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Weekend reading: Moving (and) markets edition

by The Investor on February 11, 2018

Fear not friends, and back to the drawing board foes. I’m alive and well. Thanks for the several notes of concern.

A few readers mused whether the – ahem – tumult of the past few days had sent me into exile?

Had my 100% all-in bet on a low volatility ETF blown up, taking my wealth and credibility with it?

Alas, no cigars. It takes much more than a 5% swing in my portfolio to send me packing. Besides, this is too much fun.

All week I mentally drafted and redrafted a post about the fascinating return of market volatility in the past 10 days.

Unfortunately though I first had no time to write it, and now I’ve no Internet. More on why below.

It’s probably just as well. Whenever the stock market makes the mainstream news, there are worse rules of thumb for long-term investors than to turn that news off.

Watch the rugby instead! I found this past week or so invigorating, but I’m a fanatic. You don’t need to be.

Musing on the markets

Here’s a few quick thoughts – feel free to skip if you’ve sensibly developed an intolerance for one person’s speculations:

Talking heads on CNBC and elsewhere blamed the volatility on robot traders and ETFs and the new era of Skynet and Robocop. This is mostly nonsense. Volatility has always existed in markets, especially at times of regime change, which is what I think this. (Regime change is loosely a systemic change in fear levels or rate or inflation expectations or a momentum change).

Hilariously, the same pundits have spent two years blaming the very low volatility we’ve had on robot traders and ETFs. Equally nonsense. The market has been through low volatility periods before, too.

If anything novel was dampening volatility, it was almost certainly very low interest rates since the financial crisis. It is that regime that seems to be ending.

Higher bond yields were always going to be reflected in changing equity valuations. That is one reason why I have warned those who feared bonds were excessively expensive to remember that equities are partly priced off bond yields. See my article on the problem with low interest rates for more.

I personally believe the market has detected the return of inflation, and is repricing accordingly. To some extent the sudden and sharp disruption to the long-prevailing millpond conditions was probably because lots of active money (e.g. hedge funds) had been betting explicitly on low volatility. But as I allude to in that article I linked to above, it’s also because equities are priced partly off long-term yield expectations.

None of this works like clockwork, not least due to technical factors. So for example bonds and equities can go down at the same time together, and will if the market expects increasing yields in the future. Repositioning an entire market structure creates its own short-term dislocations! It’s over months and years we’ll see what was really going on, not hours or even days. Diversification doesn’t deliver minute-by-minute compensations.

It is completely true that several daily rebalanced and in some cases leveraged exchange-traded products ‘blew up’ when volatility returned and promptly screamed off the charts. A few closed down. The products didn’t fail as such – they did what they said they’d do, in these conditions. You were silly if you’d bet the farm on them. Surely nobody did?

More relevant (far bigger) are the so-called risk-parity funds that try to balance equities and (usually leveraged) bonds to the optimal point for the best risk-reward returns. As volatility increases, their risk models change, which means they need to rebalance, which can prompt selling, which will increase volatility, which feeds into the model, and so on.

To that limited extent there was a feedback mechanism in the market. But I still think it’s wrong to blame ‘robots run amok’. Humans would do the same thing, only more slowly. Higher volatility means more value at risk in a portfolio. For some money managers that can prompt selling riskier assets (shares, maybe certain kinds of shares) to reduce risk.

Once this (supposed) ‘de-risking’ began, it was going to go on for a while. Personally I think it will likely continue for some time to come, and we may well see a small bear market develop over the next few weeks and months. Your guess is as good as mine though. I’m opining for fun – nobody knows!

High equity and bond valuations exacerbate all this, for many different reasons. But cheap equity valuations are no protection once the selling begins.

It’s different for bonds, because the pension world needs to own them to match liabilities (and arguably there’s not enough around.) There’s a permanent bid, and at some point a yield will be found where bonds stabilize. Probably higher than here, across the world.

Remember this is almost certainly a market correction, not an economic disruption. Growth is great everywhere apart from the UK, which is lagging because of the Brexit baloney (as it will likely now do for a decade, as even the government’s own forecasts have now admitted).

Great growth does imply higher inflation, but also a good environment for companies to grow profits, hire more workers, increase wages, and so forth. These are ongoing ills that do need addressing. In the long-term this is a good problem to have.

If you’re an active sort, you might want to make sure you own companies with exposure to bulk commodities. (Passive investors will have some exposure anyway in FTSE trackers etc). I’d consider owning some gold, too. (Don’t expect gold to go up the day markets go down, or anything so orderly. If share prices follow a random walk, gold follows the random walk of a drunk. But eventually he makes it home.)

People will say “you have to be in equities because they will protect you against inflation”. But remember, we may have already had our inflation protection from shares. Pundits tend to miss this – global trackers have been going gangbusters for a decade, and they could not continue like that forever. You get your on-average higher returns from shares averaged over many years. i.e. High returns in recent years could have ‘borrowed’ some returns from the future.

The best thing is a balanced portfolio that you set up for all-weathers. Many Monevator readers – particular the passive-minded who find my co-blogger less distracted than old gadfly me – have such portfolios. Along the lines of our Slow and Steady model portfolio.

Such passive investors should probably do nothing in the face of this return of volatility (and potential regime change towards higher yields). Continue with your plan, and rebalance when you’d planned to rebalance. Don’t panic!

The exception is if you’ve now realized you really own too many equities as you’ve watched your portfolio oscillate this week. Be careful! Most people find it infinitely easier to see shares go up than down. Do nothing is a plan of action to stop you focusing and fussing, and selling when markets are down. But if you genuinely feel you own too many shares in retrospect, it’s probably better to get comfortable by reducing your allocation a little (I’d switch to cash not bonds for now) rather than risk selling everything if we have a bigger correction.

Markets go down as well as up. That is not small print, it’s chalked into the walls of the stone Temple of Investing. We were bound to see falls again, and while this week has had some fun elements we will see far worse in terms of peak-to-trough declines in the future, some day.

Volatility is a feature, not a bug!

Not (yet) all mod cons

Right, so I’m in a coffee shop. Why? Because my new flat has no Internet yet.

Yes, I’ve bought a property and moved this weekend!

Let’s discuss why, how, and whether it was a good idea in a future post. I hope to be back to normal in a fortnight or so – at least back with links by next weekend.

But for now my cup running empty. The millennials around me seem happy to occupy their tables all day with an espresso bought six hours ago, but I’m made of more self-conscious stuff.

Take care, don’t do anything silly with your investments – and look out for The Accumulator’s broker table update on Tuesday!

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Weekend reading: Three graphs that boil down the retirement income conundrum

by The Investor on February 3, 2018

What caught my eye this week.

These three graphs from The Retirement Café illustrate the case for a so-called ‘floor and upside’ approach to investing for an income in retirement.

Some people plan to have all their money at the mercy of the markets in retirement. They’ll then make systematic withdrawals, either by selling down capital, taking an income, or a mixture of both.

That’s a fine approach on paper – especially if you like an exciting read, because the fact is you don’t know how the story is going to end:

An alternative is to turn your entire pension pot into a certain income. This is the equivalent of what you used to have to do in the UK when you were compelled to buy an annuity:

The floor-and-upside approach always looks the most sensible blend to me – if you can afford it. Here you turn some of your funds into a guaranteed income, and invest the rest in volatile assets:

The lack of a scale on the first two graphs does flatter the cost of buying a secure ‘floor’, in terms of forgoing potentially superior returns. But that’s a minor gripe. Do read the whole article.

Remember that British retirees are entitled to a state pension, which provides some element of your secure income floor. See our previous articles on creating a secure retirement plan and devising your income floor.

[continue reading…]

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Types of investing risks

Updated by The Investor on January 31, 2018

There are innumerable investing risks, so here is a bluffer’s guide to the main ones.

Next time you consider an investment, make sure you know which of these risks you’re taking, whether you’re comfortable with it – and whether you’re being offered a sufficiently attractive potential reward to compensate.

The presence of these risks does not mean an investment is a bad one. All investments have at least one of these risks.

What matters is whether price is right for the risk, and whether you understand what you’re getting into.

Note: These aren’t textbook definitions of types of investment risk. They’re meant to get the point across quickly to everyone, not stand up in a court of law.

Business risk

Sometimes used to refer to what I call ‘stock specific risk’ below: that is, the specific risks related to one company’s operations. Others use it to describe risks affecting all companies operating in a particular sector. For example, all fishing boats in the same port are affected by periods of bad weather, however skilled their captain or hearty their sailors. I think ‘sector risk’ describes that better.

Currency risk

The risk that comes through changes in the exchange rate between one currency against another. If you invest in European companies and the Euro collapses versus your currency, then your investment will be worth less in local terms when you bring the money back home (unless your funds are hedged, which costs). Similarly, your repayments on a foreign mortgage will rise as your currency weakens. Currency risk can work the other way of course, to your advantage.

Counterparty risk

This is the risk that someone you’ve entered into an agreement with will default or otherwise screw-up. It’s often not immediately apparent when you make the investment. For instance, the fancy Guaranteed Equity Bond your bank sold you might involve contracts underwritten by an American bank you’ve never heard of that goes bust. Don’t laugh – it happened.

Credit risk

Some people don’t pay what they owe. Nor do some companies. Sometimes even countries fail to cough up. If you’re a good credit risk, that means that banks and others think you’ll pay what you owe. If you’re a sub-prime borrower, they may be more concerned – unless you want a mortgage on a shack in a swamp in Florida in 2003-2007. Credit risk is sometimes called default risk.

Inflation

Ever increasing prices is the reason why nobody ever got rich from keeping money under the mattress (except perhaps the makers of mattresses) and the first reason to invest. It’s not just the low but steady inflation we’ve become used to in recent decades – and that you can plan for – that erodes your returns. If you’re very unlucky double-digit inflation comes out of the blue to crush fixed interest savings. Just ask the nearest German centenarian.

Interest rate risk

The risk that the value of your asset – usually a bond, but also to an extent stocks and other securities – will change in response to changes in interest rates. For instance, if you buy a long-dated corporate bond yielding 5% when base rates are 2%, it will very likely (but not inevitably) fall in price if base rates rise to 4%. A new purchaser would probably demand a higher yield (that is, would pay a lower price) to invest in the same corporate bond, given the risk-free rate was now 4%. A related risk is when you put cash in a fixed rate savings account, or take out a fixed rate mortgage. Your fixed rate will be less or more attractive as the base rate changes.

Liquidity risk

Liquidity is a measure of how easy or hard it is to sell an asset. Cash is very liquid; a house is illiquid. Some small company shares can be easy to sell – just log into your online broker and place the order – but if you try to sell more than the cost of a fancy sofa’s worth the price can plunge, which is another risk of poor liquidity. Money tied up for a year in a fixed rate bond is also illiquid, but that’s a given when you invest. You are accepting interest rate risk, and also the risk that you need your money before the term is up.

Management risk

When you invest in an actively managed fund or investment trust, you take on the risk related to the manager’s performance. He or she may do better than the market, or more likely worse. Using index tracker funds gets rid of management risk. The price you pay with a tracker (for most of us well worth it) is you’ve no chance of beating the market.

Market risk

This is the risk you take for simply showing up and investing in a volatile market. The stock market, the property market, even the market for antique hobbyhorses – all move in their own broad trends, which affect all the assets in that market. You can’t reduce market risk when hobbyhorse investing by buying two different hobbyhorses. But you could buy one hobbyhorse and spend the rest of your money on an antique sideboard. Market risk is sometimes called systemic risk – mainly by pompous people like me.

Political risk

There’s a reason why the Russian stock market usually trades on a lower valuation than Western markets, and why London-listed South African companies may seem cheap. The Russians are experts at the appropriation of private property, while South African companies operate in a beautiful country that politically appears to be going backwards.

Regulatory risk

Political risk for Western economies. The risk that politicians or other lawmakers introduce new rules or costs to an industry or sector that hurts your investment. The growing risk that we might see the election of the most left-wing UK government since the 1970s has hit the shares of energy companies, for example.

Stock specific risk

This is the risk that a particular company goes bust, even while the market sails on regardless, leaving your crappy shares in it floating lifeless in the wake. Companies can fall in price or go bust for all kinds of reasons, from fraud to poor management, though it usually amounts to running out of money. This sort of specific risk is also why fund investors (including passive investors) should spread their money between different companies as their portfolio grows. I even think you should keep some cash in different banks, even if your total balance is below the FSCS compensation limit. Assume anything can fail.

Volatility

In simple terms, volatility is the range over which the value of an asset moves over some time, usually a year (technically, the standard deviation over the return rate). If the price moves a lot, it’s a high volatility asset, whereas if it doesn’t go anywhere quickly, it’s low volatility. Low volatility usually seems more attractive, but higher volatility can deliver superior returns to compensate. Diversification can reduce volatility without denting returns to the same degree. It’s worth considering how closely – or not – academic notions of volatility mirror your own concerns as an investor. (Volatility risk has specific meanings, to do with options or currencies, beyond the scope of this article).

Remember, diversification is your best friend when trying to reduce investing risks. To learn more, please read my article for beginners about risk, returns, time, and diversification.

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Weekend reading: Mifid II reveals hidden depths to fund charges

by The Investor on January 27, 2018

Investing stories that caught my eye this week.

Where’s your fee-phobic passive investing co-blogger when you need him? That’s what I thought as I read an expose of hidden fees in the Financial Times on Monday.1

In conjunction with the similarly cost conscious Lang Cat consultancy, the FT has totted up the hidden fees on a variety of popular funds, as revealed by the new Mifid II trading regulations.

Mifid II requires funds to go beyond the ongoing charge figure (OCF). They must now also give a total cost, including transaction and trading costs and other charges.

The FT reports:

“…many investors pay almost double the OCF in the UK’s most popular funds once transaction costs are included.

This can go up to four times OCF if platform charges and performance fees are included.”

As you’d expect, some active funds don’t fare well under this particular shaft of sunlight.

For instance the FT highlights the Janus Henderson UK Absolute Return fund, which has an OCF of 1.06%, as well as transaction costs of 0.79%. If platform fees (via Hargreaves Lansdown) and a performance fee is added on, the total annual cost rises to an average of 3.82%.

But tracker funds have also found the receipt to extra charges down the back of their sofa. For example the BlackRock iShares FTSE UK All Stocks Gilt tracker fund has an OCF of 0.2%. With platform fees and transaction costs the cost rises to 0.75%.

Few Monevator readers should be shocked by the platform fee component of the analysis – our broker comparison table has long highlighted that particular burden of investing.

But transaction fees and similar data have been much harder to come by.

As Lang Cat director Mike Barrett says:

“It is grimy that it has taken some EU regulation for asset managers to tell investors what the true cost of investing is…

You have always been paying these fees, but now the fund groups have the good grace to tell you these costs upfront.”

Separately, Andy Agathangelou of lobby group The Transparency Task Force has written to the head of the Investment Association demanding an apology for a previous report from the latter that had claimed hidden fees were the “Loch Ness Monster of investments”.