Archive Monthly Archives: October 2019

What are the best long term asset allocation strategies? What level of dividend cover should I aim for? Is the science of Chartists worth studying?

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q&A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

The full set of notes and video replay are available for Patreon supporters here

What are the best long term asset allocation strategies and does frequent re-balancing make a material impact on the results?

Question: “When investing for the long term ( 20+ years), which of the following two strategies have historically had better results?

a) 100% equities (no re-balancing)

OR

b) A small amount of bonds (10% to 20%) so that when the re-balancing happens you buy cheap stocks / sell expensive stocks.

Follow up: does the frequency of the re-balance make a material impact to results? ( monthly vs quarterly vs yearly)”


Over the long term equities almost always beat bonds. That means that for long-term investors, it's almost always best to be 100% invested in equity.

For the US market (diagram below), we have a long series of data. If we go back to the 1950's you can see the equity return, which is the total return including dividends and subtracting inflation, has been 7% and the volatility has been 12%. For treasuries for the same period it was only 2.5% in real terms and the volatility has been 6.4%. Therefore, over the long term, there is no question that equities outperform bonds.

If you are going to invest for a very long period of time it makes sense to have a very high equity allocation. That is why we talk about Life Strategies 20/40/60/80s.... the longer your investment horizon, the more you need to put in equity.

If you are only investing over a short period of time then put less money into equity because there is more chance of a crash in equity then there is in bonds. That is why the volatility of bonds is 6.4% which is about half the volatility of equity.

 S&P 500 and ten-year US Treasuries

The minimum risk portfolio in the example below is actually about 21% equity and 79% bonds. This is called the minimum variance portfolio and this low level of risk is achieved because the portfolio is diversified. The beauty of diversification is that you can end up with a portfolio that has a lower risk than any of its constituents but this only works if the assets are not correlated.

As we increase the amount of equity the return increases but so does the risk. The second set of bars, in green, is where the risk adjusted return (the return divided by the risk) is greatest. This is the Maximum Sharpe portfolio and has the greatest number of units of return for the risk you take. 

The third example is Risk Parity where both bonds and equity have an equal contribution to the risk. To achieve this in the example below you need 36% equity and 64% bonds.

The re-balancing question is interesting one and the short answer is that if there’s no trading cost, re-balancing frequency isn’t that important and once a year is probably enough.

What's a reasonable amount of dividend cover when looking for a sustainable yield in Investment Trusts and does this also apply to ETFs?

Dividend cover is the ratio of net income (earnings) over the dividend. For example If a company has £100 million profit and it is paying out £50 million in dividends then the dividend cover is 2. 

Below is the example of the City of London Investment Trust (ISIN GB0001990497) which  is a high dividend payer.

There are no hard limits, but a dividend cover of over two is high and less than one is worrying.

Dividend cover is not always a good measure of what will happen moving forward, this is because the numerator (net income) is very volatile. This means that even if dividend cover is high this year it might still not protect next year’s dividend.

Equity ETFs don’t usually have dividend cover because they contain hundreds of stocks so they are difficult to calculate. However because an index that an ETF tracks contains hundreds or thousands of shares the net income and dividend tend to be more stable than they are for single stocks. Of course the dividend for a whole country equity index can fall in synch if there is a recession.

Is the science of the Chartists worth studying? (e.g. Chartists – 100-day moving averages, Fibonacci retracement etc.)

The logic behind Technical Analysis is that we should ignore fundamentals such as company earnings, macroeconomic trends, currency effects, trade wars etc. as all of these are already baked into the price. Instead the theory is that we should look for patterns in price and from these patterns we can predict the future price.

Some of these patterns have unusual names such as:
  • The Death Cross where the short term average trends down and crosses the long-term average.
  • The Golden Cross where some bad news triggers a downwards trend and the short-term average rises above longer-term average and the upward trend continues

Personally I do not buy into these theories but an argument for them that could be true is that even if the pattern is not valid if enough people believe that these patterns forecast market movements then they will become self-fulfilling. 

However the arguments against them include:

  • Long-term trends are more predictable than anything short term (e.g. the rise of stocks and bonds long-term) 
  • Humans are good at spotting patterns in data, even if they’re not true!

If you were being cynical you may come to the conclusion that short term patterns just encourage people to do short term trading, which in the long run only benefits brokers.

Below is an example taken from Burton Malkiel’s  Random Walk Down Wall Street. It illustrates what happens if you toss a coin many times. It appears to move in waves even though it is completely random and his point is that any statistician that looks at the stock market short term will tell you that the movement is just noise. There is no pattern over a short period of time, it is completely random but over long periods of time you can see a drift up in the stock market.

Many people do believe in these patterns, but i'm not one of them. There are a number of people who make jokes about the patterns you can get from Chartists and I do enjoy the comedy aspect of it.  Below is an example from Katie Martin, who works for the Financial times and came up with a Vomiting Camel pattern for gold.

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October 28, 2019

The Best Short Term Investments, Factor Funds’ Performance, & US Deficit Investments.

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q&A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

The full set of notes and video replay are available for Patreon supporters here

If you compare factor funds to the broad market are they actually delivering the superior returns that were initially theoretically expected?

The three main choices for investors are to:

  • Track the market - i.e. buy a tracker cheaply and just track the equity markets upwards
  • Pay a fund manager to beat the market - which often they can’t
  • Invest in Factor Funds - put your faith in research that shows that over long periods of time certain types of stock outperform the broader market. (e.g. small caps, low value, etc or a combination)

Because of the period of time you need to invest in a factor fund, as yet it is impossible to say if they are actually providing superior returns.

The UK Vanguard factor funds have only existed since the end of 2015, about 4 years. The graph below is a risk return plot based on figures up to 18th October 2019. Risk is shown by the X axis and the Y axis is the return. Low risk, high return is the ideal position.

From this graph you can see that Minimum Volatility has done the best, but remember the return part is very volatile so in a months time it could be very different on the Y axis, although the risk (X) tends to be stable.

So far the S&P 500 has out performed almost everything apart from the Medium Volatility but the FTSE all-share has not well.

It’s important to remember that some factor funds will under-perform for decades and then they may come back into favour. Therefore if you buy factor funds you need to have an iron will and a complete belief that it works so you don’t lose your nerve and sell.

Dimensional have been providing factor funds over a longer period of time.

They create their funds by firstly finding factors that work through a rigorous research process and then only use the factors that make sense and are proven to work. Once this is done they create their own funds to harvest the particular factors that they have identified.

The drawbacks are:

According to their research (below) they are doing well.  


The drawback is that If you don’t have a financial adviser then you can’t get one, but more funds will come to market offering a cheap way to track factors effectively and iShares World Value (tracks MSCI index) was launched in 2014 with a fee of 0.3%.

Here are 38 funds that are “smart beta” which includes factor funds such as minimum volatility, momentum and value:

https://www.ishares.com/uk/individual/en/products/etf-investments?#!type=all&fac=43511&fst=50584&view=keyFacts


What are the short term investment options?  (i.e. 1, 2 or 3 yr) and are there any alternatives to standard money market funds?

If you have a large investment and you need to draw it out within 3 years then it can be very risky. The reason for this is because in the short term markets can crash, but in the long term they tend to drift, meaning the crashing evens itself out and the drifting dominates.

For example, if you look at the S&P 500 over 100 years then you will that it just drifts with a bit of wobble but if you zoom in over a shorter period of time you will see that it is very volatile. Therefore if invest long term you can buy the drift up but over a short period of time you may have to sell during a crash.

To help overcome this for short term investments you need to buy low risk assets. Below is a table that plots the volatility of a number of them. At the bottom are the least risky and at the top the most. Just work your way up the risk table i.e. for short-term start with low-risk investments and the higher the volatility the higher the short term crash probability but in reality the only safe investment for the short term is cash.

Discuss the article by Lyn Alden Schwartzer and the potential impact of US government debt and deficits on a USD exposed portfolio.


The excellent article by Lyn Alden Schwartzer from October 2nd 2019  is here https://seekingalpha.com/article/4294621-crowded-trade

In summary, the common narrative she is trying to dispel relates to the crowded trade in US Treasuries. A crowded trade is when everybody does the same thing. This is caused because we all listen to the same journalists, read the same newspapers and end up with a kind of `group think’  relating to the best course of action. At the moment, the current common narrative appears to be that we are going into a recession so we should buy Treasuries and US dollars because they are safe but we should stay away from emerging markets.

Her point is that the only way we can get out of the place we are in is if the dollar gets weaker. She believes that the dollar is on a positive momentum trend at the moment but that something will happen to do with US dollar debt that will make it weaker. She goes on to say that there is far too much debt held by US banks and financial institutions and they can't continue buying it. The US government is also issuing too much debt and if this doesn’t stop then the Fed will have to start buying it which will require restarting its quantitative easing programme. Therefore she believes the best investments are to buy gold, as rates will fall and the dollar will weaken and emerging markets would do well in this environment too.

In her article Schwartzer goes into considerable detail with the three main points summarised below:

The Market is self correcting 

In late 2014 the Fed ended quantitative easing,i.e. It stopped "printing money" to buy U.S. government debt from institutions. This removed a significant source of liquidity and left the U.S. economy to stand on its own two feet. Once quantitative easing ended, the dollar shot up.

A country can't have growing deficits and growing debt versus GDP forever without quantitative easing,  but they can do it for a while until a catalyst brings them to a halt. Ironically for the United States, a strong dollar tends to be that catalyst.

She goes on to illustrate that there's a historical inverse correlation between dollar strength and the percentage of U.S. debt that foreign sources hold. Whenever the dollar grows stronger, the U.S. private sector ends up having to fund more of its own government's deficits and foreigners stop buying, and may even begin selling to stabilise their own currencies.

Repo Market

If you look at the amount of debt that banks are holding it is very high and they won't be able to continue buying it so this has caused the recent issues with the repo market (where bonds are sold and repurchased after a day or up to a few weeks later).

Most investors are aware that the overnight repo market has required Federal Reserve intervention every night for the past two weeks. Starting in mid-September 2019, repo rates spiked, implying that banks don't have cash to lend to each other, and it required ongoing liquidity injections from the Fed to push back down.

Some commentators in financial media were panicked  because the last time the repo market was this bad was in September 2008 when U.S. banks were afraid to lend to each other overnight due to the risk that one of them would announce bankruptcy in the morning. That was an acute liquidity crisis due to an insolvent banking system. Other commentators were saying the repo spike was nothing, just temporary timing issues. Quarterly corporate taxes were due mid-month. The U.S. Treasury is sucking up a couple hundred billion dollars in extra debt issuance to refill its cash reserves following this summer's debt ceiling issue that forced the Treasury to draw down its cash levels.

Evidence shows pretty clearly that the issue is somewhere in the middle. It was not and is not an imminent bank collapse liquidity crisis, nor was it purely a one-time thing. Instead, five years of domestic institutions fully-funding U.S. deficits basically saturated the banks with treasuries and they have trouble holding more. Their cash reserves have run low.

In particular, large U.S. banks that serve as primary dealers have been filling up with treasuries and drawing down their cash levels ever since quantitative easing ended.

Primary dealers are the market makers for treasuries. They don't really have a choice but to buy the supply as it comes, and supply is starting to turn into a fire hose and foreigners aren't buying much of it.

The percentage of total assets held as Treasuries at large U.S. banks is now over 20%, which is the highest on record.

Cash as a percentage of assets at those institutions is now down to 8%, which is right at post-Dodd Frank post-Basel 3 lows. They are pretty much at the bedrock; they can no longer continue drawing down cash and using it to buy treasuries. Cash levels can't (and shouldn't) go lower like they did in the 2000's because that's the type of leverage that led to the financial crisis and current regulations require banks to have more cash.

A lot of people are confused at how there can be too much supply of treasuries, because there is clearly investor demand for them, especially long-duration treasuries that have performed very well this year. However, most U.S. debt is short-term, and that sheer quantity of short-term debt has been pressuring the banks all year. Over the past few years, bid-to-cover ratios have been declining leading to some messy treasury auctions this year, and starting this spring, the federal funds rate has gone over the interest rate on excess reserves.

Clearly, this issue has been building for years and has accelerated throughout 2019, and September just happened to be when a couple extra pressures finally caused the system to reach its limit. It doesn't take a repo expert to see that it's not a repo-specific problem. It's a sovereign debt problem.


Dollar’s Apex Is In Sight

As this liquidity squeeze plays out and global economic growth continues to slow, the dollar is still in an upward trend, but these trends historically can reverse very quickly.

Unless the dollar weakens, foreigners are unlikely to resume buying U.S. treasuries at scale. Even though U.S. treasuries pay higher rates than European or Japanese sovereign bonds, currency hedging eliminates that difference, so only investors daring enough to hold un-hedged U.S. treasuries can take advantage of that rate differential. This means that domestic institutions are likely to have to keep funding most the deficits of over $1 trillion per year, and primary dealers already clearly have a liquidity problem and are already holding a record amount of treasuries as a percentage of assets.

There are a few ways this can play out. The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetising U.S. government deficits. This would inject liquidity into the system, take some of the burden off of domestic institutions for absorbing all of those treasuries, and is likely to weaken the dollar which could allow foreign investors to step in and buy some more treasuries as well. 

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October 28, 2019

House Prices After Brexit

Introduction 

In the UK many people are worried about a house price crash with good justification because it makes up such a large proportion of our household wealth.

It certainly seems as if house prices are slowing after the Brexit referendum in 2016 and although no one can predict what will happen ultimately, this blog lays out the factors which drive house prices so that you can make up your own mind about.

We will also look a number of predictions including a worst-case scenario from the Bank of England, just to see how bad things can get.

House Price Drivers

House price drivers are like a seesaw. Some factors drive house prices higher and some factors drive them lower:

  • Low interest rates make the cost of borrowing lower and so they push house prices higher
  • Affordability if few people can afford houses then that pushes house prices lower.
  • Increased demand pushes up prices and increased supply pushes down prices.
  • Higher wages make house prices more affordable and pushes up prices
  • High inflation tends to reduce prices as it takes money out of our pockets by increasing our cost of living which means we can borrow less.

A key factor for house prices is economic growth. If we look back to 1960 and plot economic growth versus the growth of house prices you can see that during periods of recession house prices tend to be negative, whereas in periods of strong economic growth house prices tend to grow very rapidly. 

House prices are a critical part of UK wealth. They are almost as important as pensions in the total wealth of the UK, making up about 4.5 trillion of our total wealth in 2016.

In London and the Southeast, where we've seen the strongest house price growth, property wealth is even more significant.

Brexit: Forecasts

House prices will probably depend very much on what happens with Brexit, so below are some of the forecast that currently exist.

Financial Times "Property downturns compared"


In the diagram above the FT puts some context Brexit by comparing house prices in the UK with previous house price meltdowns elsewhere in the world.

In Hong Kong when an increase in supply was announced the housing market fell by over 60% and in Japan, after the asset price bubble burst in the 1990s, house prices started a steady decline which went on for over a decade.

In January 2019, the cost of UK housing grew to 7.3 trillion. The actual forecast that is illustrated by the FT depends on the type of deal that we get for Brexit, with no deal giving the worst performance and some form of deal agreed with the EU providing the best returns.

S&P "No-Deal" Brexit Scenario

S&P says that if there is a no-deal Brexit  then they expect a moderate recession lasting  just over a year and house prices to fall by 10% over two years.

Paul Smith, CEO of Haart Estate Agent

Paul Smith, the Chief Executive of Haart the estate agent, said the following relating to Brexit and house prices

Worst Case: "The Annual Cyclical Scenario"

The worst case scenario is the  Bank of England's Annual Cyclical Scenario which it produces to stress test UK Banks to make sure that even a severe global crisis wouldn't stop UK banks from lending.

The Annual Cyclical Scenario is split into three types of stress.

As economic stress hits, the scenario in the top left hand side of the slide below plays out.  In the bottom left hand graph you will see that the Bank of England's baseline scenario for growth moves along at between 3% and 4%, but in the Annual Cyclical Scenario it falls very sharply by over 2%, which is worse than the global growth after the global financial crisis.

Critically you can see that for the UK, it’s largest trading partners experience a sharp fall in GDP and in the far right hand graph, that residential property and real estate prices fall very sharply.

In this scenario the UK would also be impacted by the global growth shock and UK residential property prices would fall to about -33% percent, which is twice the fall we got in the Global Financial Crisis which was just 17%.

In the UK we have a very large current account deficit because we import much more than we export and that leaves us vulnerable if foreign investors shun UK assets.

That "kindness of strangers" is particularly important for the UK commercial real estate market. You can see in the slide below that UK commercial real estate is 50 percent owned by foreign investors,  so if they pull their money out it would have a severe impact on UK commercial real estate.

If there's a reduced appetite for sterling assets then there would be a sharp rise in funding costs, i.e. the cost of borrowing, and consequently sterling would fall very sharply. The Bank of England estimates that it would fall by approximately 28% percent from its 2018 quarter 4 level and sterling versus the dollar would fall by 30%.

It is also worth noting that sterling has already fallen very sharply after the referendum, by 17% versus the Euro and by 18% versus the US dollar.

In this scenario, as mortgages become more expensive and property prices fall,  you will see, from the purple line in the diagram below, that UK property prices fall by over 30%. However this diagram also places it into context with previous property price falls elsewhere in the world and you will see that in the UK in 2007 there was a fall of about 17% which rapidly corrected itself, in Ireland in 2007 there was a fall of 50% and in Spain in 2008 an even greater fall. However, it's important to remember that this is the Bank of England’s worst case Scenario and it is not meant to be an illustration of the most likely outcome.

Now (August 2019)

The UK map of annual house price change shows that the only region where prices have fallen over the last year is in the Southeast around London but elsewhere property prices are still increasing.

There was certainly a turning point at the time of the referendum after which the rate which property prices were increasing has definitely slowed.

The fall in London prices has been over 4% over the previous year.

Although London prices are starting to fall and other regions are still increasing we're still a long way from convergence in house prices. The reason for this is there was the period during which London grew much more rapidly than the rest of the UK. The average house price in London is £457k which is about 3x the average house price in the Northwest.

Affordability

House prices tend to increase most when affordability is best and the graph below from Vanguard research shows five decades. The x-axis is the starting price-to-income ratio scale, therefore the expensive house prices are on the right and cheap house prices are on the left.  The y-axis is the house price appreciation over the following decade, ranging from rapid house price growth at the top to slow growth at the bottom. 

At the moment you can see that house prices are still very expensive relative to UK income which suggests that house price growth over the following decade will be fairly muted at around 2% to 4%.

Below is a graph showing the average UK house price to earnings ratio since 1989 and you can see that we're still well above the long-run average This means that for house prices to increase significantly we will need to see a substantial increase in UK earnings.

What's interesting is that in the North affordability is still quite reasonable. It's mostly in London and the Southeast where prices have simply become unaffordable for the majority of people.

Increasingly people are considering whether renting a house may be a better option and if you can learn more about this from my video and blog, Buy or Rent a House - Which is Best?

Interest Rates

In August 2019, the US Federal Reserve started to cut interest rates in what Jerome Powell called `a mid cycle adjustment’. The reasons for this were concerns about trade war and falling global growth.

Central banks around the world have followed suit for similar reasons and although the reasons why banks are cutting interest rates isn't a positive for the housing market at least the cost of mortgages will stay low.

Wages Versus Inflation

Wages are also telling a positive story In their battle versus inflation. Wage growth in 2019 is steadily improving but what’s critically important is wage growth versus inflation. While this was negative for a long period of time, since 2010 it has turned positive and it seems to be steadily rising. Greater household disposable income means that we can borrow more and that tends to push up house prices.

Supply Versus Demand

The supply and demand story really hasn't changed for quite some time and supply still remains very much constrained. 

After the Second World War most of the supply of houses were produced by local authorities but that stopped in the 1980s and nothing else has really filled that gap.

In the UK we have an oligopoly,  where the eight largest builders create more than half of the new homes and it's not in their interest to increase supply because that would reduce prices. Additionally the type of housing which is being created isn't suitable for older people which means they are staying in their houses for longer rather than moving into appropriate accommodation.

If Brexit reduces immigration then that may be a negative for demand, but as we get a greater number of one-person households, rising life expectancy, rising incomes and greater mortgage availability that increases demand.

According to a survey by RICS, the stock of properties on estate agents books is at a record low and that's probably because of Bexit and its uncertainty. They estimate the normal level to be about 70 properties at a time but at the moment there are only 41 on average.

Consequently the turnover rate (the % of households that move) is low at 5.1%, well below where it was before the global financial crisis. 

The good thing is that the rate of first-time buyers who are buying with the mortgage has recovered to the rates that we saw in 2007. The rate of cash purchases is much the same as it was in 2007, but what has fallen dramatically, probably because of a taxation and legislation change, is the number of buy-to-let purchases with a mortgage and movers who aren't first-time buyers moving with a mortgage.

In summary, the outlook for UK house prices is still fairly weak, affordability is stretched and that usually means that house prices don't increase much over the next decade.  However we do have fairly strong wage growth and supply is still constrained, which is a positive for house prices.

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October 21, 2019

Do Active Managers outperform during market downturns? KIID Transparency, Commodity Correlation & Thematic ETFs.

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q and A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

The full set of notes and video replay are available for Patreon supporters here

Do Active Managers outperform during market downturns when equity sells off?

The conventional wisdom is that during bear equity markets stock pickers will outperform by dodging the bad apples, however the evidence from Standard and Poor's Index Versus Active (SPIVA) report does not bear that out: see for yourself here https://us.spindices.com/spiva/

In a document from 2008, when people were thinking about the credit crisis SPIVA says: 

“The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes...
However, one of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities. We dispelled this myth in 2003 using the case study of the 2000 to 2002 bear market. The downturn of 2008 provided another case study. The results are similar, with underperformance across all nine style boxes.”

https://us.spindices.com/documents/spiva/spiva-us-year-end-2008.pdf

Can you explain fund/trust costs as stated in the Ongoing Charges Figure (OCF) and the Key Investor Information Document (KIID) to enable understanding of why they can appear to differ and lack transparency?

By law in the UK every fund that exists has to produce a KIID and it has to be clear. If this is not the case, or the information about fees is not correct then the FCA will intervene.

This question is explained with two examples. Firstly, Harbourvest Global Private Equity (ISIN GG00BR30MJ80). 

This is a private equity investment company which will be higher risk than investing in an index but also has the potential for higher return. Usually the fees for this kind of investment are higher. The link to the Key Investor Information Document is visible at the bottom left of the screenshot above or here https://www.hvpe.com/~/media/files/h/hvgpe/reports-and-presentations/key-information-document/hvpe-key-information-document-2019-05-30.pdf

Often the more complex the product the more complex the pricing structure may become. Below is the table from the PIID that outlines the costs and you can see from this that fees are 1.5% ongoing but there is also an “incidental cost” if the performance is better than an 8% internal rate of return.

The second example is Scottish Mortgage Investment Trust’s fees. Their Key Investor Information Document is here https://documents.feprecisionplus.com/PRIIP/BAGI/PRP/BAIEPT_BE08_en-GB.pdf

They break down the ongoing costs of 0.77% as follows

  • The impact of the management fee payable to the Trust's investment manager (0.31%)
  • The Trust's other administrative expenses (0.06%)
  • The costs of borrowing money to invest, including interest and arrangement fees (0.38%) but not any income or capital benefit of doing so
  • The ongoing costs of any underlying investments in funds within the Trust's portfolio (0.02%)

Always look at the KIID documents as other sources can be more easily misread. For example if you look at the website from Baillie Gifford, where it talks about Scottish Mortgage, the table it uses presents ongoing charges  as 0.37% but with a very small footnote that goes on to say it will actually be more because of other costs.

https://www.bailliegifford.com/en/uk/individual-investors/funds/scottish-mortgage-investment-trust/key-information/

Which commodity ETFs are least correlated to equities during a recession?

If you look at the time series available most commodities’ data to which I have access only starts in 2000. This is not a  long enough time span to draw any sensible conclusions from as we have only had two recessions since then. However, we do have data for going back to 1965 for silver and for gold from 1920, but because it was linked to the gold standard, data is only really useful since the mid-1970s.

Overall the more  a commodity is used in manufacturing the it is more likely to be correlated to equities. This can be shown in the tables below that shows how correlated  gold, silver and the S&P 500 were during both recession and growth periods. You will see that the correlation of the S&P 500 compared to gold during a recession is 0.05,  but compared to silver, which has some industrial use, it is 0.137. Anything below 0.3 is considered very low correlation, so although silver has more correlation with the S&P 500 than gold, silver is still very low .


> round(recession.cor,3)

          spx       gold     silver

spx     1.000   0.050   0.137

gold    0.050  1.000    0.632

silver  0.137   0.632   1.000

> round(growth.cor,3)

          spx        gold      silver

spx     1.000   -0.040   0.033

gold   -0.040   1.000   0.601

Silver  0.033   0.601   1.000

Why are thematic ETFs cyclical?

We can turn this question around…

Imagine you are a fund manager. You can’t compete on fees with Vanguard and Blackrock and Fidelity so how can you make money? Thematic ETFs!

Thematic ETFs are one way of making income by charging more, but for people to want to buy them, they have to be:

  • Popular as a theme. 
  • Have a credible underlying thesis.  (i.e. some reasoning behind why it might make money)
  • Offer the potential for returns above the market if the theme pans out.

Although higher return usually means that there is a concentration risk in the theme’s sector, country or currency.

A high diversity thematic ETF would never make it past the drawing board as it would be very difficult to sell.  A low-risk ETF would also be unpopular and wouldn’t be able to offer above-market returns (and would run against cheap minimum volatility funds offered by the big beast fund managers). 

This means that in most cases in order to be sexy the funds have to be cyclical and higher risk than the broad market

If you look at  justETF https://www.justetf.com/uk/etf-lists.html extract below, you will see that 

Some of these might be a bit defensive

Ageing population” would include pharmaceutical companies which would be defensive

Socially responsible” would probably be neutral i.e. neither cyclical nor defensive

Volatility” would be defensive but that’s not really thematic it’s factor investing

Water” might be defensive because it probably contains lots of utility companies

But if you look at the others they will probably be cyclical as they would give you a higher risk with potentially a higher return. However, if the underlying thesis behind them fails to materialise then you have a high chance of losing money.

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October 14, 2019

Low Rates, Low Growth, REITs & Bonds During a Recession

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q and A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

The full set of notes and video replay are available for Patreon supporters here

What are the advantages and disadvantages of investing in Real Estate Investment Trusts (REITs)?

Do REITs behave in a cyclical manner and where do they sit in the correlation dendrogram and in the economic cycle?

REITs are attractive because they offer a tax-efficient way of receiving income from property.

A company with REIT status isn’t subject to corporation tax. In return, HMRC demands that REITs distribute at least 90% of their property income to shareholders every year as property income distribution (PID) dividends. The REIT must withhold basic rate income tax of 20% on these payments. If the REIT rules didn’t exist, investors would suffer double tax: once because the company would pay corporation tax and twice because you’d then pay tax on the dividends. 

Yields for REITs will fall as yields for other assets fall. They have the same indicators as global equity and are like higher beta versions of equity.

REITs are potentially more rate sensitive given their role in a portfolio as income generators and are often leveraged investments so funding costs are an issue but the correlation to rates changes over time. The period of negative responses is significant because it contributed to REIT underperformance relative to the S&P 500 and other broad market aggregates during the past few years. That’s why the Fed’s comments that their target for short-term interest rates will remain around current levels, and the return to a positive relationship between REITs and interest rates, is favorable for REIT investors.”

When the Fed tightens policy (raises interest rates) the correlation between 10 year Treasury yield and REIT returns goes negative.

In April 2019 PensionCraft said, “At the moment it’s turned positive again so this is good for REITs if yields don’t fall sharply”. Well… now Fed policy is to lower rates and yields are falling.

If you intend to invest in REITs you need to be aware that …..

Would bonds still be a good investment If there is a recession in 2019/2020?

During a recession, yields fall because investors move their money out of risky assets (equities) into safe-haven assets (bonds). The question is really whether that remains true even in an environment when yields are low or negative.

As we’ve seen there is no proper alternative to bonds. The income on government bonds with some duration will (almost) always be more than the income on cash. The reason for this is duration risk.So why would investors accept a lower return on bonds of short duration (low but non-zero risk) than they’d get for cash (almost zero risk, government guarantee and zero volatility).  You would never buy an asset with higher risk and lower returns, particularly in the fixed income world where risk and return are so clearly linked.

If cash returns were higher than bond returns, very few investors would buy bonds, bond prices would fall and yields would rise until they are higher than cash interest rates. However don’t buy developed market bonds for capital appreciation, buy them for capital protection & diversification for your shares.  When equities fall 50% you’ll be glad of the bonds in your portfolio and that’s why Vanguard calls them ballast.

Ballast is material that is used to provide stability to a vehicle or structure. Ballast, other than cargo, may be placed in a vehicle, often a ship or the gondola of a balloon or airship, to provide stability.

Has there been a time with both low interest rates and very low growth, what was the impact on asset classes and are there any lessons that can be learnt?

Although there is no precedent, as we have never been at a time where rates and yields have been this low,  there is still a lot we can learn from past trends and use this to influence our current investment strategy. 

We do know is that low growth means low long-term yield (assuming inflation is low too i.e. not stagflation). Low growth also  means corporate earnings growth is weak, therefore equity capital appreciation is weak as well. We also know that growth will not be low everywhere and there will be a premium for growth. For example, companies that generate revenues in emerging markets manage to grow their earnings but this also brings risk.

October 10, 2019