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Leverage, often referred to in investing as a ‘double-edged sword’, is another word for borrowing money to own more of an asset. Much like a mortgage on a house, it enables individuals to own a higher value of an asset they would otherwise be unable to own, but it does run the risk that the value falls such that one ends up owing more than one owns (coined ‘negative equity’ in the housing world). This is never a good place to be.

Our systematic approach is ‘long only’ (as opposed to taking an element of short positions, which requires borrowing) and unlevered. This means that the investments are owned without inherent borrowing within the funds themselves. Of course, we do believe debt is a powerful tool that corporate finance departments and governments can use to raise capital to fund future growth and we recognise the importance of borrowing in capital markets, but we don’t generally believe that this is a risk worth taking at the fund or portfolio-level. Markets can be scary enough at times like Q1 2020, without magnifying the downside further through leverage.

The potential upside of highly leveraged strategies is magnified returns which can leave investors drooling. The downside could be 100%, or more. As you might have spotted in the press, the family office Archegos Capital Management has been made all too aware of this[1] with the recent unwinding of their leveraged bets which has left some banks, which provided the capital to Archegos, nursing heavy multi-billion pound losses[2].

The reader will be well-aware that borrowing is commonplace in the housing market, with interest rates now at historically low levels. For example, 2-year fixed-rate mortgages are now at around 1.6%[3]. Some will remember times in the 1970s and early 1990s when rates were 10 times this. Although mortgage rates are cheap, few are able to borrow ‘on margin’ on such favourable terms and for most the potential downside of such an approach outweighs the potential benefit.

Although curtailed slightly of late, the rise of retail investors over the past 12 months has been significant and has come with cheaper access to leverage through the trading of financial derivatives. With one of the common questions asked by those ‘YOLO-ing their stimmies’ (i.e. investing their US stimulus cheques) into such investments being “what is the stock market?”[4] one is led to believe these investors are not pursing a ‘risk-comes-first’ approach. Unfortunately, many will learn a painful and costly lesson.

Our default approach is to invest in unlevered long-only strategies. Our risk-focused approach to portfolio construction means that our Investment Committee regularly reviews the risk exposures of your portfolio and seeks to mitigate or avoid those that are unwanted or typically go unrewarded. In general, leverage is one of those.

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] Economist, April 3^rd 2021. “Margin call of the wild: Archegos, a family office, brings Nomura and Credit Suisse big losses”. Also, for a good insight into the backstory: https://www.bloomberg.com/news/features/2021-04-08/how-bill-hwang-of-archegos-capital-lost-20-billion-in-two-days

[2] Succinctly summed up in this meme

[3] Average at 75% LTV. UK Parliament: House of Commons Library, 10^th March 2021. “Household Debt: Key Economic Indicators”

[4] Ft.com, 9^th March 2021. “Rise of the retail army: the amateur traders transforming markets”

The word ‘ahoy!’ is an old maritime warning, usually used when either a ship or land was sighted in the distance as a warning to the crew to beware.  Today, the risk of higher inflation down the line has been sighted by both economists and – of late – the markets.

It is something that investors have not really been focusing on since the global financial crisis, with everything else going on.  Yet, inflation is the silent enemy of the long-term investor that eats away at the purchasing power of their assets.  Even benign inflation can do damage.  The ‘Rule of 72’ estimates how quickly prices will double; all we have to do is to divide 72 by the rate of inflation.  If the Bank of England is successful at meeting the 2% per year inflation target set for it by the UK government, prices will double every 36 years (72/2).  If inflation is higher, then the time to double will be quicker.  For example, at 6% inflation prices double every 12 years.  The chart below provides an insight into the impact of inflation on spending power in the UK.  It shows how much £100 of goods or services bought at some point in the past would cost today.  Even since 2010, things now cost around 30% more than they did.

Figure 1: How much £100 of goods and services in the past would cost today.

Source: Bank of England[1]

Without turning this short note into an economics lecture, a simple model that explores the balance between buyers and sellers of goods and services can be useful when thinking about inflationary pressures.  On the buyers’ side we have the amount of money in supply (M) and the number of times this money is used to buy goods and service in a year (the ‘velocity’ of money or V).  On the sellers’ side we have the price of goods (P) and the amount of goods and services produced (Y).  As everyone knows an equation needs to balance; so, MV=PY.   Since the Covid-19 crisis began, governments around the world have pumped huge amounts of money into the economy, via both quantitative easing and huge stimulus packages, not least the US$1.9 trillion package being touted by the Democrats in the US.  The money supply in the UK, and other major economies, has grown dramatically in the past 12 months.

So far, because people have been restrained from buying goods and services in lockdown, the velocity of money has been low, and spare production capacity exists in the economy resulting in little pressure on prices. Yet as the vaccine program rolls out and we emerge from lockdown constraints, people will begin to satisfy their pent-up demand – using accumulated savings – to buy goods and services, raising the velocity of money back to more normal levels.   On the supply side, economic output should grow utilising spare capacity and creating new jobs.  But if the money chasing goods and services (MV) outstrips the output of the economy (Y), then prices (P) will rise.  This is certainly a plausible scenario and the bond markets have responded to this lately, pushing yields up in compensation and, as a consequence, bond prices down.

So, what would this mean for your portfolio?  Over the medium to longer-term, equities do a good job of delivering investors with returns above inflation.  In the shorter term it is hard to know what the impact on equities will be as on the one hand higher bond yields may undercut equity valuations, whilst on the other, growing optimism and economic growth of a post-lockdown world may improve prospects for company earnings.  No-one knows.  On the bond side, the threat of inflation tends to drive yields higher and bond prices lower.  Fortunately, the bulk of bonds owned in your portfolio are shorter-dated, where price changes are much smaller than longer-dated bonds and the time it takes for you to benefit from this rise in yields will be much quicker.

Inflation (perhaps) ahoy! But no need to panic.  Sail on.

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] www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator

The madness of markets

As an investor, it is generally not a bad idea to ignore what is going on in your portfolio most of the time.  At the very least it can be distracting and at worst it can be a source of unnecessary anxiety.  That advice is as applicable today as it ever was.

The markets feel like they have gone a bit mad!  Since the start of the pandemic – and despite a 25% or so fall in late February and early March – global markets (developed and emerging combined) have gone up by more than 10%[1].  Some sectors and companies have delivered far higher returns.  For example, the ‘FAANGs’ (Facebook, Apple, Amazon, Netflix, and Google) – all beneficiaries of global lockdowns – have risen collectively by 45% since the pre-pandemic market high[2]. In May 2020, Elon Musk, Telsa’s CEO, tweeted that its share price was too high, and it fell 10% overnight to US$80, yet Tesla’s share price has, since then, grown almost ten-fold to $804 on 10^th February 2021.  Today Tesla’s market capitalisation is now larger than the next nine global car manufacturers combined, including Honda, VW, Renault-Nissan, and GM[3].  Let’s not even mention Bitcoin!  Are these fair prices or are they overvalued?

The rational investor would say that the market is simply looking beyond the pandemic and to a time of global recovery and a more normal world and that the market is the best judge of prices.  Yet some investors may have concern that markets are in a bubble and question if they should reduce their equity holdings.  Others may see the extraordinary returns from a certain sectors and companies and feel a sense of FOMO (fear of missing out) that they are not more heavily invested in tech stocks or Tesla, for example.  The problem is that the markets may be right…or wrong.  The one thing we know for sure is that it is impossible to know which with any certainty, and the evidence tells us that even professionals have little ability to time entry into or out of stocks, sectors, or markets successfully.  Markets can remain seemingly mad for a long time.  As John Maynard Keynes famously once said:

“Markets can remain irrational longer than you can remain solvent.”

Sensible investing is about remaining highly diversified across markets, sectors, and companies to avoid absolute losses and to try to smooth out returns as much as possible over time. To many that is a great comfort and allows them to sleep at night.  Rebalancing periodically and reminding yourself that you do not need to cash in your equity assets in the near term is worthwhile.  It may not be as exciting as punting (which is what it is) on Tesla or Bitcoin, but it will reap its rewards over time.  Remember too that by being diversified means that you will benefit from being in the companies and sectors that do well.  In 2020, the developed global stock markets returned around 12% in GBP terms.  Of this 12%, half – or an absolute 6% – of this return was attributed to the top 10 stocks.  The FAANGs alone represented 30% (i.e. around 4% of the 12%)[4].  That is surely enough exposure for most.  Stick with the plan and try not to look at, or think about, your portfolio too much.  Attempting to second guess the market is a fool’s errand.

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.

Use of Morningstar Direct© data

© Morningstar 2020. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.

[1] MSCI ACWI Index in GBP terms from 19/02/2020 to 10/02/2021

[2] https://uk.tradingview.com/chart/?symbol=FX%3AFAANG in USD

[3] https://www.researchaffiliates.com/en_us/publications/articles/819-tesla-the-largest-cap-stock-ever.html

[4] GSI (2021), The recent performance of Growth and Value.

Bitcoin and bandwagons

In the past few months, it might appear – at least to some – that making money in markets is easy – just buy Tesla or Bitcoin and you are sure to double your money! That is to confuse gambling with investing, and these are certainly not recommendations by the way.

Bitcoin – boom, bubble or bust?

In October 2008, a mysterious white paper was published by an unknown author titled “Bitcoin: A Peer-to-Peer Electronic Cash System”[1] and the world had been introduced to its first ‘cryptocurrency’. Driven by blockchain technology, the main attraction compared to traditional currency was clear – Bitcoin provides a decentralised way for two parties to exchange value. In other words, Bitcoin has no need for a governing body, no central bank and is merely a digital ledger that facilitates and records transactions. Without getting too granular about how exactly this works, the complicated mathematical procedures in place make falsifying Bitcoin transactions unlikely with today’s technology[2] (although never say never!).

Figure 1 The cryptocurrency market value is small relative to the global equity market

Data source: CoinMarketCap.com, MSCI ACWI Factsheet. Figures as at 28/01/2021.

Twelve years down the line the cryptocurrency space has seen thousands of alternatives, or ‘altcoins’, come to market, all of which attempt to improve upon the blueprint pioneered by Bitcoin. One challenge is scalability – Bitcoin can handle a paltry 350,000 daily transactions[3] compared with VISA who executed ≈500m per day in 2019[4]. Furthermore, in a society that is ever more focused on sustainability, a currency that requires enormous warehouses full of energy-hungry computer equipment to keep it going, feels like a square peg in a round hole. A useful tool built by the University of Cambridge estimates that the Bitcoin network currently consumes around 110 TWh of energy per year, roughly the same as the Netherlands[5]!

Despite the implementation issues, the value of Bitcoin – and many of the ‘altcoins’ mentioned previously – have skyrocketed of late leading to a lot of excitement for investors (or rather gamblers). The only thing we know for certain about investing in cryptocurrency is that it is highly speculative. The extraordinary volatility of most ‘coins’ makes them an unreliable store of value. Going to sleep and waking up 10% richer (or poorer) is commonplace. Furthermore, Bitcoin is not a capital asset – it does not pay dividends, nor does it have a positive expected return. Positive outcomes are simply the result of demand outstripping supply, although investors are quick to forget that the future expectation of demand is already factored into the current price. There are 18.6 million Bitcoins in existence, yet recently the sale of 150 Bitcoins resulted in a price drop of 10%[6] demonstrating no depth or liquidity to the Bitcoin market.

It is possible that we may one day transition to a world where cryptocurrency is adopted by the masses. Who knows if that is even remotely likely, and better yet who knows which cryptocurrency will be the one that ticks all the boxes? As an investment today, cryptocurrency plays no role in portfolios and any investor (gambler) should be willing to accept a maximum loss of 100%.

Here is another example of gambling masquerading as investing:

GameStop – reddit vs Wall Street

In what is a fast-moving situation, a group of amateur investors using discussion website reddit as a platform, have banded together to take on the professional hedge fund space in the US. The group has focused their conversation on a few stocks of late, the most recent of which is an American consumer electronics firm, GameStop. On the one side we have the hedge fund managers, who are engaged in a process known as ‘shorting’, essentially betting that the share price of GameStop will go down over time. A successful short involves borrowing stock from a third party, selling it on the marketplace and then buying it back later when the price has fallen. This allows the short seller to return the stock to the third party and cash in the difference in price. The danger of this is that if prices were to rise, purchasing the stock back becomes more and more expensive for the short seller and they cannot afford to return their borrowed stock. Professional investors are aware of these risks more than anyone.

The companies featured recently on the forum are heavily shorted and include GameStop, AMC Entertainment, Koss Corp and Blackberry (throwback). By purchasing shares in these firms, investors are bidding up prices creating huge losses for some of the hedge fund managers. These are not small market movements either. As of the 27^th of January, the share price of GameStop closed nearly 2000% up since the start of the year[7]. Yet in the time it has taken to write this article, on 28^th January the price fell by almost a half! A quick glance at the forum shows that the motivation for some is to ‘stick it to the man’, whereas others are perhaps looking to make a quick buck. As the situation progresses it has certainly caught the eye of the regulator on suspicion of market manipulation, as well as the newly appointed US Treasury Secretary, Janet Yellen, whose team are “monitoring the situation”[8].

Either way, it is difficult to see how this will have any sort of happy ending. Other than the handful of investors (gamblers) who might sell at the right time, the only guaranteed beneficiaries to all this are the market makers and middlemen. If you want excitement, just follow the stories, and enjoy the schadenfreude that follows. This is just gambling and best avoided.

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] Bitcoin.org (2008) Bitcoin: A Peer-to-Peer Electronic Cash System.

[2] Forbes (2020) Can All of Bitcoin Be Hacked?

[3] Research Affiliates (2021) Bitcoin: Magic Internet Money.

[4] Statista (2019) Number of purchase transactions on payment cards worldwide in 2019.

[5] University of Cambridge (2021) Bitcoin Electricity Consumption Index

[6] Jemma Kelly (07 Jan 2021), No, bitcoin is not “the ninth-most-valuable asset in the world” Time for some realism. FT.com

[7] Google Finance (2021) GameStop Corp. Share price.

[8] BBC News (2021) GameStop: Amateur investors continue to outwit Wall Street.

Equity markets and US Presidents

The final days of Donald Trump’s Presidency are turning out to be a somewhat unedifying affair.  Enough said.

Yet when it comes down to the returns of stock markets under different Presidents – Democrat or Republican – does it really matter who is in power?  Should we change our portfolios? Can we predict what is going to happen?  The quick answers are ‘no’, ‘no’ and ‘no’!   Take a look at the figure below which sets out the returns of the US stock market after inflation going back to Richard Nixon. There is no clear conclusion to be drawn.

Figure 1: Democrat and Republican Presidents and equity market returns

Data source: S&P500 TR Index from Morningstar Direct © All rights reserved 2020.
Note: Red = Republican and blue = Democrat.

This is perhaps not really very surprising as the price of a company’s shares is based on the future cashflows that it will deliver discounted back to a present value, using a discount rate that reflects the risks associated with that company’s cashflows.  A Presidential term is four years, but a company’s cashflows run into the distant future.  Despite the partisan nature of US politics at this time, Democrats and Republicans are all still capitalists and believe in personal freedom, property rights and, yes – even if it does not feel like it at this moment – democracy.  In a broad political sense, Democrats and Republicans are simply variations on a democratic, capitalist theme.

Active managers may try to position portfolios to reflect world events, but crystal ball gazing is hard to do.  There was much talk of the ‘blue wave trade’ prior to the election to position for a Democrat clean sweep of all parts of government yet look how that seems to be turning out!  A few days ago, the prospect of a vaccine for Covid-19 sent airlines, banks and energy companies soaring and Zoom and other ‘lockdown’ benefiters, such as Ocado, down.  Random events and the release of new information moves the market’s view of cashflows and discount rates resulting in the movement of stock prices.  Guessing against randomness is hard but taking on the known risk that equity returns are far less certain than holding cash, rewards investors who ignore this short-term noise and focus on the long-term.  The choice of the US President is important to some, but to the long-term investor it is largely irrelevant from an equity market perspective.

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.

Past financial performance is no guarantee of future results.

Use of Morningstar Direct© data

© Morningstar 2020. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.