Some great reading on money and investing.

When you’re young, half the classic books you read seem to apply to you. For example, like many a nerdy teenage bookworm without a girlfriend, a driving licence, or even a favourite tipple, I managed to see myself in Jack Kerouac’s literary tale of drop-out debauchery, On The Road.

Yet simultaneously my favourite poet was John Keats, the prototypical Smiths-ian hero – and a Romantic who possibly died a virgin.

As you get older, you start to get a better sense of who you are. As the English dandy Quentin Crisp once quipped:

“It’s no good running a pig farm badly for 30 years while saying, ‘Really, I was meant to be a ballet dancer.’ By then, pigs will be your style.”

Something similar has happened to me with my investing, and the investment books I enjoy. In my earliest days of investing (and even in writing with this blog) I toed the sensible line of putting away a bit of your earnings every month, investing it entirely passively, and waiting for the pay off 30 years down the line.

But in reality I’ve grown more drawn to biographies of Warren Buffett or even profiles of hedge fund managers, and I’ve invested my money ever more actively and aggressively.

Let me stress as usual that I don’t say this is the right thing for you to do. Most people are statistically best off following the passive approach outlined by The Accumulator here on Monevator. A good chunk of my money is in various index funds that are periodically rebalanced, too.

But it’s a case of do as I say, not as I do, with the rest of it, and I’m sure that’s what makes Free Capital, a just-released profile of a dozen super-successful UK private investors, such a compelling read for me.

Pre-release copies of this new book by Guy Thomas have been floating about the UK investment scene for a several weeks now, and I was very glad to get my hands on one. Extra frisson comes from the fact that – in online form at least – I know who a few of the purportedly anonymous investors really are. Long-time denizens of bulletin boards like The Motley Fool, ADVFN, and Stockopedia will have fun trying to guess the usernames behind the biographies and strategies.

Actually, there’s very little pure strategy discussion in the book. Thomas also resists the urge to say that just because these 12 investors made themselves millions by investing in the stock market, “you can to”. In fact, he’s downright frank, discussing in some depth the role that luck undoubtedly played in their success.

But he also writes:

A reasonable observation put to me by one of the interviewees is that there are two types of luck. The first type, ‘lottery luck’, is wholly random – like winning the lottery – and exposure to its possibility requires negligible effort, like buying a ticket. But there is another type of luck characterised by French microbiologist Louis Pasteur: “in the fields of observation, chance favours the prepared mind.”

I think this is a reasonable compromise. Several of the investors profiled made huge gains in the late 1990s stock market bubble, for instance, and held on to them. They were lucky to be in the right place at the right time, and then to buy the right stocks, and perhaps even lucky to get out before the crash (as opposed to prescient). But it was no accident that they were invested.

Inevitably, survivorship bias looms large. This is a book about 12 investors who – leaving aside a couple of very distinct outliers – reinvested savings from their salaries into strategies that paid off big time. They’ve made themselves ISA millionaires. Given the short time ISAs have been in existence, that’s something that can only happen by compounding very strong gains.

It isn’t a book about the losers who tried to do the same.

On the subject of losers, I’m not surprised to see these self made millionaires didn’t get there by relying on financial advisors, or even fund managers. Trying to beat the market may be a quixotic goal, but doing so while also paying for a bunch of hangers-on is an even harder one, unless you’re rich to start with!

Whether you go active or passive, it pays to read obsessively, take responsibility, and do it yourself.

I’m not going to write much more about the lessons, such as they are, in the book: Most are lifestyle orientated, as opposed to general investing ones, anyway. Virtually all the mainly 40-somethings featured (all male) are living reasonably modestly compared to their net worth, many are childless, and the few who risked getting married often got expensively divorced. Most seem introverted, and a couple borderline Aspergic.

All useful traits for accruing self-invested wealth, but if you want something different out of life, you’d be a fool to copy them for money. As for me, while I’m not quite the shy bookworm of my teens, I’m still your basic introvert, a natural long-term thinker, a marriage-a-phobe, a dedicated follower of business and the markets, and living well below my means. I’m also on a path that could put me in this book in a decade’s time. (Well, with luck!)

I heartily recommend the book if this sounds like you, too.

[continue reading…]

Note: What follows contains lots of speculation and fantasy finance. It is not a prediction. It is a reminder to keep our eyes on the horizon.

I had a dream which was not all a dream.
– Lord Byron

So here we are in April 2020. It’s a strange date to type out – it reminds me of when I was both a kid and a bookworm, and so I dreaded the arrival of 1984. For the first two or three months of that year I felt like someone was watching over my shoulder as I wrote the infamous date into my schoolbook each morning.

Now it’s 2020, and I can’t help looking back with 2020 vision.

Bear necessities of an investor’s life

As a Monevator reader, you don’t need me to tell you it’s been another good year for the stock market.

Strange to think that when I started writing this blog back in 2007, the memory of the Dotcom crash and the slump that followed had barely been expunged by a timid march towards the pre-crash highs, before we ran into the sub-prime crisis and another plunge in stock markets around the world.

I used to believe that investors of my generation would one day be grateful for a chance to get into equities at reasonable levels, but I don’t think many of them actually did. Going on Monevator traffic, it wasn’t until 2015 or 2016 that people really started taking an interest in shares in a big way again.

As a still-anonymous blogger – barely – the long years in the wilderness with just a loyal band of readers suited me fine. Having the Daily Mail camped outside my front door in 2018 after Time Warner tried to buy Monevator was infinitely scarier than seeing shares plunge in 2008.

And in case you’re still wondering, no I’m not Richard Branson, King William, Toby Young, Lady Gaga, or that Australian from the old show, Dragon’s Den.

Things could only get better

Anyway, I’m rambling – an increasing foible as you age, they say, but long-suffering readers will know it’s always been my vice!

Back to today’s stock market, and it seems fitting that the FTSE 100 finally broke through the 14,000-barrier this month. Round numbers don’t mean anything to computers, but thanks to behavioural economics we know they have an impact on us sentimental investors.

I’d love to have a time machine to go back to 2009, when other bloggers ridiculed me for writing about the potential for a great decade to come for equities.

Not because I would like to take them an iPad 11 to show them a screenshot of the FTSE 100 at 14,000 – if they ignored the evidence of historical asset class returns in favour of Doomsday scenarios, then I don’t see why they’d listen to a salt-and-pepper haired blogger from the future in a blue jumpsuit.

No, I’d simply use my time machine to go back and invest more money.

Short of borrowing to invest, I threw most of my disposable income towards snapping up equities between 2008 and 2011. Yet who wouldn’t have invested even more knowing what we now know?

Then again, as I say the decent run for shares wasn’t entirely unpredictable.

Short-term returns from equities are fiendishly volatile, as any investors who lived through that grim first decade of the 21st Century will attest. But over the longer-term, it tends to even out.

Indeed, by April 2011, the FTSE 100 had already soared like a phoenix from the flames (or like a bonfire of discarded share certificates heaped and set alight in a dumpster) to break back above 6,000.

14,000 and rising

Now, we know the long run nominal return from UK shares has been about 10%.

As well as inflation, that 10% return includes dividend income. Excluding the latter but not the former, we might have guessed the FTSE 100 would grow at about 7% for the nine years to 2020.

This would have taken the index to 11,000. But remember too that the decade from 2000 to 2010 was one of the worst on record for shares. Things were likely to do better than average, in turn.

True, much of the near-20% returns per annum that optimists predicted for the decade that followed were delivered in the early years of the recovery, as the market roared back from the March 2009 lows.

Yet valuations and sentiment had both become so thoroughly depressed by 2009 that equities have had a decent push beyond their long-run average for most of the past 11 years.

As it turned out, an investor who put £10,000 into the cheapest FTSE 100 index tracker in April 2011 and reinvested all her dividends should now have a nest egg worth approximately £30,000. And if she’d been even braver, and invested in the nadir of 2009, she’d have over £50,000.

Who says optimism never pays?

Bonds a bust, gold got sold

It hasn’t all been plane sailing. While we’ve seen none of the truly horrendous turmoil that scared that earlier generation of investors so silly that for a crazy moment in late 2008 they accepted negative returns on US Treasuries, we have had the usual lurches in confidence – along with the usual background noise of geopolitical posturing.

And needless to say, while equities are the biggest daredevils of any portfolio, they aren’t the only asset class that can give investors the willies.

The great bond rally of 1980 to 2010 finally broke down, for example, to the dismay of those who’d gorged on those 30-year issues that Central Banks pumped out in 2009 and 2010. But at least with bonds you get your money back if you hang around long enough.

Not that anyone seems to want to hold bonds these days. Nor cash, for that matter, despite 7% interest rates. We would have killed for that a decade ago!

Of course, back in April 2011 it was all about gold, which had just hit $1,500 an ounce – roughly where it sits today. Gold bugs were right that the price of gold would go higher, but wrong that we’d all eventually trade in our American Express credit cards for Krugerrands and shotguns. Eventually, gold fell. The yellow metal is a valuable diversifier, but there’s no comparison between backing it or human industry.

The same might be said about oil and the other commodities. Yes, they provided the early juice to the recovery, as countries like China and India took the accelerated steps that turned them into the top-tier powers we know today. But oddly enough, just like the British Empire and the American one that followed, China and India still haven’t consumed every last lump of whatever the Australians can dig up. Our energy use has changed, and we’re also changing how we make things, which ultimately put a lid on price rises.

Just ask anyone who bought into that insane IPO of 2015, which simply proposed an open-ended mandate to begin an “undertaking of great advantage” through mining operations in the last unexplored realm within our reach.

Back to the future

The flotation of Moonshot Mining PLC aside, most of the past decade has been largely free of the bubbles that blighted the previous ten years.

So has humanity finally learned its lesson? Hardly. I’m sure we’ll see bubbles again in my lifetime.

It’s true that 2000 to 2010 did leave a painful memory. But frankly, those same events also left the average Man on the Clapham Hoverbus without much money to pump up a new bubble – especially given the competing need to service those horrendously huge mortgages taken out on UK property as a result of the last one. (Even higher interest rates from 2012 haven’t really dented London property prices. Long-time Monevator readers will know I’m STILL renting as a result!)

Having said all that, there are some signs that shares are now getting frothy.

The rally over the past decade has been broad, with miners eventually giving way to leadership by the global consumer companies that rule our world, and to the eventually rehabilitated banking and housebuilding sector.

But technology shares have arguably become very overvalued, 20 years after the last tech bubble burst.

Also, while I’m his biggest fan, I do wonder whether Warren Buffett can really keep running the very expensive-looking Berkshire Hathaway from a life support machine.

Bond vigilante

Overall the market isn’t expensive, claim my critics, who call me a grizzly old bear. “Britain is booming!” they cry, adding that we can hardly have a recession when so much of what we used to call the emerging world is now living the middle-class dream.

It’s funny how things turn on their head if you wait long enough.

Maybe I am an old fuddy-duddy. From 2008-11 I was happy to run 90% equity exposure: I knew it would hurt me in a dip, but the opportunity was there for the taking and the odds seemed fair. Plus I had a crucial long-term perspective.

Now I’m 50% in cash and bonds, which is much more conservative than my share crazy doctor tells me I need to be. (He’s also more bullish that I’ll eventually reach my centenary, too, but then I can remember when even a 70-year old was considered ancient. Buy more GlaxoSmithKline-Zeneca, I say).

So why the shift in my portfolio? Joking aside, it’s partly an age thing – I’ve ten years fewer left now to ride out the vicissitudes of the stock market.

But there’s also the thorny matter of valuation.

Back in 2011, the FTSE 100 was on a forecast price-to-earnings ratio of roughly 10. The P/E ratio fell to less than 9.5 for 2012. These numbers suggested investors didn’t expect much growth to come.

Fast-forward to 2020, and I’m assured a P/E of 22 reflects the new reality of a world population that’s topped 8 billion hungry souls.

The next bear market

A new reality, eh? Now where have I heard that before?

Personally, I suspect a new bear may finally be preparing to emerge from the history books. Don’t ask me when it will strike – nobody ever knows, and markets can stay irrational far longer than you will want to wait. (Did I mention I’m STILL renting?)

I tell you this though: I am more fearful today given how everyone seems so gung-ho about equities, compared to when none of my friend’s cared less.

What should you do? Some will say stock up on gold and cans of tuna, but of course there’s no tuna left.

Instead I suggest you rebalance your portfolio a shade more conservatively, consider a few alternative assets, and don’t be afraid to hold cash.

I know, I know: you tripled your money by investing in shares over the last decade. But take it from an old codger – the good times won’t last forever.

The sleepy backwater of passive investing has been rudely disturbed by the clanging of alarm bells. The explosive growth in Exchange Traded Funds (ETFs), especially synthetic ETFs, has been spotlighted as a potential threat to the stability of the global financial system in reports by the G20’s Financial Stability Board (FSB), The International Monetary Fund (IMF), and the Bank for International Settlements (BIS).

The reports warn of a daisy-chain of risks embedded in the design and operation of ETFs. They urge investors, regulators and the ETF industry to take heed.

Having read a flurry of disturbing media articles based on the reports, I dived into the original material hoping to discover the threat had been hyped out of all proportion. Unfortunately not. The FSB talk of “disquieting developments” and the BIS paper draws upon the experience of the sub-prime implosion to warn of the dangers of looking the other way.

There’s a lot to take in, so I will concentrate purely on the potential threats posed by synthetic ETFs (also known as swap-based ETFs) in this article, and deal with physical ETFs later.

Emerging synthetic ETF risks

It’s the runaway success of ETFs that requires the risks to be reassessed. The ETF dream is access to a diversified low-cost portfolio using a simple investment vehicle that can be traded like shares. That’s jacked up global ETF assets under management from $410 billion in 2005 to $1,310 billion in 2010, according to the BIS.

But this rapid rise has fostered innovations like synthetic ETFs that could have unforeseen impacts during times of market turmoil. The reports highlight a number of possible dangers that feed into each other, including:

• Counterparty risk
• Collateral risk
• Liquidity risk
• Conflicts of interest

Counterparty risk

The most famous example of a counterparty default is Lehman Brothers. In the ETF world, counterparties are most commonly used by synthetic ETFs. Unlike physical ETFs, synthetics don’t use their investors cash to buy the physical underlying assets of the index they track. Instead they buy a total return swap from a counterparty (usually an investment bank) that guarantees to pay the ETF provider the return on the index being tracked.

If the counterparty goes bust then there’s nobody to pay the ETF return. That’s unpleasant but supposedly not disastrous because the counterparty hands over collateral to the ETF that’s meant to cover at least 90% of the ETF’s assets. In an emergency, the ETF provider can sell off the collateral to repay investors.

It’s conflict of interest time again

Unfortunately, all three reports identify potential conflicts of interest in the structure of many synthetic ETFs, to the extent that I’m reminded of playing Jenga on a wobbly kitchen table – in Tokyo.

The problem is that ETF providers and counterparties are often different arms of the same institution – especially in Europe. For example, Db x-tracker ETFs are part of Deutsche Bank and Lyxor ETFs are a chip off the French bank, Société Générale.

The suggestion is that investment banks can save costs in other parts of their business by using ETF collateral baskets as a dumping ground for illiquid, hard-to-sell securities that might otherwise be cluttering up their books. For example, your FTSE 100 ETF might actually be backed by unrated corporate bonds or Japanese small caps.

The FSB suggests that lowering the cost of funding may be the reason why investment banks conjured up synthetic ETFs in the first place:

As there is no requirement for the collateral composition to match the assets of the tracked index, the synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market.

And while that may be good for the banks, it’s not so great for investors in the event of a market crisis.

Collateral risk

Though synthetic ETF assets and investor interests are theoretically covered by collateral, all is not rosy:

• Illiquid collateral is hard to shift. This could damage the liquidity of ETFs that are forced to sell in order to meet redemptions.
• The collateral may not adequately cover the ETF’s assets, especially in a falling market.
• The ETF may not be able to sell pledged collateral, if it is frozen by a bankruptcy administrator when a counterparty fails.

ETFs often maintain collateral worth up to 120% of assets, but as the BIS comments:

Overcollateralisation might provide little comfort, as crisis experience has shown that collateral quality tests and collateral coverage tests designed by rating agencies for structured products did not protect senior tranche holders from losses.

If collateral provides cold comfort and seismic market events heighten the possibility of counterparty default then nervous investors could force a run on synthetic ETFs, as outlined by the BIS:

Patterns of withdrawal from money market funds during the crisis show that institutional investors are likely to be the first to run when markets question the solvency of a fund provider, which can then trigger a broader run on the industry.

Liquidity risk

If the ETF provider faces a tidal wave of redemptions requiring cash to be returned to investors, then a mechanism that has previously been a font of cheap funding could become a strain, in the view of the BIS:

Sudden and large investor withdrawals triggered by market events or counterparty risk concerns can also lead to funding liquidity risk. This risk can propagate through the investment banking function, which might take for granted the access to cheap funding through the swap arrangement with the ETF sponsor.

The evaporation of funds, compounded by congealing collateral, could also compromise the ETF provider’s ability to maintain the market liquidity of synthetic ETFs, according to the FSB:

In case of unexpected liquidity demand from ETF investors, the provider might face difficulties liquidating the collateral and may be faced with the difficult choice of either suspending redemptions or maintaining them and facing a liquidity shortfall at the bank level.

Funding stress at the bank – in the teeth of extreme market conditions – would surely heighten fears of counterparty risk. As the FSB puts it:

Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.

Moreover, the other option of suspending redemptions could have knock on effects for the market-makers who match buyers with sellers on the exchange, adding to the turmoil. The BIS paints the picture:

Because ETF redemptions will require cash to be delivered against collateral assets that might be illiquid, market-making activities could be severely hampered, as funding these assets might take priority. The collapse of funding for individual financial intermediaries could then reinforce funding stresses for the financial system as a whole.

Run for the hills?

Added together it’s enough to make my primal-self want to split my money between the mattress and a hole in the ground. However, all three reports are careful to point out that they’re highlighting potential risks, not an imminent doomsday scenario.

The ETF industry is already responding with talk of how robust their operations are and claiming that the theorised collision of calamities is the kind of black swan that won’t fly.

Still, few saw sub-prime coming either and no doubt that’s contributing to greater regulator vigilance this time.

There’s plenty more in the reports if you fancy a bigger dose of the willies. Warnings about the complexity of leveraged and inverse ETFs, the impact of ETFs and ETCs on their underlying markets… and there’s no need to look smug if you only hold physical ETFs. Security lending programmes leave them exposed to collateral and counterparty risk, too.

I’m not advocating consigning synthetic ETFs to a toxic tank that’s already full of endowment mortgages and split zeroes. We need to see how this one plays out.

But rest assured I’ll be keeping an eagle eye on synthetic ETF risks in the future.

Take it steady,

The Accumulator