, include the Schroder Diversity, Jupiter Merlin, M&G Episode and Coram Global ranges. The Aviva AIMS Target funds also deserve a mention in this regard. They do target a low overall volatility, but this tends to fall out of the investment process, rather than being their raison d’etre.
Fund volatility will naturally rise and fall but, so long as the investment philosophy is sound and well-articulated to the end-user, this phenomenon can be relegated to the status of background noise. Let’s stop putting numbers on portfolios and funds and get back to understanding what the fund manager is about and explaining that to the investor. Isn’t that what we used to do?
FundCalibre is a direct-to-consumer funds website and ratings business
Dust off the bargepole
Continuing on his quest for value in equity and bond markets, Clive Hale, a director of FundCalibre, highlights three areas with potential for growth over the longer term – though of course many investors will currently be reluctant to touch them
Equity and bond markets across much of the world have enjoyed the benefits of central bank quantitative easing (QE) – first in the US and the UK and then, more recently, in Japan and Europe. QE is first directed at sovereign debt purchases from the banks and other institutions, which leaves them with cash to do with what they will.
With loan growth rising – though very slowly – much of this cash has ended up back in the markets. Bonds are not only being bought by central banks, but, knowing there is more buying to come, also by other investors – or should that perhaps be speculators? This has driven yields in parts of Europe below zero. Apart from the speculative component, this cannot be called value by any stretch of the imagination.
Equity markets in Europe – and in Germany and France in particular – have benefited hugely from bond-buying by the European Central Bank. Arguably they are playing catch-up, having missed the train the S&P 500 has been riding, because of concerns over the future of the eurozone.
As Europe’s largest exporter Germany should benefit from the weakness of the euro but, at the same time, businesses face headwinds in terms of slowing export markets, particularly in China. The French economy is suffering from socialist government meddling and, while much is made of improvements in the Club Med countries, it has been from a very low base and now euro weakness is adding to import costs. So European markets are rising on a significant flow of liquidity rather than the prospects of strong – as opposed to tepid –economic growth.
In the US all appears well on the surface with unemployment close to 5%, but the hourly earnings rate, set out in the chart on the right, tells a different story. It has barely moved for five years and what trend there is is down – much of the US is not that well-off. Earnings surprises have mostly been to the downside so far in 2015 and the equity markets can hardly be described as cheap.
So which markets have not benefited from the rise and rise of the S&P 500 and the mighty dollar? Where might we find some value? Well, of course, it is usually in all those areas that come into the ‘not to be touched with a bargepole’ category. Not everyone has been convinced by the Japanese three arrows strategy and so they have missed out on some interesting gains – albeit with the currency hedged back into sterling.
It might just be that dollar strength is over for the time being – the markets are saying there will not be a rate rise until December, having originally gone for June – so hedging probably is not necessary and, as you can see from the chart below, the Nikkei has a very long way to go catch up even a small part of its decades’ long underperformance of the world indices.
Since 2000, it has barely marked time and, while a return to the excesses of the late 1980s is highly unlikely, there is room for more pick-up against the more expensive equity markets. Funds worth considering here are Baillie Gifford Japan, GLG Japan Core Alpha and Neptune Japan Opportunities – the unhedged varieties in the case of the latter two.
Across the East China Sea, the Shanghai Composite index has had a remarkable run on hopes there will be further stimulus from the government. The concern here is that speculators will be in for a very bumpy ride if the authorities decide to restrict share-buying on margin so perhaps, in the short term, we may see some profit-taking.
The Asia Pacific region generally has underperformed the world index since 2010, however, and a lull in dollar strength and better news from China would reverse this sector’s fortunes. Funds here to look at include Schroder Asian Alpha Plus and Aberdeen Asia Pacific Equity.
And finally to the emerging markets, which have been hammered by dollar strength and commodity price weakness. With both these factors on the turn, there could be a pleasant surprise awaiting investors. In the debt markets, Standard Life Emerging Market Debt and Aberdeen Emerging Markets Bond are two FundCalibre Elite-rated funds while, for equities, we would highlight two relative newcomers – Charlemagne Magna Emerging Markets Dividend and Somerset Emerging Markets Dividend Growth – along with M&G Global Emerging Markets.
On a long-term view, these three markets offer the potential for growth – especially in Asia and the other emerging economies, where the rise of the consumer will be a powerful driver.
FundCalibre is a direct-to-consumer funds website and ratings business