What caught my eye this week.

For anyone who owned US technology stocks that cratered in 2022 partly because society had not, after all, accelerated many years into the digital future, UK offices seem like a bit of a Twilight Zone.

Supposedly life is back to normal, so there’s less need for Zoom or Amazon – let alone ASOS or Peloton. The extra capacity these companies scaled-up to provide during the lockdowns is thus redundant. Cue plunging valuations, and mass layoffs of skilled tech sector workers.

That’s the narrative we’ve heard for at least six months. Yet I personally only know one former office worker who is back to doing (full) time.

Most of my friends with office jobs only do some days of the week. They say they are loath to lose the freedoms they discovered during the pandemic.

I was getting my hair cut before an office reunion this week – and I had to admit to my hairdresser that I’d misspoken when he asked whereabouts. These guys don’t even have an office any more.

Elsewhere my daily walk to my gym takes me through one of those modern campus business parks that’s a bit like an activity centre for adult Tellytubbies. These days it has an underpopulated feel that reminds me of the childless playground in Children of Men.

There’s the coffee kiosk on the corner that now closes by midday on Friday. The once-crammed food truck event that’s become just a man in a van. The gym that has more student bros than workers.

Brent over

We have been discussing this in Weekend Reading every few months for a couple of years. A clear majority of readers who’ve commented have said they’d never go back to five days in the office – at least not without a fight.

I had put it down to either hope over expectation or else our special audience. But it’s proven to be both a common aspiration and proven out in wider statistics.

For example, a new report from property specialists Remit Consulting found that:

…while numbers coming into offices are slowly rising — the national average office occupancy of 34.3% in the week ending January 27 was the highest since the group began tracking the figures in May 2021 — there are few signs of a rush back to five days a week “presenteeism”.

Almost three years into the pandemic – with all its disruptions fading into the memory like a broken fever dream – and yet offices are still only a third full.

Meanwhile London’s Evening Standard this week asked every FTSE 100 company about its current working arrangements. The responses suggest:

…that the old Monday- to-Friday office week that was once the default is far from making a comeback.

The research found almost all respondents offer the option of flexible and hybrid working although there are some businesses that want people in for at least a certain number of days weekly.

It suggests that for most private employers the new normal is for workers to be in offices for between two and three days per week, often between Tuesday and Thursday.

Britain appears to be at the vanguard of this Monday-Friday refusenik movement. I’ve heard it chalked up to everything from our longer commutes, worse public transport, even worse weather, or more positively to our love of gardening.

One thing is clear though – if this changed working pattern continues to hold (and by now who’d bet against it?) then the ramifications will be massive. Surplus offices rezoned, new build homes designed with a study as standard, maybe a change in how we support (or don’t support) childcare.

But for my part as someone who discovered and championed this way of life two decades ago, I just wonder what took you all so long?

Have a great weekend!

[continue reading…]

While nothing is always true in investing, it’s generally the case that buying cheap assets gives you a better prospect of higher future returns.

With bonds the relationship is clear. Lower bond prices mean higher yields – and your starting yield with a bond is an excellent indicator of the return you’ll ultimately receive.

With equities and other assets, the relationship is muddier, but still broadly true. Cheaper buys you future cash flows at a lower cost. Hence you should earn a higher return on your investment.

The track record of value investing beating growth over the long-term is testament to this truth.

But caveats abound!

Value doesn’t always outperform, even broadly. And many individual cheap shares do terribly. By the same token, a particular expensive company might prove to be the next Amazon. There also exists a ‘quality factor’ – a cohort of costlier companies with strong operating metrics that beat the market, at least on a risk-adjusted basis, despite their higher valuation.

Oh, and price is a terrible short-term timing tool. Even over ten years, its forecasting ability is weak (if better than the alternatives.) Expensive shares can get more expensive.

All that said, when you invest in a frothy bull market with high valuations (1999 or 2021) you’ll usually do much worse compared to when you invest in a lowly-rated market (2003 or 2009).

How expensive assets become cheap assets

The obvious question for the wannabe Scrooge McDucks among us is: what are cheap assets today?

Well like the aesthetics of a mullet, cheapness is somewhat in the eye of the beholder.

But it’s not controversial to say that prices (and hence valuations) came down sharply with the wealth destruction of 2022.

With these lower prices should come higher expected returns. (Not guaranteed. Expected).

Who says so? GMO says so

Tracking, crunching, and forecasting such returns across all asset classes is a full-time job. It’s handy then that one very respected shop – GMO – makes its output public.

And the good news is these often-gloomy guys seem much more chipper in 2023.

In a recent quarterly letter, GMO’s co-head of asset allocation Ben Inker first looked back to the end of 2021. Most assets then seemed priced to deliver little gain (return) for the pain (volatility):

Again, expected returns are not set in stone. But if you were a betting person, all that clustering below the 0% real1 return line would have given you the willies.

True, GMO was notoriously gloomy for most of the past decade – during much of which time the US market continued higher on a tear.

But the firm’s warnings were at least somewhat vindicated by the rout in global assets in 2022.

Cheap assets in 2023

The good news is last year’s crash means GMO’s new forecasts are much rosier:

As you can see, there’s now plenty of stuff expected to deliver decent-ish gains over the next seven years, at least according to GMO.

At a glance we can see that most of the risk-to-return line – imperfectly fitted though it is – now sits above the 0% mark.

Also, notice how the slope of the line has steepened? This shows that in GMO’s view, investors can more confidently expect to be rewarded for investing in riskier assets.

Rejoice?

Indeed – but not quite by turning the party dial up to ’11’.

Firstly, lots of these expected returns are still quite miserly compared to history.

Worse, GMO continues to see kegs of disappointment-powder stashed beneath the global market in the shape of expensive US assets.

The US makes up 60% of a typical global index tracker fund. So US equities mired below that 0% waterline might curb expectations for huge global tracker fund returns for the next few years.

GMO’s fund full of cheap assets

But what if instead of our beloved global tracker funds, we went went naughty and tried to only own the stuff that GMO reckons is priced to deliver a stronger return?

Well as a fund shop, GMO provides its clients with just that in the shape of portfolios that accord with its forecasts.

In his letter, Ben Inker flags up what one such fund now holds according to GMO’s ‘Benchmark-Free Allocation Strategy’:

Do you like what you see? Then you can buy into GMO’s fund and hopefully profit.

That is… you can buy into that fund if you have a minimum of $25m to invest. (And £10 leftover to pay for a stiff drink afterwards.)

But fear not!

I did it my way

For the rest of us mortals, I’ve had a bash at approximating a similar portfolio that uses investment trusts and ETFs accessible to UK investors.

Please remember the result is just for fun and (possibly) educational purposes.

It is not a close replication of GMO’s strategy. And it is definitely not investment advice.

Cheap tricks

I’ve made several executive decisions in creating this portfolio, most of which we could debate:

• I’ve used low-cost ETFs where possible.

• In a couple of cases a better vehicle to my mind was an investment trust.

• Some elements of the strategy (especially the structured products and liquid alternatives) are hard to replicate as a UK private investor. (Even US investors have seen mixed results with ETFs that implement the strategies). I’ve fairly arbitrarily picked a couple of relevant ETFs for this slot.

• GMO’s global value versus growth allocation is a long/short strategy. We can’t easily replicate that. Instead I made a (smaller) allocation to global value and increased the holdings in the small cap ETFs. Hopefully this will capture most of the benefit from any continued re-rating of value versus growth (/the market), albeit without the downside protection of shorting growth.

• There will be overlap in the underlying portfolios of the ETFs. (GMO states it gives resource stocks a low direct allocation specifically because they feature in many other positions.)

• I’ve picked some funds more relevant to UK investors – notably the high-yield debt fund – that can be expected to further change the returns from what GMO sees. (On the other hand, we wouldn’t have to pay GMO’s fees!)

• I’ve made allocations in increments of 5%. Finer weighting is spurious for our purposes.

• I do not have an encyclopedic knowledge of ETFs. There are other choices to pretty much all the funds I’ve selected. Some will be cheaper. Feel free to share your suggestions in the comments.

Also note GMO is based in the US and in certain cases (say for fixed income) currency factors may be influencing whether or not something is included in its portfolio.

Bottom line: this is a cheap portfolio of cheap assets inspired by GMO. It’s not a slavish copy.

Do I need to stress again this is just for fun?

The cheap assets portfolio: 2023

Here is what I came up with.

Portfolio of cheap assets for a UK DIY investor

Asset	Security: Ticker	Weight
Global value	iShares Edge MSCI World Value: IWFV	15%
Emerging value equities	iShares Edge MSCI EM Value: EMVL	20%
Japanese small value	iShares MSCI Japan Small Cap: ISJP	10%
European small value	iShares MSCI European Size Factor: IEFS	10%
Resource stocks	Blackrock Energy and Resource Trust: BERI	5%
Cyclical quality	iShares World Quality Factor: IWQU	5%
Emerging debt	iShares JP Morgan $ EM Bonds: SEMB	5%
High-yield / distressed	iShares Global High Yield Bonds: GHYS	10%
Low volatility	iShares World Min Volatility: MVOL	5%
Momentum	iShares Momentum Factor: IUMO	5%
Macro trading	BH Macro Global Trust: BHMG	10%

Source: Author’s research

As I’ve stressed, this portfolio rhymes with the GMO one. It isn’t a replica.

More notes on the selected securities

I’ve mostly chosen iShares ETFs for simplicity. Other ETFs are available.

I chose a general small cap Japanese ETF rather than say a Japanese value-tilted active fund. So we’ve lost the value tilt here. But broad Japanese equities look cheap to me.

I couldn’t find an ex-USA global value ETF. Also hard to allocate to is the tiny ‘US Deep Value’ slot. I might have further increased the global value ETF, but that has 40% in US equities. Instead I again increased the allocation to small cap and emerging market value ETFs.

A commodities investment trust covers resource stocks. With an income bias, it should tilt to value.

Cyclical quality is an odd GMO-bespoke factor I believe. I went with a general quality factor ETF.

I rounded up both resources and high-yield because too-small allocations are pointless.

The thorniest issues were the structured products and liquid alternative allocations.

Liquid alternative ETFs – which basically attempt to wrap an investing strategy into a tradable fund – are not popular in the UK or Europe. Some recent launches here have already delisted.

In the end I arbitrarily plumped for a couple of fairly-applicable iShares ETFs.

The first is a global minimum volatility ETF. It doesn’t seem to have achieved very low-volatility to me. Still, unusual times. More problematic – given GMO’s expected returns – is its 60% US weighting.

I also added a momentum ETF. This, alas, is flat out US-focused. But it should at least have the advantage of being in what’s recently winning. (The downside will come in reversals of trend).

Both of these ETFs are very debatable. Another option would be a multi-factor ETF such as the JPMorgan Global Equity Multi-Factor ETF (JPLG). But it felt more useful to break things out.

Finally I added a chunk of the UK-listed macro hedge fund BH Macro Global. This investment trust has a record of diversifying portfolios, especially in recent years. However I dialed down the exposure to 10%. There’s a lot of idiosyncratic risk when you invest in a costly managed fund.

Could you hold your nose and these cheap assets?

Would I buy this portfolio today?

Well, no. For starters I have my own ongoing active investing adventures to get on with.

Creating it has been an interesting exercise though. It’s revealed to me how relatively expensive my own portfolio probably still is, even after it went through the wringer last year.

It’s also made me wonder whether I shouldn’t rejig things a bit to include some cheap value, and more emerging market assets.

Can you imagine owning such a wildly-off benchmark fund, with all the attendant emotional drama if and when things don’t go according to plan for a while? Let us know below!

But I don’t think anyone sensible would suggest even GMO’s ‘proper’ fund should be the only thing an investor should own. It’s diversified in that it owns a bunch of different and hopefully-cheap assets, but it’s not a proper diversified portfolio constructed to reduce risk.

Also remember GMO’s real-life strategy will be dynamically managed. If value got expensive, say, it would trade it for cheaper growth. The fund wouldn’t hold its allocations indefinitely.

That will make evaluating how my Frankenstein copy performs a rather quixotic endeavour.

Nevertheless, I think unless the market goes totally bananas (sorry, technical jargon) the allocations should be good for a year or so before rebalancing is required.

Perhaps we’ll check back in 2024 to see where we’re at – and what we’d change?

1. That is, inflation-adjusted. [↩]

After a gruelling year in which bonds got pasted, it’s time to take a hard look at the other defensive assets that can comprise a truly diversified portfolio. Bonds alone are not enough. 

We Brits imported the idea that government bonds can shoulder the burden of defensive duties alone from the US. But their perspective is misleading, because their bonds have performed much better than ours:

Data from JST Macrohistory 1 and Aswath Damodaran. January 2023.

The chart shows annual real returns2 of US equities against US government bonds over the past 123 years. 

When the blue equity bars head south, we want the orange bond bars to point north. 

In a nutshell, the case for US government bonds is pretty sound:

• US Treasuries are often negatively correlated3 with US equities in a crisis. (They tend to rise when equities fall). 
• US bond losses have been quite merciful. Up until 2022, that is! 
• For a defensive asset US bonds have done pretty well: 1.44% annualised from 1900 through 2022. 

(All returns quoted in this piece are inflation-adjusted real returns.)

The track record of UK gilts is less impressive:

Data from JST Macrohistory and FTSE Russell.

As an aside, as a proud citizen of Blighty I can’t help but notice how the thick-wooded mass of positive US equity returns in the first graph contrasts with the stunted scrub-land of their UK counterparts in the second. It’s a reminder of why we need to be globally diversified.  

The really unflattering comparison though is with our government bonds. 

Bungling bonds

The UK experience is that our gilts relatively rarely put in a positive performance when equities are down.

In fact, the rise of gilts when equities tumble is mostly a 21st Century phenomenon. 

Gilts are more temperamental than their US cousins. They’ve meted out bear market losses five times and breached -30% losses twice.

To top it off, their long-term growth contribution is a measly 0.91% annualised return. 

UK government bonds have been less effective than US Treasuries in large part because we’re more vulnerable to inflation over here. 

Why a diversified portfolio needs a multi-layered defence

Bonds hate accelerating inflation. So we need to layer in additional diversifying investments, which aren’t as susceptible to the inflationary money bandit. 

Click to enlarge. Gold GBP data from The London Bullion Market Association and Measuring Worth. Cash data from JST Macrohistory and JP Morgan Asset Management. January 2023.

This chart shows how several key diversifying asset classes perform when we narrow the focus to years when equities posted a negative annual return. 

Exciting technical note: In this chart I’ve used the performance of UK Treasury Bills as a proxy for cash. Ordinary investors can hope to do better with ‘best buy’ savings accounts. Gold returns are priced in pounds.

UK equities ended the year down 42 times out of 123 from 1900-2022. That’s 34% of all occasions. Ideally we’re looking for defensive assets that pop their heads over the 0% parapet whenever the going gets rough with shares.

We can see cash offers some limited resistance at times. Gold wins a medal for defying the big, bad bears of the 1970s and the Global Financial Crisis. 

But not a single asset class relieves the pain with convincing regularity – not across the entire timeframe. 

There are also wasted years when nothing works.

This muddy picture suggests we need a bit of everything. 

How often defensive assets support a diversified portfolio 

The bar chart shows how often each asset class succeeded in diversifying against equity losses. By which I mean they weren’t as bad as equities that year. It doesn’t mean they always clocked up a positive return. 

Gilts softened the hard equity rain in just under 70% of all stock market down years. Gold rode to the rescue almost 80% of the time. Meanwhile cash deployed its emergency parachute on 86% of occasions. 

On the other hand, each diversifier sometimes made matters worse:

• Gilts 31% of the time
• Gold 21% of the time 
• Cash 14% of the time 

Remember we’re talking inflation-adjusted returns here, which explains why cash can be a loser even when shares are down.

Nobody’s perfect

I don’t think the fallibility of portfolio diversifiers is widely understood. Many investors expect their portfolio countermeasures to work perfectly every time. They don’t. 

In fact, all three diversifiers failed simultaneously 10% of the time. That means equities were actually the least-worst asset class to own during those particular down years.

Oh, you were hoping your defensive assets would actually produce a positive return during a crisis were you?

Tsk! Some people. 

Okay, just for you let’s see how often the diversifiers landed sunny-side up.

Frequency that diversifying asset classes produce positive returns

Hmm, not great. 

Gilts coughed up a positive result barely 29% of the time. Gold scrapes over the 40% line and cash manages a 42% hit rate. 

And all three turned negative simultaneously in 36% of years that equities fell. 

Psychologically that’s going to grind down anyone if they don’t realise it’s perfectly normal! 

Portfolio diversification isn’t broken. This happens sometimes. More often than we’d like to think.

Although it’s easier to live with if we remind ourselves that storms pass and the long-term outlook is highly favourable.  

What is the best diversifying asset class when equities fall?

Which asset class generates the strongest performance during a down year?

Cash dominates the field, then gold. Gilts head up the defence only 17% of the time. 

 

Again, that blue wedge shows that the diversifiers fell further than equities four years out of 42. 

(Note: The pie doesn’t sum to 100% due to rounding errors and The Investor’s allergy to decimal points.)

But not all stock market slumps are equally terrifying. How do the diversifiers offset the risks of equities during the biggest disasters faced by UK investors?

Defensive diversifiers vs the UK’s eight worst bear markets

Our historical record contains some dark days. The all-time low occurred when the stock market collapsed -72% in 1972-74. 

Meanwhile, World War One and the Spanish Flu combined to smash stocks -57% from 1913 to 1920. 

World War Two was the awful sandwich between two bears. The first letting rip in the late 1930s, with the second only subsiding by 1952. 

Here’s how often each asset class blunted the UK stock market’s eight biggest blows:

Asset	Outperformed equities	Positive return	Best diversifier	Failed
Gilts	6	3	1	2
Gold	8	4	4	0
Cash	7	4	3	1

By this measure gold and cash still look like the UK’s leading emergency first responders.

Gold beats equities in all eight nightmare scenarios. It delivers a positive return four times, and was the best diversifier four times. Cash notches similar numbers.

That’s especially worth noting if you’re a retiree whose sustainable withdrawal rate depends on your portfolio surviving an investing tsunami of a similar magnitude. 

If you combine the three defensives into a single diversified portfolio then:

• All assets outperformed equities six times out of eight. 
• All assets were in negative territory on three occasions. 
• At least one asset managed a positive return five times. 

There wasn’t a single calamity when all three assets failed to improve portfolio returns. 

Horses (of the Apocalypse) for courses 

World War One and its aftermath was terrible across the board. Cash was the top-performing asset on this occasion. But it was still down a cumulative 45% by New Year’s Eve 1920. 

The Great Depression wasn’t as big a shock to the UK system as it was to America’s. Our equities were down -29%. But gilts and cash both rose by over 20%, with gold not far behind. 

Also note that:

• The diversifiers all have a pretty good record against deflation. Especially gilts. 

• Everything fell into the red during World War Two and stayed there. 

• Gilts really benefit from negative correlations with equities from the Dotcom Bust on… until 2022. 

The connection here is interest rates. Gilts are likely to perform in a crisis when interest rates are cut rapidly to deal with falling demand. But gilts are typically a loser when interest rates rapidly rise – especially when inflation rears its ugly head. (Hello 2022!)

Gold also has a solid track record during 21st Century slumps. Partly thanks to the role of the dollar as a safe haven. 

King dollar to the rescue

Sterling generally weakens like a balding Samson during ‘risk-off’ events. Which means that UK investors who own USD-priced assets – including gold – will often experience a welcome ‘bounce’ in that corner of their portfolios when the dollar appreciates.

If you’re intrigued but not convinced enough to hold unhedged US Treasuries in your diversified portfolio, then gold is another way to benefit from that currency shift during a market storm. 

Would you like to play a game of Risk?

Inflation, pandemics, and war are the major threats that are hard to adequately defend against. 

The years when all three diversifiers turn simultaneously negative occur around World War One, World War Two, the Suez Crisis, and the Covid/Ukraine polycrisis. 

Government bonds were useless in four out of five of those onslaughts. But you wouldn’t have wanted to be without them in the Great Depression, the Dotcom Bust, or the Global Financial Crisis. 

A realistic reading of history admits the scale of those events is not predictable. 

Remember that a number of smoking crises had already been snuffed out before Europe combusted into World War One. Even then the major players thought the war would be short. 

The Great Depression was preceded by the euphoria of the Roaring Twenties. 

Hitler could have been stopped earlier. 

The world was unprepared for Covid. And Putin’s Ukraine atrocity, too. 

I could go on.

The point is we don’t know what will happen. So why not lean into diversification and spread your bets across every useful defensive asset class? 

Isn’t there anything better to diversify risk? 

Property REITs, private equity, infrastructure, dividend stocks, and other equity sub-asset classes are all highly-correlated when there’s a global FUBAR. 

So I say: “Next!” 

Index-linked bonds and broad commodities are the two obvious next stops. But our short-term index-linked bond fund pick was beaten by gold and cash in 2022. That’s despite its supposed role as an inflation hedge.  

The short answer to that conundrum is that index-linkers can provide good protection against prolonged, unexpected inflation – provided you buy individual index-linked gilts for a reasonable price, and hold them to maturity. 

The even shorter answer is it’s complicated. Especially with index-linked gilt funds.  

Non-retirees may well be better off relying on equities to simply outpace inflation over time. 

Broad commodities are a wild card. They’re occasionally awesome as in 2022 and 1973-74. But more often they’ll drag you down like concrete Ugg boots. 

Moreover, commodities’ long-term returns look like chump change. Which brings us to another important point.

Diversifiers must be growth-positive 

Why not just ditch government bonds? Here’s one reason: gilts’ long-term growth rate is better than gold or cash.

The 1900 to 2022 scores on the doors are: 

• Equities: 4.85% 
• Gilts: 0.91% 
• Gold: 0.82%
• Cash: 0.45% 

Gilts are twice as good as cash, as measured by UK Treasury bills. It’ll be a closer run thing with best buy cash accounts. But the point still stands. 

The expected returns of government bonds are higher than gold and cash. 

Diversifying risks in a down market

Doubtless we can dial up an optimal blend of assets based on historical returns to reassure ourselves we have the best diversified portfolio possible.

But the truth is there’s no point in finessing asset allocation to the last percentile when past is not prologue. 

What the UK’s historical asset class returns tell me is we need them all – because we need to be ready for anything.

For portfolio equity allocations of 60% and above, I’d personally take the defensive remainder and split it evenly three ways between government bonds, gold, and cash.

Or four ways if you are keeping the faith with index-linked bonds. (I am.)

This is a rough-and-ready solution but that’s fine because ‘Man plans and God laughs’.

Apologies to all the non-men out there but it’s a good adage. 

Take it steady,

The Accumulator

Postscripts

P.S. If I was starting my diversified portfolio from scratch, I’d invest in global government bonds hedged to GBP rather than just gilts. Here’s some ideas for the best bond funds.

P.P.S. You may conclude that you should just invest in US securities and be done with it. But there’s no guarantee that America’s charmed run will continue. Not because its superpower status is imperilled but because US returns have lagged the rest of the world for entire decades in the past. Ultimately, equity results rest upon valuations. If the prices of US securities are bid too high then they will disappoint those who buy based purely on recent performance. Stay global!

P.P.P.S. I examined UK returns going back to 1871, but equities were only down one year in the Victorian Golden Age. Our top-hatted forebears had to cope with a -1.1% thrashing in 1891, triggered by the Baring Crisis. Gilts and cash were both marginally positive that year, with treasury bills just edging it. 

P.P.P.P.S. This is getting silly now.

1. Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. [↩]
2. Real returns subtract inflation from your investment results. In other words, they’re a more accurate portrayal of your capital growth in relation to purchasing power than standard nominal returns. [↩]
3. A positive correlation of 1 indicates two assets move up or down together in perfect sync. A negative correlation of -1 indicates they move in opposite directions: when one rises, the other falls. We want diversifying assets to be negatively correlated with equities when stock markets slump. Although we don’t want them to nose-dive when equities rise, either, so ironically it’s best that two assets aren’t perfectly negatively correlated. A correlation of 0 shows that two assets are randomly correlated. In other words, their movements have no relation to each other. [↩]