Investment Newsletter February 2018
Risky business
Mike Deverell Investment Manager
Over the years we’ve often referenced the economist Hyman Minsky.
view many investors have taken on much more risk than they realise.
Minsky’s best known theory is essentially that stability, in itself, breeds instability. The longer a market remains stable, the more complacent people become. Investors gain a false sense of confidence and therefore take on more risk and more leverage.
Some popular strategies that have been hit hard recently include “risk targeted” and “risk parity” funds.
Because of this gearing those investors can be hard hit by what starts out as only a slight downturn. They become forced sellers which can create a vicious cycle. A small drop can quickly escalate, causing a very sharp fall in prices. This has become known as a “Minsky moment”. For “stability” you can read also “volatility”. In past newsletters we have remarked just how little volatility we have seen in markets. This has encouraged many people to take on more and more risk. In fact, in our
If you’re unfamiliar, a risk targeted fund automatically invests in assets and particular instruments to target a predetermined volatility rate. For example, an investor might decide they are comfortable with volatility of 5%. In other words, they say they are comfortable with moves in normal market conditions of plus or minus 5% from the long term trend. A risk targeted fund for them would then automatically aim for the highest possible returns at 5% volatility. This is sort of the opposite of what we try to do, which is to aim for a target return at the lowest risk possible. Remember that volatility is only one way of measuring
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter February 2018
risk. It is not the same as the most important measure of risk – the risk of permanent loss of capital. On the face of it, a risk targeted fund sounds like a good idea. In normal times risk targeted funds invest in a mixture of assets to keep volatility low, holding fixed interest and cash to balance out the greater movements in the stock market. However, when equity volatility is as low as it was until recently the funds automatically invest more in stocks. At the extreme, if the volatility of the stock market is
Correlation
Other automated strategies have also struggled and may be partially responsible for the sharpness of the recent correction. Volatility is one issue for such strategies, whilst another issue is correlation. Some funds use complex algorithms to optimise how much they invest in equities, bonds and cash depending on the correlation between the asset classes as well as their expected rate and return. However, just like volatility, correlation is not a constant. Assets can be lowly correlated or even negatively correlated in some market conditions, but then become much more highly correlated in other times. Therefore, an asset that is being held as a hedge might actually be increasing risk. Most of the time we’d expect equities and bonds to move in completely different directions. However, one thing we’ve been worried about of late has been the way low interest rates and quantitative easing (QE) has driven up both equity and bond markets at the same time. As discussed in last week’s blog (www.eqllp.co.uk/ blog/getting-interesting.../) and in past newsletters, we’re now in a period where global rates are going up and where QE is essentially being slowly reversed. What we’ve seen over the past weeks is that bond prices have fallen in response to this, meaning yields
less than 5%, the example fund above might invest 100% in stocks. Some funds even gear up to hit the volatility target. This means that if volatility increases, which often coincides with a market fall, the fund is forced to sell stocks to get back below its target. By then of course it is too late and what they’re actually doing is crystallising losses. Whilst that’s bad for the individual investor, more worrying is that all these funds are doing the same thing at the same time, which means they also pose systemic risk.
have risen. As stocks and bonds have been falling at the same time their correlation has gone from a slight negative to a strong positive over a short period. This has led to unexpected losses for some funds whose strategy banked on low correlations. Whilst this has meant short term losses for bond investors, the flip side is the future potential return from those bonds is now higher due to the increased yield. It’s possible we’re at a tipping point where some cautious equity investors could decide they now prefer bonds, which in many cases now yield more than the stock market. Certain types of stocks, often called “bond proxies”, could be particularly vulnerable. Bond yields can also affect markets in other ways. For example, one traditional way of valuing a company is to use a discounted cash flow model. Essentially, an analyst looks at the earnings they expect the company to make in the future and discounts it back to today using bond yields. This low discount rate has also inflated the share price investors are willing to pay in the same way it has inflated transfer values. However, as bond yields begin to rise then (given the inverse relationship) the implied “fair value” price of a company is lower, and so investors won’t be willing to pay such inflated prices.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter February 2018
Short Vix
Another contributory factor to the recent market turbulence has been investors betting on volatility itself. Over the past few years volatility has generally moved lower and lower, punctuated by a few spikes. Various products have sprung up to allow people to benefit from this trend. For example, certain exchange traded funds (ETFs) allow investors to short volatility – in essence, betting that it will continue to drop. Often they have some gearing to enhance the returns. However, over the last few weeks volatility has increased dramatically. The “Vix” index, which measures the volatility of the US market, was below 10 for much of January. On 6 February 2018 it hit 49, an increase of 390%. If you short something which goes up 390% you lose 390% - almost four times your original investment! It can be even more if your investment is geared.
Luckily for those who bought the short volatility ETFs, their loss was limited to only 100%. It is very likely the losses on such products may have added to market turbulence. Markets have always been complicated but the amount of algorithmic trading and derivative products means that these days there are often some unpredictable knock on effects of market events. Whilst for many, the spike in volatility has been uncomfortable, for us we see it as opportunity. We have been relatively cautious of late and have been holding less equities than usual. We also had a plan that we would top up equity by conducting a “volatility trade” should the FTSE 100 drop below 7,200. This is what we did, and we will sell this should markets recover. We also had a plan to strike a new defined returns product should the FTSE 100 drop below 7,100.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter February 2018
General Economic Overview The global economy continues to exhibit strong growth in almost every region. The question is how long this can continue since many economies are now close to full capacity with high levels of employment. The UK economy has been relatively sluggish with prices increasing more than wages. Whilst we expect inflation to reduce as the pound stabilises, last month’s figures were above expectations. It now looks more likely the Bank of England may increase rates this year The reversal of the Federal Reserve’s quantitative easing programme and further interest rate hikes in the US are likely provide headwinds for asset markets this year. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets As markets have dropped we have increased our score from -5 a couple of months ago to -3. We continue to see more value in Asia including China and Japan, and smaller companies within the UK.
Score
-3
Fixed Interest Given the expectation of increases to interest rates and the reversal of QE, fixed interest markets have performed poorly of late. On the one hand this means that yields have increased which is positive for future returns. However, we expect that some parts of the market could see further falls in the short term.
-4
Commercial Property We believe the commercial property market as a whole is not especially attractive at present. However, by avoiding areas like London offices and holding more in favoured sectors like industrials, we expect to see solid low single digit returns.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-3 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent EIM’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.