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It feels at the moment that the markets have gone a little mad.  Almost everything you hear on the news or read about investing suggests that everything is going up.  The US market is up by around 44% in the past year[1] in dollar terms, Tesla’s share price has risen by 124% over the same period, and Lucid Motors, who have just started production on its electric car in Q3, for which it has (a mere) 13,000 orders, floated on the NYSE and already has a market capitalisation greater than that of Ford, after its share price doubled in a month!

In the US, call options on individual company shares, which provide investors the right to buy a stock at given date in the future at a predetermined price in return for a premium payment, currently exceed the value of actual shares traded by value by almost a half.  Options are a way of leveraging exposure to a stock without having to come up with the face value of buying the stock directly.  They are a sure sign of speculation, not least by retail investors.

There is no doubt that when markets become frothy, investors are prone to a fear of missing out (FOMO) that makes them wish that they were invested in something that has done well (mostly identified with hindsight) and tempting some to lose discipline and plunge in, hoping that the magic (luck) will continue.  When things do not go as hoped, there is a temptation to cut losses and run.

Let’s take a quick look at the ARK Innovation ETF that has hit the investment news headlines as one of the best performing funds in 2020, gaining over 150% in US$ terms, and more importantly how investors in the fund have fared.  It is a very concentrated portfolio of technology and healthcare innovators.  It holds more than 10% in Tesla and the top 10 of 45 or so stocks make up more than 50% of the portfolio. The firm also owns more than 10% of the shares of a number of portfolio stocks, which raises liquidity risks (remember Woodford?).

In the case of ARK Innovation, it had a stellar run from April 2020, out of the bottom of the Covid-induced sell-off until December 2020 but has struggled since then, falling almost 35% at one point in the first few months of 2021.

Figure 1: Fund flows often follow performance

It is worth noting that the fund had inflows of just US$25 million in Q4 2019 but these peaked at almost US$ 7.8 billion in Q4 2020.  You do not have to be a mathematician to work out that the investor money that went into the fund at the back end of 2020 will have not captured the bulk of the positive returns of 2020 and suffered the subsequent downswing. A rough calculation using monthly performance and fund flow data suggests that from the start October 2019 to the end of October 2021 the fund delivered an annualized return of 66% p.a., whereas the average investor return was around 25% p.a. i.e. a 40% p.a. difference.[1] Over this same period a well-known US index fund delivered 26% p.a.!¹

ARK Innovation relies on manager skill (or luck) in picking a mere 45 or so companies out of the many thousands of companies around the world.  The risks are very high. The fund management world is littered with the corpses of such ‘stellar’ funds.  In the UK for example, over the past twenty years or so, around half of all investment trusts launched have failed to survive[2] in their original form.

It is hard not to suffer FOMO at times like these, but it is worth remembering that investing is a not a sprint but a marathon.  When markets rise substantially, as they have done recently, regular rebalancing results in the sale of assets that have performed well and banks the excess proceeds.  Seemingly irrational markets can persist for a long time and as the old saying goes, no-one rings the bell at the top of the market.  Stay invested, remain diversified and be thankful that your financial well-being does not lie in the hands of any one fund manager owning just 45 stocks.  Remember that it is the tortoise who wins the race.

Risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]     Albion Strategic Consulting used an XIRR calculation with monthly fund size, flows and performance data and assuming fund flow occurred at the start of the month.  It provides a rough estimate and order of magnitude insight.  Daily data unavailable.

[2]     Numis, as quoted in: Investors Chronicle. Surviving the investment trust shake-up August 6, 2020, By Dave Baxter

[1]      Vanguard Total Stock Market Index Fund in US$ Admiral share class www.vanguard.com

We associate the term ‘bond’ with mutual connection, whether the subject is chemistry (between atoms, ions, or molecules), personal relationships (between human beings), or finance (between borrowers and lenders). The latter is often thought to be difficult to understand and shrouded in complex mathematics. Actually, bonds can be quite a straightforward concept.

In their simplest sense, bonds are IOUs set up between borrowers and lenders. At the outset, the borrower will determine how much and for how long they would like to borrow, and what they are willing to pay the lender – typically once or twice per year – as appropriate compensation for borrowing their money.

Bonds are also known as fixed income securities. The simple example of a bond setup below illustrates why bonds carry this other name. The future cash flows a lender receives are fixed and predictable. At the outset, a sum is lent. Each year, an amount is paid to the lender (the coupon) and at the end of the term the original sum is returned.

Figure 1: Simple illustration of a 3-year bond with an annual coupon

Borrowers, also known as bond issuers, are prominently composed of governments and companies around the world. A significant difference between bonds and more traditional loans is that bonds are marketable. In other words, the lender in the IOU agreement can sell the right to receive the cash flows to someone else. This is why the lender will more commonly be referred to as the bondholder.

The relationship between risk and return does not come unstuck for fixed income. If the borrower is a large, developed government it is highly likely that bondholders will be repaid and so the government can offer lower coupons. The USA, for example, has never defaulted on its national debt. By contrast, a company on the brink of financial collapse would have to offer much higher compensation to encourage lenders. This is the point where fixed income often becomes less ‘fixed’.

Analysing the ability for companies or governments to pay back lenders is a complex and comprehensive process for investors. Thankfully rating agencies do much of the heavy lifting. S&P, a rating agency, demonstrates[1] on average between 1981 and 2020 bonds with the lowest rating of CCC/C had a 28% chance of defaulting over the next 12-month period, whereas for those rated highest at AAA that chance was zero.

Figure 2: Cumulative average default rate % of global corporate bonds 1981-2020

Data source: S&P (2021). “Default, Transition, and Recovery: 2020 Annual Global Corporate Default and Rating Transition Study”. Rating refers to rating at outset of respective period.

The reader will notice that owners of investment grade bonds are considerably more likely to receive back the capital lent to the borrower compared with high yield bonds (formerly ‘junk’ bonds!). It is for this reason we allocate the fixed income element of your portfolio to these such bonds through the use of investment funds that diversify across many different highly rated bonds. We may often refer to this part of the portfolio as the ‘defensive assets’.

The key takeaways

• A bond is an IOU between a borrower, such as a government or company, and a lender. The ownership of this IOU can be traded between lenders (bondholders), and with it the right to receive the cash flows from the borrower.
• The main features of a bond are the maturity (i.e., term of the loan) and credit quality. The latter is determined by rating agencies and gives an insight into a borrower’s credit worthiness.
• Investment grade bonds provide more certainty of future payments to lenders compared with high yield bonds. A shorter lending term also generally corresponds to higher certainty of repayment. For this reason, when investing in bonds we typically allocate to shorter term, higher credit quality securities.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1] S&P (2021). “Default, Transition, and Recovery: 2020 Annual Global Corporate Default and Rating Transition Study”

For those readers interested in financial news (some might call it noise), the unfolding story of Chinese property developer Evergrande (a name which is ironic given its dire financial position) has spooked global equity markets.

The short version of the story is that the company is very highly leveraged i.e. it has borrowed US$300 billion from banks to fund its property developments and has hit material cash flow problems, leaving suppliers and debt repayments at risk.  Property prices have risen dramatically in urban China over the past few years and the Chinese Communist Party (CCP) is now clamping down on bank lending to slow the boom, which is part of Evergrande’s problem.  To add to the drama, Evergrande has also sold high risk retail products to its wealth management arm’s clients, which it appears to have misrepresented as low risk investments.  Some of these investors’ funds have been diverted to shore up the company’s own working capital and some has allegedly been used to pay off other investors, which is the hallmark of a Ponzi scheme.   More acutely, the company needs to meet an interest payment of US$84 billion this week and the markets are waiting with bated breath to see if they manage to do so.  Its bonds are trading at 25 cents on the dollar and its equity has fallen by 85% in value in 2021.  Not pretty.

IF Evergrande default – some have suggested this could be the equivalent of Lehman Brothers collapse that set off the market falls leading into the Global Financial Crisis – AND if this then leads to the collapse of the company with repercussions for lending banks (most of which are Chinese), AND if there is a resultant fire-sale of properties, AND suppliers go unpaid AND this all precipitates a collapse of other development firms, THEN this could cause a major challenge for the CCP (not least that 1.4 million buyers who have put down deposits on unfinished properties) AND impact on Chinese growth on which the world depends.  Could it THEN cause a contagion in global markets resulting in a major decline in stock markets around the world?

BUT, hold on a minute, what started as a potential corporate default has grown – in this story – into a major decline in world growth and a stock market crash!  BUT in this case, much of the debt is in local currency and lent by banks that are mostly owned by the CCP, which can force them to roll or forgive debt and provide unlimited liquidity to the banking system.  It does not mean that things will be easily resolved, BUT it does not mean that the conflated IF, AND, THEN story of conditional probabilities is likely to occur.

It is important to remember that many material world events occur on a regular basis, but do not always end up in negative market outcomes.  Even COVID, which put a dent in equity market valuations in early 2020, has failed to turn into a prolonged downturn.  Global markets are now well above their highs before the COVID-induced falls.  Certainly it is true that on occasion a single event precipitates a market fall, but the problem is that we, as investors, have absolutely no chance of knowing which event this might be and position portfolios ahead of any anticipated fall.  If this were possible, the market would already have fallen! In this particular case, it is important to note that Evergrande’s market cap is under USD6 billion – or put another way, Apple is over 400 times larger – so any portfolio holding would be miniscule at worst.  The company represents around 0.01% of global equities and China is only 4% of the global equity markets. Our suggestion: don’t pay too much attention to the financial ‘news’!

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Don’t run out of money

Of all the financial challenges and concerns that we face over our lifetimes, avoiding running out of money in retirement probably sits at the top of the list.  No-one wants to end up relying on meagre state benefits and eating own-brand baked beans every day.  Retirement Rule 1 is crucial but not guaranteed.  As Warren Buffett might say, Retirement Rule 2 is not to forget Retirement Rule 1!

In the good old days, retirees could rely on defined benefit pensions and/or annuities to provide lifelong retirement income. Today, many retirees rely, to a varying degree, on taking money from accumulated pension pots for their retirement income.  That makes outcomes less certain and decisions far tougher.

From time-to-time scary data surface about the state of retirement planning in the UK. Recently, LV – the insurance company – published the results of a survey of 4,000 people relating to how they intend or are handling their pension arrangements[1].  LV estimate that there are around 30 million pension holders in the UK.  The results are a little startling, to say the least. Take a look at the chart below.

As one third (or effectively 10 million people) do not know how to make their retirement pot last, it implies that two thirds apparently do know.  Perhaps these are the two thirds who plan on taking advice!  Not running out of money is a complex problem that taxes even the best financial brains.  It would seem that many people may be overconfident in their assessment of how much they truly know about retirement planning.

The figure below provides an overview of just how tricky this process is and how it must be an ongoing, dynamic process, not a one-off decision at retirement. Knowing what you cannot control and understanding what you can, provides some insight into the complexity of – and solutions to – retirement planning.

Retirement is meant to be a time of financial freedom allowing you to do the things you want to do, when you want to do them and who you want to do them with.  It is a great shame that many people in the UK will fail to achieve even a modicum of financial freedom and lifestyle choice.  As a broad rule of thumb, today, £1 million will buy an inflation-linked annuity income of around £27,500 a year[1].  Yet the median UK pension pot is around £91,000[2] (for those 55-64 years old), which on the same basis will deliver only £2,500 a year.

Taking an income from an investment portfolio may allow a withdrawal rate that is potentially a little higher but needs a lot of care and attention to reduce the risk of running out of money.  Making sure that you optimise the decisions that need to be made – and control all the things you can control – will allow you to maximise the stability, level and longevity of retirement income you need.

That is what a good adviser will help their clients do and where they earn their fees.  The best way to achieve Retirement Rule 1 is to take proper financial planning advice.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

[1] https://www.scottishwidows.co.uk/retirement/retirement-explained/taking/pension-options/guaranteed-income/index-linked-annuity/

[2]     Office for National Statistics. https://www.ons.gov.uk/peoplepopulationandcommunity/personalandhouseholdfinances/incomeandwealth/datasets/pensionwealthwealthingreatbritain

[1] 10m pensioners risk running out of money, FT.com 26^th August 2021

Investing is all about tradeoffs. Each choice made is paired with an implicit decision not to do some alternative; the ‘opportunity cost’. For example, by investing solely in a basket of UK companies one accepts the risk of losing out if the UK market struggles relative to the rest of the world, and vice-versa. An investment portfolio could be constructed to reflect other preferences, such as the appetite to have exposure to certain companies or industries, adopt a specific level of equity or fixed income risk, or attempt to adjust the average fee paid to managers, to name a few. Choices come with consequences.

Recently, insight provided by Hargreaves Lansdown – the UK’s largest fund platform managing around £120bn[1] – and Interactive Investor – the UK’s largest flat-fee platform[2] – shed some light on the preferences of younger investors coming to market[3].

“The younger generation want things they are passionate about, that they can engage with, that resonate with their particular desires and preferences, whatever those may be. They want things they can be passionate about.”

The data suggest that younger investors have tended to invest in companies they feel strongly about, a standout theme being the electric car industry at present through firms such as Tesla and NIO. Gavin Corr, head of manager selection and due diligence services at Morningstar, went on to say:

“The younger generation will not be happy in a multi-asset balanced 60/40 portfolio, sitting alongside another million other investors that are profiled exactly the same way. This democratisation or mass customisation is coming”
Gavin Corr, Morningstar[4]

The challenge is that preferences naturally come with their own tradeoffs. This is crucial to remember. To avoid a traditional balanced portfolio and instead own a portfolio of ‘clean energy’ firms, perhaps with electric cars, wind turbines and solar energy as themes, one must accept that they own a highly concentrated portfolio of stocks with low levels of diversification, large sector biases and likely with high management costs. This is likely to negatively impact returns in the medium to longer term.

The aim of this short note is not to suggest that these preferences are wrong, in fact investors may benefit from an ‘emotional dividend’ to compensate investors and make the tradeoffs worthwhile[5]. This emotional dividend, however, is rewarded at the cost of actual investment returns and investors may not realise the magnitude of this cost.

A key pillar of our investment philosophy is to accept that capital markets do a good job of pricing securities and therefore markets are difficult to beat. The table below demonstrates this belief by comparing a simple two-fund developed equity and bond portfolio[6] against the cohort of managers running ‘balanced’ portfolios Corr (2021) referred to. Each of the other managers in the figure will have had their own preferences, which evidently come with consequences.

Figure 1: Multi-asset peer group performance – 10 years to Jul-21

Morningstar Direct © All rights reserved. Morningstar category: EAA Fund GBP Moderate Allocation.

The tradeoffs are well demonstrated in the chart above. A traditional 60/40 portfolio holds up exceptionally well. Only 3 of the 116 funds in the sample provided a superior return to the 60/40 ‘balanced’ portfolio, that is without accounting for any funds that may have closed in the last 10-years! Investors who wish to express their preferences in portfolios should be aware they are at a high risk of market underperformance. Sticking to sound, well researched investment principles is key to a successful outcome.

[1] Money to the Masses (2021) https://moneytothemasses.com/saving-for-your-future/…

[2] FT Adviser (2020) https://www.ftadviser.com/investments/…

[3] Citywire (2021) Everything you need to know about young investors. https://citywire.co.uk/…

[4] Citywire (2021) Morningstar: Impersonal 60/40 portfolio won’t impress young clients. https://citywire.co.uk/…

[5] Rational Reminder Podcast (2021) Episode 156: Climate Change vs. The Stock Market.

[6] Portfolio: 60% Vanguard Global Stock Index, 40% Dimensional Global Short-dated Bond. Rebalanced annually.