Investment Newsletter March 2017
The long and winding road We have had many discussions with clients recently about their investment “journey”.
Mike Deverell Investment Manager
Our investment philosophy is to focus not just on where we end up, but how we get there. We know that equities tend to offer the highest returns of any of the main asset classes over the very long term. If we were just concerned about the final destination and had a long enough time horizon, then a 100% equity portfolio would be the way to go. In fact, this often would be our recommendation for many of our younger clients who have 25+ years to retirement, especially those making regular payments into their pensions. However, most of our clients don’t have the risk tolerance for such a bumpy journey. Having worked hard all their lives to build up their portfolios most
clients would find it hard to stomach the 20%, 30% or sometimes even 50%+ losses that stockmarkets can suffer from time to time. With enough time markets eventually recover such losses but many of our clients require money out of portfolios regularly and can’t afford to wait for a recovery. Our aim therefore is to not go for the best possible return but the return that is required to meet our clients’ financial goals with as comfortable a journey as possible. During recent discussions with a client we noted that over the 12 months to 22 February 2017 (his review date) the adventurous portfolio had returned 16.8% (after all fees) whilst the FTSE 100 was up 25.7% over the same period.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter March 2017
We then looked back at his returns over the previous 12 months ending 22 February 2016. Over that period the adventurous portfolio was down 0.72% whilst the FTSE had lost 9.3%. We had “captured” 65.3% of the gains in the positive year, but only 7.7% of losses in the negative year. This is exactly the sort of ratio between gains and losses we want to see. This also meant that the adventurous portfolio in fact returned slightly more than the FTSE over the full two years (15.98% vs 14.06%) without the emotional and practical issues that a large loss would create.
If we chart the FTSE 100 over the last five years (red) we can clearly see the sharp drop in the FTSE in late 2015 and early 2016, before it then recovers. Also on the chart is Equilibrium’s adventurous portfolio (in blue – after fees). Our portfolio held up well during that period and despite the stockmarket recovery ended up in a very similar place to the main UK index over that period. We could have bought a FTSE tracker instead but the journey would have been much more uncomfortable.
It may be difficult to remember now with the FTSE riding high at 7,400, but just over a year ago we were seeing a very different picture. From its previous peak on 27 April 2015 to 11 February 2016 the main UK index was down 20.02%, even with dividends reinvested.
Chart 1
A - FTSE 100 [50.12%] B - Equilibrium Adventurous model [45.70%]
16/03/2012 - 16/03/2017 Data from FE 2017
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter March 2017
Benchmarks
Our objective for most portfolios is to achieve returns well in excess of cash and inflation. We typically expect returns over the very long term to average around 7% to 8% pa. We are happy for our portfolios to be compared to any relevant index or portfolio with similar risk levels. However, we don’t have formal benchmarks as we believe this can lead to muddled thinking. Let’s assume we had a formal benchmark of 50% FTSE 100 and 50% FTSE Allstocks Gilts Index – half equities and half fixed interest. This is not untypical for an institutional portfolio such as a pension scheme. Right now we think both equities and gilts represent poor value for money, so the logical thing for us to do would be to hold less equities and gilts than usual and invest somewhere else. That is what we do in our portfolios as we are focused on achieving the objective. However, many institutions think differently as they are focused on beating the benchmark rather than the returns the client needs. They might do something different entirely. When Donald Trump was elected this was the catalyst for the stockmarket to go on a steep rally pushing it from already fairly steep valuations to downright expensive. That is because markets quickly bought into Trump’s promise of tax cuts and stimulus which they hope will lead company profits to grow.
We have had many meetings with fund managers where they express scepticism about this potential profit growth and share worries about how expensive the market has become. However, very few of these managers have done what seems to us to be the rational response, which is to reduce equities as it becomes more expensive. If anything, many have done the opposite. This is where institutional thinking can lead to poor outcomes. If markets are flying and your benchmark as a portfolio manager is to beat the index, you can’t afford to be underweight in the index. Holding more equities might lead to more portfolio risk but holding less leads to a risk that investors don’t care about if the fund then gets low returns - the portfolio manager’s career risk! What this can mean is that during a market rally those managers who had been underweight move back to a “neutral” position, buying equities even as they become more expensive. They do this, so as not to get left behind and be asked tough questions by the pension trustees about why they are lagging their benchmark. This sort of behaviour leads to what we often see at the end of a bull market, which is a sharp spike upwards in which prices are rising or expected to rise. This is known as a “bear capitulation” where all those fund managers that had previously been bearish get fed up of being left behind and give up their positions. By not benchmarking our portfolios against any particular index we are not affected by this institutional behaviour. We much prefer to sell high and buy low rather than buy at highs! If markets continue to storm ahead that’s fantastic – we might make less money than we would have if we had held more in equities but it will still help our clients achieve the returns they need. Crucially, it will also help us protect our clients’ wealth should markets move the other way.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter March 2017
General Economic Overview The global economy continues to perform well with decent growth in most regions, although there are some indicators of reduced growth in the service sector. Given the anticipation of increased fiscal spending in the US in particular, expectations of higher growth and inflation are now being priced into markets. The US Federal Reserve has just put up interest rates in response and are likely to do so perhaps two more times this year. The weakness of Sterling is adding to inflationary pressures in the UK which may force the Bank of England to increase rates back to 0.5%, but they are unlikely to go much higher. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets As with last month our score is -5, which means we expect returns over the next 18 months to be significantly below the long term expected return on equities of 10% pa. Valuations look stretched in many regions but in areas like Asia including Japan there remains some value.
-5
Fixed Interest Unchanged from last month. Higher inflation and possible interest rate increases provide a challenging backdrop for bonds. We continue to hold some index-linked gilts but otherwise prefer corporate bonds.
-3
Commercial Property Our score for property remains unchanged as whilst rental yields remain attractive but there will be little in the way of capital growth. We believe there are particular issues in the London office market and therefore are avoiding this part of the market.
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 and equity, and hold only a small amount of property. 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 Equilibrium’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 (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.