Archive Monthly Archives: November 2019

Bond Bubble Explained

Bond Bubble - Why Now?

The yield on many government bonds has turned negative and that has led some people to suggest that we're in a bond bubble.

Prices are just simply too high because they have been over inflated by central banks pumping money into the economy.

If they are too high then perhaps they are about to crash so in this blog we will look at how big a crash in the bond market could be and where we should expect rates to be over the long term.

In a spreadsheet from Charlie Bilello below you can see the negative bond yields in pink.

Over time the amount of debt which has negative yield is increasing so that in June 2019 it reached 12.5 trillion dollars

As the amount of negative yielding debt increases, some people have started to suggest that this is a bond bubble which has been inflated by the central banks.

Why Buy Bonds?

There are 3 main reasons for buying bond these are:

  • Capital Protection
  • Diversification
  • Income

Capital Protection

We buy bonds for capital protection and in the case of government bonds from developed markets they are very safe.

In the graph below we compare the return on the S&P 500 with the return from 10 year treasuries since the 1950’s. 

You can see for equity (in red) there are lots of rises and falls in the price and that's because equity is very volatile.

If we compare that with bonds (in blue) you see a much smoother line. There is still up and down movements relative to the trend but these tend to be much smaller.

As an investor you may want to think about how much the index has fallen relative to the highest peak it's reached. If the index is at an all-time peak then it stays at zero but if we fall relative to that peak we start to see a drawdown. 

What really stands out for equity (below in red) is that those falls relative to the peak are very severe. For U.S. stocks there are several times when it's been more than 40%,  in the 1970s, in the early 2000s and during the global financial crisis.

If we compare that with bonds (in blue) you can see the crash is much smaller relative to the previous peak. It's very unusual for it to be more than 10%.

So while bond bubbles for U.S. treasuries have popped in the past, the size and duration of those bond bubbles bursting are considerably smaller than they are for U.S. equities. Therefore there is a lot less to fear about the popping of a government bond bubble than there is for an equity bubble.

Below I look at that difference between bonds and equity in a slightly different way. The monthly return is on the x-axis, so positive returns are on the right and negative returns on the left.

You can see that this downside tail for equity is much bigger than it is for bonds. It is very unusual for bonds to stray below around -5%. For equity there have been several cases where a monthly returns have been less than -5%. 

So bonds preserve this cardinal rule of investment which is not to lose money or at least not too much and not for too long.


Another reason for holding government bonds is diversification.

Below are some Vanguard funds and the size of the dots on this diagram show you the size of the correlation between two funds.

For example you can see by the size of the dots that the European Equity (VEUR) is highly correlated with a UK FTSE 250 index (VMID). Whereas the correlation between European Treasuries (VETY) and the FTSE 250 is very low.

This block of very large dots shows how equity funds are highly correlated with one another.

It is  almost impossible to diversify the equity in your portfolio by buying another equity fund. No matter where that equity fund is based or its investment style.

This is also true,  to a lesser extent, with bond funds, they are also correlated with one another.

The place you get diversification is if you combine stocks and bonds. Only then can you really reduce the overall volatility or risk of your portfolio. 

Below we just consider two funds: a FTSE 100 fund and a UK Government Bond fund, in the period between December 2016 and June 2019. Risk is plotted on the x-axis and return on the y-axis.

You can see that the stocks are high risk and high return, whereas the UK Government Bond is low risk and low return.

These bonds have have about half the volatility of UK equity but if we combine them in this magic ratio of 75% bonds and 25% shares, the portfolio has a risk which is smaller than either government bonds or UK equity!

Therefore, although it's return is considerably less than for stocks, that minimum risk portfolio has a return which is considerably better than that of UK government bonds alone. 

This is  what we mean by diversification. We combine assets and the combined risk is considerably less than the risk of any of the ingredients.

In the graph below we see that in terms of prices. The stocks are in red and the bonds are in blue. If we mix them in that 25%/75% ratio the combined portfolio is shown in green.

Notice how the fluctuations and the value of the combined portfolio are considerably smaller than either those of bonds or of equity and that's due to the benefits of diversification.

If you would like to take one of our £4.99 courses that will teach you how to choose the best funds that can offer you the right level of diversification then please click here


Another reason for choosing government bonds is to generate income for your portfolio.

Does Negative Yield = Negative Income?

Many people ask me, if the yield is negative does that mean the income from their bonds will be negative.

Take for example an iShares fund which buys UK gilts (e.g. UK government bonds). 

Below you can see the fund paying out twice a year since November 2015 and the payments are always positive.

Dividends on a fund will only ever be zero or positive, they can never be negative.

You can always look up a bond on the UK Debt Management Office Website (here)

The government raises money through gilt auctions and you can find out how much money was raised and what the coupon was on the latest bonds.

You can see from the top line in the screenshot below, that on the 2nd of July the government sold this bond which matures in 2025. The coupon on the bond was five eighths of a percent (0.625%) and the amount the government raised was £3.4 billion.

A government bond starts off its life at a price of £100 and it ends its life at £100. This is because all you are doing is lending that money to the government and then receiving your £100 back after a set period of time.

In the interim you will receive some interest payments and that's the coupon. 

The bond below was issued in 2013 and paid a coupon of 1.75%. Notice how the price started out at around £100, it rose a bit and then it fell back to £100 just before it matured in 2019.

So if we invest a £100 in the bond we would be paid twice a year, which is the convention for UK government bonds, and each payment would be half of that 1.75% which is 87.5p.

The last coupon payment would be on the 22nd of July 2018 and this coupon will never be negative.

A coupon can be zero but it will never, ever be negative.

Below is an example of a bond which will give you a 0% coupon. In other words no interest payments at all.

This is a 10 year bond which was issued on the 10th of July 2019 and it will mature in 2029.

You can see the coupon is 0% but note that even though the yield is negative the coupon isn't negative.

If  we can take the total return on a bond and break it down into two components it looks like this.

Total Return = Capital Gain + Income

Capital gain is when you buy at a low price and then sell before maturity at a higher one. Income is the coupon payments.

The fund below is an iShares UK Gilts All Stock Index Fund which purchases UK Government bonds. 

I have compared the accumulation version of the fund (e.g. where the price incorporates the coupon payments) with the income version (e.g. where the price doesn't reflect the income). 

If we subtract one from the other we can see the income from the fund and separate it out from the capital gain.

Below are those two components, the capital gain is in red and the coupon income is in green.

Notice how that coupon income is like a steady, safe heartbeat. It is effectively riskless because it's paid to you by the UK Government which has never defaulted on its debt and it has never failed to pay a coupon.

Compare that with a capital gain which is extremely volatile and risky. This is because it responds to the changes in the yield curve which is flopping around all the time.

Below I have put those two components onto a risk return plot.

You can see that the capital gain has been very high but it's also been very risky.

The coupon income for UK Gilts is extremely safe, almost risk-free, but of course it's much smaller than the capital gain that we have seen as yields fell.

Below is a useful way to think about the two components of total return for a government bond.

The capital gain component is high risk and usually that's not why you buy a government bond.

The income on the other hand is very safe and low risk and that's the reason why many people buy government bonds for that safe and steady income.

Can Capital Gain be Negative?

We have seen the income can't be negative. The coupon is always either zero or positive but can the capital gain be negative?

Below is a yield curve plot of how much it costs different governments to borrow over different periods, ranging from 1 month up to 30 years.

Usually if the government borrows for a longer period of time it costs them more in terms of interest payments. From your point of view you get a higher level of interest rates for longer-dated bonds.

What is critically important is that the yield curve isn't a static thing.

In dark green you can see the latest curve but that is quite different from the yield one week ago (in orange) or one month ago in (lighter green). As the yield curve moves around the price of your bond will fluctuate.

Every country has a different yield curve. In the US the yield for the 10 year point on the curve is 2.1% versus just 0.8% for the UK.

Japan has notoriously had negative rates for a long period of time . The 10 year yield in Japan is negative at -0.1% and in Europe it is -0.38% when I made this graph in July 2019. 

The eurozone yield curve has a -0.38% yield but what does that mean in terms of individual German bonds?

Below is a 10 year bond that matures in 2029. At the time it was issued in January 2019 a fair coupon was considered to be 0.25% and that will be fixed for the entire lifetime of the bond.

We saw for the gilt the value of the bond on the day that it was issued was a 100 euros. Then its price steadily increased until it reached a 106.3 euros on the 5th July. However you need to remember at maturity the bond will always go back to its original value of a 100 euros. 

Because the bond will exist for 10 years, it means that we are going to lose out on 6 euros spread over 10 years, which is a capital loss of 0.6%.

That means that the total return on the bond will be the income which is 0.25% minus the capital loss which is 0.6%, which will give us a total return of -0.35%.  

As the price of the bond went up the yield on the bond went down until it reached -0.37% in July. It's not because the income was negative, it's because the capital gain was negative and that dragged the total return into negative territory.

Can Total Returns Be Negative as Yields Increase?

Now the natural fear when yields are negative is to worry about what will happen if yields suddenly start to increase, which in turn could make the price of bonds fall sharply.

Could we still get a positive return even if yields are increasing? 

As it turns out yes we could, and in order for this to happen the income would have to exceed the capital loss in any period of time. 

The income is just the % coupon and that is fixed. In order for the total return to be positive, this has to be greater than the capital loss. The capital loss for a bond is its duration multiplied by the shift in the yield curve. 

This is why we say the longer the duration of a bond the greater its risk. Therefore a 30 year bond is much riskier than a 10 year bond.

If we divide  by duration on both sides of that inequality we come up with this very simple result.

You can think of this as a speed limit. If the yield change is slower than the speed limit over the course of a year, then even though yields are increasing, we could still make a positive total return. 

The speed limit is defined by the coupon of the bond divided by its duration

In the case of the German bond I discussed earlier the coupon was 0.25% and the duration was 9.5 years, which means that the speed limit is 0.03% per year. 

If the yield curve increases by more than 0.03% per year we'll make a loss on the bond.

For that bond which had no coupon at all the speed limit is zero. So any increase in the yield will decrease the value of the bond.

Can We Apply the Same Logic to Bond Funds?

Can we apply this speed limit idea to bond funds? Yes we can!

Below you will see the ishares Gilt fund IGLT as an example. 

The yield of the fund is 1.2% as of the 4th July 2019. The effective duration was about 11.6 years and that means the speed limit is 0.1% per year.

If the UK yield curve increases at more than 0.1% per year then we would make a negative total return on this fund.

Below is a graph of the value of a hypothetical £10,000 invested in that fund since December 2006. 

Over that period of time you can see the total return has been positive. But also for the same period yields have been falling in the UK, therefore both the income and the capital gain have been positive.

How Much Will Rates Rise?

A key question is how much rates are going to rise? They are at an all-time low at the moment but if rates don't rise much from where we are now then that could limit our capital loss.

Below is the UK 10 year rate since 1993.

You can see that is has been falling fairly steadily over that entire period. That has been great for bond holders because they made capital gains during that period.

Fortunately the Bank of England keeps very long term records and you can see that their Bank Rates below has been falling fairly steadily since the early 1980s.

In fact the Bank of England’s records go all the way back to 1694 and the  average rate has been somewhere around 5% over that huge period of time. 

There was a large spike in the 1970s when inflation reached very high levels. After the financial crisis there has been another very unusual period but in this case it is because rates were very low. This has been the case for many central banks around the world.

The Bank of England uses the term equilibrium interest rate also known as R*. 

Think of this as a kind of anchor rate to which policy returns if everything is okay. By okay we mean a position with no output gap, where our economic output is equal to our potential output and inflation is at the 2% target rate.

If the Bank of England sets the bank rate equal to that R* value it will  just keep the economic machine ticking along. 

If we look at the Bank of England inflation report from August 2018, they do a fascinating analysis which shows that the bank rate is likely to remain materially below that 5% level the we have seen since 1694. 

The estimated fall in the equilibrium interest rate R* It is not just a small fall, it is more than 2% since 1990.

If we add back inflation at 2% that means that neutral rate or R* will be around 2% to 3% which is considerably lower than 5%.

You can see that the equilibrium real rate was falling before the financial crisis. It fell significantly during the crisis and now it  has come back to a level which is far lower than it was in the past.

What are the economic drivers of that fall?

The big ones are slower population growth, increased life expectancy and very slow productivity growth here in the UK.

None of these things are likely to change much in the near future, so that lower R* value is likely to be here for some period of time.

Our population continues to age and our productivity growth remains stubbornly low. As the Bank of England raises rates,the upshot of this for bond investors will be that the endpoint will be much lower than it was in the past.

This means that those capital losses will be smaller than you might expect if the equilibrium rate was still at 5% and this will limit the size of the pop if the Bond Bubble bursts

The capital gain on bonds has been boosted by that steady fall in yields that we've seen for several decades, but that is about to end.

However it looks as if we are not going to see a huge spike in rates, given the beliefs about R* which is now going to be lower than it was in the past.

Therefore I am not particularly worried about a Bond Bubble and I certainly wouldn't buy into the idea that you should have no bonds in your portfolio because the bubble is about to burst.

Michael Burry, who successfully predicted the Dot Com Bubble and US Housing Bubble, says we are currently in an Index Bubble. If you would like to read my blog about this then please click (here)

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November 26, 2019

Russian Equity Funds, OEICs vs ETFs, Taleb Barbell strategy, ETF closures & PMI indices explained

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

Which ETFs offer the best route into the Russian market?

  • Russian ETFs tend to be expensive, none of them cost less than 0.59% per year ongoing charges
  • The risk-return plot below for prices since 2012 (it doesn't include income) shows how the Russian ETFs compare to the LifeStrategy 20 to LifeStrategy 100 funds.

  • The Scooby Doo tree showing the correlation relationships between the funds is as follows

Please explain the merits of OEICS versus ETFs for index investing

  • OEICs (Open Ended Investment Companies, called mutual funds in the US) and Exchange Traded Funds are both open-ended
  • As more people buy the fund it buys more assets and creates more “units”
  • Creation and redemption process for ETFs
    • APs contract with the issuer (the ETF fund manager) to create and redeem ETF securities in large ‘creation units’.
    • Only APs can create or redeem ETF shares with the issuer.
    • Creation
      • The AP applies for new ETF securities to be created in multiples of creation units (typically this is 100,000 shares).
      • The AP delivers the basket of securities or cash equivalent specified by the issuer.
      • On settlement, the AP then has inventory of ETF securities that can be sold onto the stock exchange (the secondary market).
    • Redemption
      • The AP applies to redeem shares of the ETF in multiples of creation units
      • The AP receives a basket of securities or cash equivalent
      • The AP sells the basket of securities on the exchange



Traded directly with the fund (via broker)

Traded on a stock exchange such as the London Stock Exchange (via broker)

One price produced at the end of each day linked directly to Net Asset Value.  You pay the forward price which is produced at 12 pm each day. If you purchase after this time you will pay the 12 pm price the next day which is unknown at the time of purchase.

Price updated minute-by-minute while the stock exchange is open. You can trade at the price you see. You can also place stop losses, limit orders and open orders as you could with stocks. Price can deviate from NAV during periods of market stress. Authorised participants can arbitrage this difference away risk-free during normal times.

Usually buys physical assets

Can be synthetically replicated with a future or a total return swap

No commissions on trades but pay stamp duty of 0.5%

Have to pay commission on trades but no stamp duty

No bid-offer spread

Small bid-offer spreads due to high liquidity

Often active

Usually passive

Can you explain the Purchasing Managers Indexes where to find the relevant information for each index and how important you think they are when it comes to investing?

  • This is survey-based so it’s "soft" data (compared with GDP which is "hard" data)
    • Thousands of businesses are asked to regularly fill out a questionnaire
    • They’re diffusion indices such that > 50 signals improvement or expansion
    • Less than 50 indicates deterioration or contraction
  • A lot of investment is about finding the inflection points when a trend (such as increasing GDP growth or falling GDP growth) reverses and PMI indices can help spot these reversals but in practice you would look at many other indicators

What are the indicators (e.g. liquidity) that an ETF is likely to be closed?

  • Unless it is a new fund if the assets under management are below around £20 million it means it is not economically viable to the fund manager to continue with it. e.g. 
    • 1% of 20 million = 10,000
    • 0.01% of 20 million = 100
  • Larger funds may also close if they can't compete with cheaper competitors following the same index.
  • SeekingAlpha publishes a monthly deathwatch for ETFs (here)

Any thoughts on Taleb's Barbell strategy and how retail investors in the UK can practically implement it?

  • Taleb is the author of “Fooled by Randomness” and “The Black Swan: The Impact of the Highly Improbable”
  • The idea of a barbell strategy is to hold both extremes of the risk spectrum e.g. US Treasuries and out of the money call options
  • His strategy is to put 85–90% of his money into the safe investments and the rest on the riskiest bets
  • How extreme and safe those investments are is a matter of choice e.g.
    • UK Gilts and Emerging Market equity
    • Options are generally not available to UK retail investors (for good reason!) as they incorporate leverage and you’re quite likely to lose your entire investment
  • Would you be happy earning almost nothing most of the time then very occasionally making large gains (the Barbell Strategy) or making steady gains most of the time with the occasional loss (a diversified portfolio)?

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November 26, 2019

China ETFs & Chinese equity, income funds and quantitative methods explained

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 pros and cons of the different China indexes and ETFs? 

  • Chinese Stock Exchanges
    • Shanghai Stock Exchange (SSE) capitalisation $4 trillion, 4th largest globally
    • Hong Kong Stock Exchange $3.9 trillion, 5th largest globally
    • Shenzen Stock Exchange capitalisation $2.5 trillion, 8th largest globally

  • Chinese stocks
    • A shares: are listed on Shanghai and Shenzhen stock exchanges and priced in RMB
    • B shares: are listed on Shanghai and Shenzhen stock exchanges and priced in foreign currencies
    • H shares: shares of companies incorporated in mainland China which trade on the Hong Kong stock exchange
    • Red Chips: shares of mainland China state-owned companies incorporated outside but which trade on the Hong Kong stock exchange, e.g. China Mobile, there’s a list of Red Chip companies here
    • P Chips: the “P” stands for the private sector, and these are Chinese companies with operations in mainland China traded on the Hong Kong stock exchange but incorporated in the Cayman Islands, Bermuda and the British Virgin Islands
  • Stock Connect “A unique collaboration between the Hong Kong, Shanghai and Shenzhen Stock Exchanges, Stock Connect allows international and Mainland Chinese investors to trade securities in each other's markets through the trading and clearing facilities of their home exchange”

  • Has allowed foreigners to buy mainland China-listed shares
  • Part of the integration of China into global capital markets
  • Avoids China’s capital controls as described here by the US website
    • “China maintains a "closed" capital account, meaning companies, banks, and individuals can't move money in or out of the country except in accordance with strict rules.”
    • “On December 30, 2016, China People’s Bank of China issued Measures for the Administration of Financial Institutions' Reporting of High-Value Transactions and Suspicious Transactions, with the goal of targeting money laundering, terrorism financing and fake outbound investment transactions.  As a result of the law, banks and other financial institutions in China have to report all domestic and overseas cash transactions of more than 50,000 RMB (approx. $7350), compared with 200,000 RMB (approx. $29,400) previously. Banks will also need to report any overseas transfers by individuals of $10,000 or more.  In addition, all banks must report to central government on every single foreign exchange transaction of at least $5 million. SAFE will supervise and halt any on-going ODI projects in which Chinese investors still need to transfer more than $50 million out of the country. Only once they have vetted the authenticity and legality of the company's ODI plans will the green light be given.”

This is tiny! 200 billion RMB = £22 billion = $28 billion, in 2018 the annual volume of shares traded in the US $33 trillion vs the annual volume of shares traded in China was $13 trillion according to the World Bank

  • Chinese indices
    • CSI 300 is a market capitalisation weighted index of the largest A-shares that trade on the Shanghai and Shenzhen exchanges. CSI is the acronym of the China Securities Index company that maintains the index.
    • FTSE China 50 contains the largest A-shares that trade on the Shanghai and Shenzhen exchanges
    • MSCI China contains the largest stocks that trade on the Hong Kong stock exchange but also B-shares, Red chips and P chips
  • Cheapest ETFs from JustETF (here) are

  • Franklin Templeton FTSE China ETF (here)
  • OCF is 0.19% which is very competitive for a China tracker
  • Tracks the FTSE China 30/18 Capped Index 
  • “FTSE China 30/18 Capped Index represents the performance of Chinese large and mid capitalisation stocks. The index has a broad coverage of Chinese share classes include A Shares, B Shares, H Shares, Red Chips, P Chips, S Chips and N Shares, where the A Share constituents are available to international investors through Northbound China Stock Connect Scheme, eligible under the scheme’s Buy-And-Sell List. The index constituents are weighted by free float, restrictions applied to foreign investors, and reviewed semi-annually. To limit over concentration in any single security, constituents are capped quarterly so the largest company’s weight does not exceed 30% and any remaining company weight does not exceed 18%.”

Could you please discuss quantitative methods for index investing?

  • My Great Aunt Lilian bet on horses which shared the same name as her dogs...
  • The idea behind quantitative methods is to choose stocks based on numerical criteria
    • Usually, this is done via a stock screen
    • Criteria based on fundamentals (valuation, earnings growth, return on equity), price changes (moving averages), volatility...
  • Factor funds or smart-beta funds are one example of this approach e.g.
    • Momentum (buy stocks that are rising)
    • Value (buy stocks that are cheap)
    • Growth (but stocks whose profits are growing strongly)
  • Other methods are
    • Risk parity (equal marginal risk contribution from each asset)
    • Minimum volatility (lowest risk or equivalently maximum diversification)
    • Maximum Sharpe ratio (largest risk-adjusted return)
  • Newer developments are to use machine learning techniques such as deep learning to identify stocks that will outperform

  • Methods include
    • Statistical arbitrage which extend the pair trade idea e.g. Ford Motors goes up 5% this week and GM goes down 5%, go long GM, short Ford Motors but market neutral. They should converge.
    • Equity market neutral goes long “good” stocks and short “bad” stocks so as to be neutral for the market as a whole and/or neutral other factors
    • Trend following e.g. momentum
  • An alternative is to buy pre-built quantitative indices
    • For example, MSCI World Growth screens stocks according to:
      • Long-term forward EPS growth rate
      • Short-term forward EPS growth rate
      • Current internal growth rate and long-term historical EPS growth trend
      • Long-term historical sales per share growth trend
    • MSCI has lots of these indices
  • Grew out of Benjamin Graham’s book “Security Analysis” first published in 1934 (here)

Where can I find less expensive CAPE rated countries that don’t have crippling fees?

  • which is also found in our #frequentlyaskedquestions channel on Slack for PensionCraft Patreon supporters
  • Vanguard doesn’t have as many country-specific ETFs as Blackrock’s iShares range

How do you rate the Vanguard Lifestrategy 40% as a means of providing an income in retirement

  • The dividend yield of LifeStrategy 40 isn’t very high, just 1.4% as of November 17th 2019 but it’s
    • Diversified regionally and across asset types
    • Has low-ish capital risk
  • This means that if you invest £100 you’d earn about £1.40 per year.
  • There are other funds designed to provide high income, what varies is how much capital risk you have to take to produce the income i.e. how much will your £100 vary in value in percentage terms per year. If it falls just before you have to sell it that’s a problem.
  • Last week ​here​​​ I provided which ranks Vanguard funds according to their risk-adjusted yield i.e. which funds give the highest amount of income per unit of risk
    • LifeStrategy 40 came fifteenth in the list
    • The top six were all bond funds, mostly currency-hedged which reduces their risk by neutralising their currency fluctuations (volatility)
    • The US is the developed country with the highest yields at the moment so its government bonds and corporate bonds all have relatively good yields

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If you want to ask your own questions then why not join us on our live Q&A session? It's informal, friendly and you can ask anything you want. All you have to do is to support us on Patreon for $10+VAT a month or more. Then you can join our live Q&A sessions, and chat with us on our Slack Channel.

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November 20, 2019

How To Invest During Recession


Global growth is fading, central banks are talking about cutting rates, and the US yield curve has inverted.

Now is a good time to think about how to invest during a recession, what a recession would mean for your portfolio and what strategy can you adopt to ride out the volatility?

What is a recession?

Before we look at how to invest during a recession, let's start by exploring exactly what we mean by recession.

The most frequently used definition is that it's two consecutive quarters of decline in real gross domestic product (GDP). GDP is the total amount of goods and services produced by a country.

In the U.S. the National Bureau of Economic Research has a slightly different definition. They say that they don't just use real GDP they also use a range of other indicators, particularly indicators which arrive every month that allows them to create a more timely definition of when activity starts to decline. They also consider how large the decline is and the phrase they use for this is "a significant decline in activity".

What is a recession

The Bank of England has data on UK growth going back all the way to 1700.

A big cause of recessions in the past was war. In the graph below they have shaded the major war periods in blue.

From this graph we can see that before the early 1800s we spent about half our time in one war or another and as a result we had this continual onslaught of recessions leading up to the early 1800s.

Recessions before the 1850s also depended on things like poor harvests, because the UK economy used to depend more on agriculture. There were also investment fads, for example investing in canals or toll roads. There were also very large and significant bank failures and you can see that after 1850 the frequency of recessions dropped quite dramatically.

The First World War and the Second World War also had their recessions. Most recently the most significant recession was the 2008/2009 financial crisis.

How long is a recession?

Given that we have this very detailed history of recessions in the UK, we can use that data to see how long a recession typically lasts. 

In this table below, taken from the paper by Hills, Thomas and Dimmesdale published in 2010, they break up the three century period into five sub periods.

In the most recent period, between 1952 and 1992, the average downturn lasted about three years, followed by an upturn also lasting three years.  That makes an an overall cycle of of just under six years.

Therefore if we do get a recession it may not be over quickly. In fact three years can feel like a very long time during a recession.

Why now?

If you read the Bank of England's inflation report for May 2019 the first graph in the report (below) shows this quite marked decrease in economic activity for both emerging markets and  advanced economies.

If we look at leading indicators it can give us a slight hint as to what will happen with growth in the near future. 

The Purchasing Managers indices (below) shows the manufacturing components have fallen below 50, which is a sign of contraction. But you can also see the composite, which combines manufacturing and services, is still above 50. Therefore the PMI indices just point towards a continued fall in the GDP.

When discussing the reasons for this fall the Bank of England and the Federal Reserve in the United States point the finger at trade tensions, in particular the trade war between the U.S. and China.

The direct effect of this has been on the bilateral goods trade between those two countries. The broader effect has been due to reduced global business confidence. The manufacturing sector has been particularly hard-hit. 

When companies are worried about economic policy and in particular trade policy they are less likely to invest. This results in slowed down economic growth but fortunately consumption growth has remained resilient.

Yield Curve Inversion

Another factor that has spooked investors is the inversion of the yield curve.

In my video explaining the bond bubble (here), I look at the four countries depicted in the graph below and discuss why yields are negative in some countries and what that means.

For example, the bottom left quadrant of the graph is the yield curve in the United States. It represents how much it costs the US government to borrow over one month and up to 30 years.

The green line is the latest yield curve.  If you were buying a ten-year government bond on a day I made this video (August 2019) you would be paid 1.54% by the US government.

What is really unusual about this is that it is less than the amount you would have been paid to lend money to the U.S. government over shorter periods of time. Normally the yield curve is upward sloping because investors demand a higher rate of interest for locking in a fixed rate of borrowing for a longer period.

In the U.S. the yield curve has been a fairly good predictor of economic growth. 

The Cleveland Federal Reserve Bank publishes a model which takes the difference in yield between short term bonds and long term bonds. As an output it forecasts GDP growth and the probability of a recession in the coming year.

This model is certainly not perfect as there have been two notable false positives. In late 1966 the US yield curve inverted but there was no recession and the same thing again happened in 1998. 

Below is the data that feeds into the model and the orange line is the steepness of the yield curve.

You can see that when it goes negative there is a grey bar that follows, usually within a year and that marks a U.S. recession. You can see in the graph the false positive in 1966 where the yield curve inverted and there was no recession. But on the whole when the yield curve inverts we normally get a recession within one year.

It happened in the 80s, the early 1990 and the early 2000s and then before the global financial crisis and you can see it's happening again now.

Now there's no economic theory behind yield curve observation,  it's just a relationship that people have noticed in the data.

Another problem is that there really aren't that many data points, there haven't been that many recessions since WW2. We only have about ten data points to work with, so the statistics aren't particularly robust. 

Below,  for what is worth,  the model currently forecasts a 40% chance of recession in the year to come. But it’s worth pointing out that the U.S. data is still okay. They still have very strong employment data, a fairly brisk wage growth and their PMI indicator is still above 50.

In the UK the National Institute of Economic and Social Research (NIESR) says that there is a significant risk that the economy is already in a recession that began in April and if we get a no-deal Brexit there is the clear possibility of a more material downturn.

Asset Returns

As an investor what we really worry about is what happens to asset returns during a recession and there is a fairly clear and consistent pattern with this.

On the x-axis in the top section of the graph below, I show the monthly return on U.S. Treasuries. You will see there are large positive returns of about 10% on the right and large negative returns of -10% on the left.

I have split the monthly returns into recession periods in red and periods of growth in blue.

What you can see is that during periods of growth, the total return on Treasuries is small and positive but during a recession the average return increases significantly. There is a shift to the right of this distribution and an increase in the size of the upside tail. 

You get more large positive returns during a recession and the reason for this is that people sell equities and buy Treasuries.

Treasuries are seen as much safer. They have a much lower volatility and they carry almost zero credit risk in the United States. We call that selling of equity and the buying of government bonds de-risking a portfolio.

n the bottom graph, If instead we look at equities the S&P 500  pattern is exactly the opposite during periods of growth.

The returns on the equity market tend to be stronger but during a recession the average return is negative.  If you look at the distribution of returns you can see that it's grown a large downside tail. In other words during a recession you're much more likely to have a large negative return and that drags down the average return for equity.

If we had a crystal ball that could predict recessions (which we don't) then the best strategy would be to de-risk just before recession hits and then just as the recession is ending switch back into equity.

In the graph below, we look at a broader range of indices.

As a I don't have such long time series for these, I've had to use a shorter time period, from 1995 to 2019.

I have ordered the assets from left to right according to the amount of the difference in return during periods of recession and growth. Recessions are in red and periods of growth are in blue. You need to look at the  black line which is the median return. 

For the Hang Seng Index you can see that during periods of growth the median return is positive, whereas during periods of U.S. recession the median return became negative.

The only one of these assets where the return turned positive during periods of recession was gold and that's because gold is also seen as a safe haven during periods of financial crisis.

I have covered whether gold is a good Investment in a previous blog and if you want to read more about it click here

If you want to actually buy those indices you can do so very cheaply through exchange-traded funds (ETFs). 

In the graph below, I've shown six of those ETFs from the iShares range, which is managed by Blackrock. These are the ones which had time series that extended before the global financial crisis.

What you can see is that UK gilts were the only fund which kept their value during periods of U.S. recession. The median is roughly the same during periods of recession and growth.

Whereas European Equity showed much larger volatility or variation in returns during periods of recession. The median return was also negative 

UK corporate bonds also sold off during periods of US recessions,  as did European Equity, the FTSE 100 and the S&P 500 tracker.

If we did have time series stretching back further for these funds, we would see would be a very clear split. 

As investors de-risk they would  move their money into safer funds, typically fixed income. The safest part of the fixed income universe would be government bonds, either issued by the UK or by the US.  But if you did want a safe version of a US Treasury you would probably have to go for the hedged version to get rid of the currency risk. This is because for US Treasury funds the volatility is so small that it's swamped by the currency volatility. 

The assets that would sell off would be the risky ones (in red) and that's the equity funds particularly the most risky which the emerging market stocks.


What strategy should we adopt when we're thinking about recession?

Fixed Allocation

The fundamental problem is that we can't predict when recessions will happen. Of course we can look at PMI indices or we can listen to the central banks but unfortunately they don't know either.

There is no perfect model for recessions, so the simplest thing you can do is to create a diversified portfolio.

Find a risk level that you are happy with and use that to fix your equity/bond allocation. Keep your fees low, then simply drip-feed your money into your investments over your lifetime and completely ignore the news.

Although this may  sounds like a dumb strategy, for the majority of people in the past this has produced a good outcome.

The reason why you ignore the news is that over the very long term shares may give you a bumpy ride but if you simply keep your money invested, markets recover and erase those periods of large loss.

That is true for equities in red but also true of bonds in blue.  

Dynamic strategy - (vary allocation)

An alternative is to have a dynamic strategy where you vary your allocation according to what you think is about to happen in markets.

That is exactly what dynamic multi asset funds managers will be doing on your behalf.

With these multi asset funds you often pay a fairly high fee for expert fund managers to do that fiddling for you. They try and predict what's going to happen in markets and then they move your allocation accordingly. 

However, if we compare them with something like a Life Strategy 80% fund, which is in blue in the graph below, you can see that this Schroder dynamic planner portfolio actually under performed that fixed allocation even though the fee is considerably higher.

Many of these multi asset managed funds fail to beat the market and that's true of this Investec Cautious Managed fund which has also under performed The Vanguard Life Strategy 60%

Even one of the best performing funds like Artemis Income Fund is running roughly neck-and-neck with the cheaper and fairly dumb Life Strategy 80% fund.


So that should be a warning to us. These extremely expert multi asset fund managers have failed to beat these fairly simple fixed allocation life strategy funds.

If those well resourced, intelligent, very well paid fund managers failed to beat a fixed allocation fund,  then you and I would probably also fail to do so.

Therefore, for most of us, it is probably best to go with a fixed allocation that suits our appetite and capacity for risk. 

If you want to learn more about DIY asset allocation then PensionCraft have a course that will help. Find out more by clicking DIY asset allocation

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November 12, 2019

Buy or Rent a House – Which is Best?


Is it better to buy or rent your house?

The buy versus rent house decision is made more difficult because most of us think that renting is throwing money away. But if you buy a house you're throwing away interest payments on the mortgage interest and maintenance costs for the house plus the huge costs of purchasing and selling.

In this blog we look at different ways of comparing the option to buy or rent. We also provide access to a spreadsheet at the end so you can play with the assumptions for yourself.

Buy vs Rent

In this example I've assumed £35,000 in savings. You can either invest it in the stock market then rent a house or alternatively you could use it as a deposit to purchase a house.

House Price Growth

In order to make that comparison we need to estimate how much house prices will grow in the future and we can calibrate our expectations by looking at house price growth in the past.

The general pattern, that you can see below, is that the further back we look in time, the slower the house price growth. 

Our first source of information is from the Land Registry and it goes back to 1968 and although there are huge fluctuations in house price growth over time the average annual price growth is 8.5%.

The Nationwide House Price Index goes back further to 1952. Notice that the period before 1970 falls below the average, so it's not surprising that the average over that period of time is 7.4%, which is lower than it is over the period since 1968.

If we use the very long time series from Dimson, Marsh & Staunton which covers the period from 1900 to 2017 we see that in the UK the real house price growth has been 1.8%. 

Unlike the previous numbers, this has not had inflation subtracted from it. If we add inflation back in we would be looking at something more like 4% annual growth, but that is still far lower than we've seen since the 1970s.

Share Price Growth

If we're going to compare house price growth with share price growth we also need an estimate for that.

Using Robert Shiller's data set we can push the S&P 500 back to 1871. Over that period the growth has been 6.8% per year but this is just for the US stock market. The figure is inflation adjusted so we will have to add back the 2%, it assumes that dividends are reinvested which increases the return significantly and the time period is a huge 148 years.

We can also use Dimson, Marsh & Staunton’s work which shows that the global rate of equity growth is about 5.2%. Again this is the  real rate of return so we have to add inflation back to get to about 7% and the UK is pretty similar to that global growth rate.

Vanguard’s 10 year outlook suggests that we may not see the very high returns that we saw in the past.

The 1970’s were just a period of much greater growth and just like house prices, if we look at a more recent period, the rate of growth comes down. In the coming decade they expect returns to be around 4% per year. They think that the 11% returns since 1970 and 8% returns since 1990 are very unlikely to be repeated. That is  because of a combination of high valuations, in other words things are just expensive, but also low interest rates. According to their forecasts there's almost nowhere to hide, we get these lower rates of return in almost any asset class whether it's bonds or equity.

Cash vs House Comparisons

The first two comparisons which I'll show you compared buying a house with investing your money in cash and as you might expect the economic gain from buying a house is much better than that of investing your money in cash.

Example One

The first piece of research below is by Mostafa & Jones in which they compare the financial returns from buying versus renting and focus on first-time buyers

Source: “The financial returns from buying versus renting: The experience of first-time buyers in different regions of Britain”

Mostafa & Jones, Journal of European Real Estate Research, 2019

  • The average First Time Buyer (FTB) cases created on average £12.40 of wealth for every £1 of the Initial Outlay (IO) in present value terms over the 37-year study period (1975-2012)
  • Seen in terms of gross return for every holding year per £1 IO:
    • Generate £0.61 per every holding year on average
    • 90% of all cases create £0.30 per year
  • Ignoring capital gain for every £1 of the IO:
    • Average FTB cases create £5.60 of wealth
    • £0.30 on average per holding year

  • Capital gains contribute to just 56% of the overall return
    • Varies amongst regions with some regions’ return relying more on the growth in house prices (London) than others
  • Despite the huge range in the level of average house prices between regions broadly from north to south, the financial benefits hold for all localities.

Example Two

Again in this comparison by Rob Thomas the cash was simply put into a savings account compared to being invested in a house.

Source: “The intergenerational divide in the housing and mortgage markets”

Rob Thomas, Intermediary Mortgage Lenders Association, October 2019.

“Even assuming no house price growth for the next 30 years, someone buying an average home, initially with a 25 year 95% LTV repayment mortgage, could be £352,000 better off than someone who continues to rent privately. Mortgage rates would have to exceed 11.5% over the life of the loan before renting was as financially advantageous as buying”

Below is one of the tables from his paper comparing the cost of renting and buying from 1996 to 2018.

If you start with £2600 which you had saved at the start of 1996 and used it as a 5% deposit with a 95% mortgage then that would buy an average priced property at the time.

The rent over the period would be £212,000 using average rental rates.

The comparison is with cash deposit rates which over that period averaged about 3.2%.

Now that 3.2% is  a very low bar to beat if we compare it to the total return on the FTSE 100 over that same period, it was a much higher at 6.3% and the S&P 500 was higher still at 8.3%.

So part of the reason why the mortgage rate would have to be so high to make renting worthwhile is because the investments were put into cash which has a very low rate of return.

Stocks vs House Comparisons

In this section we will look at the comparisons between buying a house versus renting a house and investing in the stock market.

5% Rule Example

The first example is from based on numbers from an excellent video from Benjamin Felix called "Renting vs Buying a Home: The 5% Rule".

Ben Felix also uses the Dimson, Marsh & Staunton’s estimate which gives you a 3% growth rate for real estate and he uses a 6.57% for stocks. This gives you a 3.57% difference in expected return between real estate vs. stocks. To keep things simple and conservative he rounds that down to 3%. 

That 3% opportunity cost, which is the difference between the rate on real estate and the stock market is very similar to the interest rates on mortgages in Canada at the moment, which is where Benjamin Felix is based. Therefore he says that the cost of capital is 3% whether it's through a mortgage where rates are 3% or a down payment where the opportunity cost is 3%.

In Canada, property taxes are about 1% per year and he estimates that maintenance will also be 1% per year, therefore 3% + 2% gives you the 5% rule! Homeowners can expect to pay about 5% of the value of their home in unrecoverable costs.

Now the accepted wisdom is that it's always better to buy because if you rent you're just throwing that money away but what's great about Benjamin Felix's video is that he also shows that you have unrecoverable costs when buying a house. For example the maintenance that you pay when the boiler breaks down or when the roof leaks and you have to mend it. 

Below is an example of how the 5% rule works to have comparable unrecoverable costs between buying and renting. 

For buying in Canada you will pay 3% to the bank in interest payments. You will pay 1% maintenance costs per year for the property and you'll pay that 1% Canadian property tax so you will get a 5% unrecoverable cost.

To get an equivalent unrecoverable cost for rent you would  have to pay rent which is 5% of the house price. For example, if you want to buy a house for $430,000, 5% of that would be $21,500. Therefore if you pay a rental of less than $1,792 per month then your unrecoverable cost for rent will be lower than if you had purchased a house.

UK Example

Next I will look at an example from the UK and there is a spreadsheet at the end of this blog which will allow you to experiment with the numbers for yourself.

For my example I have just chosen the following amounts and based the calculations on those long term returns which I explained at the beginning of the blog.

I've assumed you have £35,000 to invest and you can either use that to buy a house by putting a deposit down and also paying those initial costs or you can invest that money in the stock market and to rent.

You have £5,000 worth of costs (outlined below) leaving you with £30,000, which is a 10% deposit on a £300,000 house.

You can see from the slide below, if you break that down to a monthly repayment mortgage, it will be £605 principle in the first month plus £675 unrecoverable interest, which gives you a total of £1,280 per month. In the first year the total you pay will be £15,364 of which about £8000 in unrecoverable interest payments.

I have assumed the maintenance cost is going to be 1% and that's going to be £3,000 per year/ £250 per month. That figure needs to go up in line with the rate of inflation as there's no way that a plumber will charge you as much today as they'll charge you in 25 years time.  That is why you can see those monthly maintenance costs creeping upwards at 2% per year, so after one year it's not £3,000 but £3032.

At the end of the first year, if the property is increasing at 3% pa then the value of the property is going to be £309,000. Because the house price is roughly the national average, I have also assumed a national average for the rent which is £926 per month or £11,000 pa (based on figures from the BBC

You will see that in the first month you're going to invest £603, which is the difference between the mortgage and the maintenance you would have paid on a house and the rent.

Over the first year that would add up to over £7,000 which you would invest in the stock market 

Therefore if you take your initial money put towards buying a house which was £35,000 and add the extra money which you saved by not owning a house and you also consider the return on investing it, (which i’ve estimated at 6%), you would end up with about £44,500.

This £44,500 is the investment value if you had rented and not bought.

Sale Profits

When you come to sell we can compare the overall economic advantage of renting versus buying by examining the sale profits.

Below is an example after 25 years and the assumptions in the calculation are in the top right hand corner of the slide.

The mortgage rate of interest might seem fairly high at 4.5%, but I will explain later why I have chosen that figure in the Mortgage Rate Sensitivity section.

The rate of house price appreciation is 3% and that is the global long-term average.

I've assumed the investment return is a fairly low 6% and that is for a 100% equity investment which is somehow tax sheltered for example in a ISA or SIPP.

After 25 years the house price has more than doubled but unfortunately the estate agent fee, the conveyancing fee and the maintenance have all risen in line with inflation. 

The interest is money we will never get back which has been paid on the mortgage. The principal and the deposit was simply repaying the purchase cost of the house. Once we subtract all those costs we get a net gain of about £43,000.

If instead we had rented over the same 25 year period, the total rent would have been about £360,000 but our investment value would be £625,000. 

If we look at the net gain, which is the difference between the investment value and the total rent we paid, it is about £43,000, which is the same as we would have if we had bought the house and sold after 25 years.

If you are interested to learn more about what drives house prices the I go into this in detail in my House Prices After Brexit blog and video.

Mortgage Rate Sensitivity

One of the key things in the calculation above is the sensitivity to the mortgage rate of interest.

In the graph below, the block in yellow is the monthly mortgage payments on a house which stays fixed over a 25 year period.

In this scenario, I've assumed a much lower mortgage rate than the previous example at 1%.

I have added the other big unrecoverable cost which is the maintenance cost of running a house. This gradually creeps up at 2% per year due to inflation.

I have also assumed that rent goes up in line with inflation. Any difference between the total cost of owning the house and the rent is invested into the stock market so initially that's just under £300 a month.

You will see the rent creeps upwards until it finally surpasses the mortgage payments. After this point there will be no additional investments into the stock market because the rent is more than the monthly cost of owning the house.

In the example below where the mortgage rate increases to 2% the house purchase has a double disadvantage.

I have assumed the rent is unaffected by the higher mortgage rate but that now means that the mortgage is always higher than the rent, so you're continually investing in the stock market right until the end of the 25 year period as you're paying more interest.

Below is a graph with the mortgage interest rate plotted on the x-axis ranging from 1.5% up to 4.9%.

What you can see is that when the mortgage rate is 3.8% the money you throw away and rent will be matched by the profit you make with your stock market investment.

Above the 3.8% breakeven you will start to make a profit, where your investment is more than the amount you pay in rent.

In the graph below, If we compare the profit you make in renting versus buying the break-even is much higher, it is now at 4.5%.

So if the mortgage rate is above 4.5% on average over the 30-year life span of the mortgage, then according to these assumptions you would be better off renting.

If you think a 4.5% rate seems very high, it is worth looking at the graph below which shows the Bank of England interest rates since 1694.

The current rates, which are very low close to 0%, are extremely unusual. We've never seen anything like this in the last three centuries. Therefore, it may be more realistic to think in terms of rates of around 4% or more.

I hope I have illustrated that it is not as clear-cut as you might think.

Renting isn't just throwing money away because any money that you keep and which you don't spend on a deposit, maintenance or interest payments can actually be ploughed into the equity markets or to other investments.

Of course it does depend critically on those numbers that I've assumed for the mortgage interest rate, for the rate of return on the investments and also on the rate of inflation. All of these numbers affect the outcome and that's why I hope you'll find the spreadsheet useful, so you can play around with those numbers for yourself and make up your own mind.

Buy vs Rent Calculator 

This spreadsheet will allow you to get an idea of the costs and benefits of buying versus renting. It isn't a recommendation about either course of action. The decision is going to involve many factors many of which aren't financial.

Fill in your name and email below to get a link to access the spreadsheet. You'll also get updated weekly on global markets and our latest content. I email about once a week. No spam. Don't worry, if you change your mind, you can unsubscribe at any time free of charge.

November 11, 2019

CAPE weighted portfolio, junk bonds vs emerging markets bonds, negative rate mortgages, safe saving ETF & short term investment.

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

Could you share several strategies that are likely to provide decent returns or at least protect the downside for the next 2-3 years, please?

If you watch my video “Portfolio Inspiration” by clicking  here it talks about robo fund fixed allocation portfolios and how to cheaply mimic LifeStrategy returns with either Vanguard or iShares funds which are cheaper.

  • A horizon of 2 to 3 years is very short
  • You can’t have decent returns and protect your downside
  • If someone says you can have both they’re lying a reliable scam keyphrase
  • If you want to protect against downside increase your bond allocation
  • Over a 3-year to 5-year horizon equities (in the US) fell with a probability of about 25% and bonds fell with a higher probability of about 30%.
  • The typical loss when equities fell was larger (about -15%) over a 3-5y horizon than it was for bonds (about -7%)

What are the pros and cons of a market-weighted portfolio vs a region-by-region value-weighted one?

  • CAPE is the
    • Cyclically Adjusted which means it smooths volatile earnings over a whole business cycle of ten years
    • Price because it’s the number of dollars you pay…
    • To Earnings ...divided by the earnings averaged over the last decade
  • This is one of the best predictors of future long-term returns I know of
  • To use the information you increase your equity allocation (buy equity and sell bonds) when CAPE is low and decrease it when CAPE is high (sell equities and buy bonds)
    • This takes iron discipline!
    • I have had a low equity allocation since 2017 and had to put up with comments like “you’re too cautious”, “I’ve made over 20% while you missed out” etc.
    • FOMO (fear of missing out) is your enemy
    • Then you have to buy equity when every news story is talking about how markets are doomed
  • At the moment CAPE in the US is high 30.5 for the US
  • The best research I’ve seen on this is by Star Capital here



Could improve returns if the future resembles the past

Cognitive biases make this approach very difficult indeed

CAPE is one of the few predictive variables for equity returns

Requires rebalancing

Anchors equity values: cheap or expensive

It takes a decade to see the results

I'd like to get up-to-date on what government or corporate bond ETFs I might consider as an alternative to 1-3-5 year fixed rate cash savings accounts.

  • Cash is like a bond with a very short duration, or a floating rate bond which has almost zero duration
  • A money market fund, which is now offered by Vanguard, is cash-like but has some duration risk
  • MoneySavingExpert has a list of the best  instant access cash accounts available here

  • It might be helpful to look at how much return you get for every unit of risk (volatility) as demonstrated in this spreadsheet: here

Junk bonds or emerging market debt? Both seem to be on comparable high yield but the risks may be quite different?

  • EM debt risks
    • Default risk is higher than developed market government bonds
    • The danger is greatest for double deficit countries where there is a fiscal deficit (the government is spending more than it’s earning in taxes and plugging the gap with debt issuance) and a current account deficit (it imports more than it exports)
    • The triggers for an EM crisis can be a combination of
      • A currency crisis
      • A banking crisis
      • A debt crisis
      • Political instability
      • See IMF Global Financial Stability Report here

  • Junk bond risks
    • Defaults are rare when rates are low but spike when there’s a big market move in, say, commodity prices
    • This happened when the price of oil fell from $105 to $30 in 2015/2016 and “zombie” US oil companies started to default much more rapidly
    • Covenants have weakened, these are designed to protect investors against things like issuance of more debt, calling the bond (redeeming early) such as a 5NC3 bond which has a maturity of 5 years but cannot be called in the first three years after issuance, monitoring the health of the company via automated reporting if certain balance sheet measures hit warning limits, paying a dividend to equity investors…
    • Bond Indentures & Bond Characteristics article  ​here​​​
    • Moody's Analytics article is here


Are negative interest rate mortgages a possibility in the UK and what are the implications on the property valuations/market?

  • Currently, Bank Rate is 0.75% in the UK so we’re quite a long way from negative rates
  • Denmark’s Jyske Bank (their Nationwide or Halifax equivalent) offers negative rate mortgages
  • Negative interest rate mortgages are common in Denmark, and this is also why Jyske issued a negative coupon AAA-rated covered bond ​here​​​
  • In practice, although interest on the mortgage is negative the borrower still ends up paying back more than they borrowed due to fees
  • The negative rate is like a rebate on the mortgage fees borrowers don’t get paid to buy a house
  • This is what Jyske says on its website (thanks to Google Translate)
    • Jyske Realkredit is ready with a fixed-rate mortgage with a nominal interest rate of minus 0.5%.
    • Yes, you read right. You can now get a fixed-rate mortgage with a maturity of up to 10 years, where the nominal interest rate is negative. However, you are not exactly going to make money borrowing. Namely, there must also be paid, among other things, establishment fees and contributions, and there will be a loss of prices.
    • "Practically, it will be experienced that the mortgage loan repayment will be greater than it would be with a positive interest rate. The negative interest rate will act as a 'subsidy' to the repayment. And the repayment portion will become smaller and smaller as the debt is reduced," explains Jyske Banks. housing economist Mikkel Høegh.

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November 11, 2019

How I Invested 20k – Update for Q3 2019


Many of you asked me how I invest my own money,  so in this blog I'm going to look at my own portfolio in quite a bit of detail.

Do NOT copy my portfolio! The goal is for you to see my approach to investing then use it and adapt it to your own circumstances and beliefs. What is appropriate for me is almost certainly not appropriate for you.

If you do want more detail about this there is a booklet that accompanies my "How I invested 20k" series and you can access this and the other videos in this series by clicking ​here​​​

What's Changed?

Global Price to Earning Ratios

Star Capital produces this valuation map of the world (below). 

The expensive regions are in red and the cheap regions are in blue.

The valuation measure we're looking at here is a cyclically adjusted price to earnings (CAPE) ratio developed by the Nobel laureate Robert Shiller.

What the CAPE measure tells you is the number of dollars people are willing to pay for every dollar of earnings generated over the last decade. The earnings in the denominator are averaged over a decade because that roughly corresponds to one business cycle. It also irons out the volatility of earnings which tend to fluctuate up and down a great deal from year to year.

The three maps below are how things looked in September 2017, May 2018  and March 2019.

The final map (below) is from September 2019. 

What's notable is that the U.S. is still very expensive, it's still one of the most expensive regions in the world. 

The UK is still cheap, largely because of Brexit uncertainty. 

Europe is also relatively expensive, whereas Russia remains very cheap due to concerns about sanctions against them. Japan is also quite expensive.

The reason why I look at cyclically adjusted price ratio is that looking a decade into the future, it is one of the best predictors of equity return.

In the graph below, the numbers on the y-axis are how much of the variance of stock prices is explained by each of these factors.

You can see that the Shiller ratio comes out top, but only for decade ahead returns, not for one year ahead, which is much less predictable. 

Even the price of stocks today divided by earnings over the previous year, which is  labelled P/E1, is also quite predictive of returns over the coming decade. But unsurprisingly rainfall isn't very predictive, so anything that's to the right of this is essentially noise.

This is far from a very accurate forecast. There's still a huge amount of uncertainty about what equity prices will do even though we do look at the CAPE measure. Currently we are at a CAPE multiple of just under 30. 

You can see in the diagram below, that there is a huge variability in the return of stocks over the following decade.

What you can see is that when valuations are very high, which is where we are now, returns tend to be lower than they are when valuations are low at a multiple of around ten. 

If we look up the average return over the next decade, when valuations are this high, it's only a little bit above zero on average.

Purchasing Managers Indices

Another factor I like to look at are the Purchasing Managers Indices (PMI).

When these are above 50 it signals expansion and when they're below 50 its signals contraction. 

In the Euro Zone, the last time that I looked at my portfolio these were falling very sharply which was a cause for concern. Whereas in the U.S. the PMI indices were holding up quite well and the composite index was still above 52.

What has happened since then is that the European PMI has fallen further and is now just on the cusp of falling below 50. Even the U.S. PMI, which until that point was very strong, has deteriorated significantly and it's now 51.2 as of October 2019.

You can see that while we are still in expansion territory, it's certainly weakened.

A weaker PMI index is a headwind for GDP growth and a headwind for GDP growth is generally a headwind for corporate earnings and for equity prices.

Therefore overall the picture for equity is looking a little bit worse than it was last time I updated my portfolio.

A perpetual worry for investors is that China is going to slow down. But you can see below that the Chinese PMI is actually okay. It is 51.9 as of September 2019.

China’s  manufacturing PMI increased to 51.7 in October 2019. What is positive about this is that the orders placed with companies improved substantially in October, despite the Sino-U.S. trade war. 

It's not all a rosy picture because business confidence has been weak and the employment sector continued to contract.

However, a big support for the Chinese economy has been large infrastructure projects and  it's very strong export market. So I'm not particularly concerned about China being a tail risk at the moment.

If we look at the kind of infrastructures which are helping the Chinese economy, the roll-out of 5G which is happening this month is a great positive.

So far it's only been rolled out in the largest cities. Large in China means really large! So Shanghai, for example, is 24 million people, that's almost three Londons.

What's incredibly important is the collaboration between business and government in rolling out this infrastructure. According to the mobile telecoms organisation GSMA, China will have about 40% of the total global 5G connections in 2025.


On the October 30th the Federal Open Markets Committee, which decides U.S. interest rates, reduced rates for the third time in 2019.

The reasons they gave for this was that this was insurance against ongoing risks. They did it despite the fact that the economy in the U.S. is growing at a moderate rate. 

There's certainly no sign of recession as yet in the U.S. as they've got strong household spending, which is very supportive of the US economy. There is also a very healthy job market with extremely low unemployment and U.S. incomes on average are still rising.

On the downside  business investment and exports remain weak. There are clear signs that manufacturing output has declined over the past year and the sluggish growth abroad is starting to affect the U.S. The trade war is now also starting to weigh on the U.S. economy.

The European Central Bank has also responded to the weakening of economic data and its response has been to make its negative interest rates even more negative. 

Below the European Central Bank gives the five ways in which it is implementing its very accommodative policy.

The Bank of England has not cut its interest rate, its official bank rate is still 0.75%. 

As financial conditions start to deteriorate, after Brexit they may have to cut interest rates in order to stimulate the economy. However they have said that cutting interest rates after Brexit is not a foregone conclusion

My Portfolio

Market Changes

Next I will examine the market changes my portfolio. 

As illustrated below I have quite a bit of exposure to the United States but also to Europe and to a lesser extent Asia Pacific. Therefore if sterling strengthens that's bad for my portfolio.

Below is the value of sterling versus the U.S. dollar.

After they announced a general election in December 2019 sterling rallied considerably because the probability of a No Deal Brexit fell sharply. That rally has in turn hurt the non-Sterling parts of my portfolio.

Below is what the risk-return plot looks like for Vanguard funds between 2016 and April 2019.

Risk is along the bottom, so high-risk is on the right and low-risk is on the left. Return is on the y-axis, so low returns are bottom and high returns are up top.

The 3 funds I chose in April were:

  • Global Minimum Volatility Factor, which is one of Vanguard's global equity funds.
  • UK investment Grade Corporate Bonds, because I didn't want to have too much equity risk.
  • Emerging Market Government Bonds, because of their very high dividend yield.

If we update that graph below for October 2019 the story is pretty much the same.

Global Minimum Volatility Factor is still performing fairly well compared to other assets.

My safety play, which is UK Investment Grade Corporate Bonds, have done their job, which is to have low volatility and to provide a little bit of income. 

The Emerging Market Government Bonds have held their value and they have provided a very high level of income. 

If we rank those funds available from Vanguard by their 12-month yield you can see that at the top of the table we still have Vanguard US Dollar Denominated Emerging Market Government Bonds with a yield of over 5%.

How I Beat the Market

The way I've chosen to beat the market is to have factor funds. The factor I've chosen to have low volatility. In previous iterations of my portfolio I have included Global Value, but if you want more detail about that then there is a video on YouTube about it.

Vanguard offers four of these factor funds:

  • A Global Value Factor Fund - which buy stocks which are cheap according to three valuation measures.
  • A Momentum Factor Fund - which buys stocks which are trending upwards in price
  • A Liquidity Factor Fund - which buys stocks which have low liquidity. 
  • A Global Minimum Volatility Fund (the Fund I include) - which chooses stocks for optimal diversification low risk.

A reason that I like the global minimum volatility fund is that it contains a lot of real estate investment trusts and these offer quite good income over the long term. 

A reason I don't like this fund is that it has a 50% exposure to the U.S. and as we saw earlier, the valuations there are very high at the moment.

Making Changes?

I'm going to finish by looking at the portfolio changes.

 If you are familiar with my videos on YouTube or have read my booklet, which describes how I allocate,  you'll know that I start from risk. 

Part of the way I analyse risk is by using a tree and in this tree I characterise various markets using characters from Scooby Doo.

A tree is a very simple way to visualise the behaviour of asset classes,  just as you could describe the different characters in Scooby Doo in a tree.

What's different about this tree is that it's sideways. It grows from left to right and the illustration below is what the correlation tree looks like using the latest data.

It splits very cleanly into bonds at the top and shares at the bottom. 

Bonds, I've characterised with Velma because they're kind of boring and prudent. 

The shares I've characterised as Scooby Doo, because Scooby's a little bit exciting and a little bit crazy.

Notice how I've chosen one fund from each part of the tree, that way I'm not doubling up my risk.

I've chosen an Emerging Market Government Bonds at the top of the tree.

I've chosen UK investment Grade Bonds in the middle of the tree.

From equities, which are all shown in blue,  I've chosen the Global Minimum Volatility Factor, because I don't want to take too much equity risk.

Now it turns out that my new allocation is the same as my old allocation, so the only question is; Should I re-balance my portfolio?

Should I Re-balance?

There are various optimal ways of choosing a portfolio.

For my three funds I previously used a slightly modified version of a risk parity portfolio. Where the contribution to the risk of my portfolio is the same from every asset class. 

In practice this means you have very little equity in your portfolio because it tends to have a higher risk.

I then took those risk parity weights and adjusted it so that I had 60% bonds in my portfolio and 40% equity.

When I did that I ended up with:

  • 20% of the Emerging Market Bonds 
  • 40% of the UK investment Grade Bonds 
  • 40% in equity,  in the Minimum Volatility Fund

If I rebuild these optimal portfolios using the latest data then the numbers come out exactly the same.

That means for now I'm not going to change my portfolio allocation as there's really no need. My portfolio weights are pretty much where I want them, 60% bonds and 40% equity.

If the markets had moved a lot then I would have re-balanced and I might do that in a future update, but for now there's no need to do anything .


The macroeconomic data has got slightly worse but the central banks, particularly in the U.S. & Europe, have become more accommodative, which should help counteract those negative effects on the economy.

I will however be keeping  a very close eye on the factors we looked earlier on in the blog.

These are: 

  • Nonfarm payrolls 
  • Spread in credit markets 
  • Volatility in markets
  • The PMI indices, which give you a forward-looking idea of what's going to happen to growth in the near future.

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November 11, 2019

Fallen Angels, internal rate of return, quality dividend funds, volatility & credit risk.

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 do you think of quality dividend ETFs for long term investing?(E.g. - iShares MSCI Europe Quality Dividend UCITS ETF EUR (Dist) EQDS:LSE:GBX - iShares MSCI USA Quality Dividend UCITS ETF USD (Dist) HDIQ:LSE:GBX)

UK high dividend funds such as IUKD don’t come with these filters for sustainable dividend

iShares has three of these quality dividend ETFs, one which is for global equities, one which is for European stocks and one for US equities.

The funds are

  • The dividend yield is a measure of how much a company pays out in dividends each year relative to its share price.
  • The benchmark index excludes any Real Estate Investment Trusts (REITs, i.e. closed-ended investment vehicles that invest in, manage and own real estate) that are part of the parent index.
  • In order to create the benchmark index, the index provider (MSCI) applies a dividend income and quality screening process to the companies which make up the parent index with REITs excluded. This screening process excludes companies
    • (i) whose dividend payments are extremely high (i.e. in the top 5% of constituents, on the basis that dividend payments which are particularly high relative to a company’s earnings could be unsustainable) or negative
    • (ii) which do not have a good track record of growing dividends
    • (iii) which could be forced to cut or reduce dividends due to potentially weak fundamentals (i.e. information about a company which can be expected to impact the price or value of its shares, including profitability, consistency of earnings over time and debt levels)
    • (iv) which rank lowest among the remaining constituents based on recent annual performance.
  • From the list of companies which remain after this screening process, only those with a higher dividend yield relative to the parent index will be included in the benchmark index yield relative to the parent index will be included in the benchmark index.

How to interpret “Internal Rate of Return”? (A.K.A. money-weighted return or personal rate of return)

This is how Vanguard’s tooltip describes the internal rate of return:

Rate of return that

  • If all past investment amounts are invested at that rate they will lead to the value of the portfolio today
  • All past investments discounted at that rate will give a total present value of zero

Is there any evidence that "Fallen Angel" bonds which have been downgraded from investment-grade are indeed then "over sold" by institutional managers and hence provide an opportunity?  (iShares Fallen Angels High Yield Corp Bond UCITS ETF (RISE) is an example of an ETF in this area)

Yes, but… it comes from the index constructors such as Russell launched 2016-06-21

For example, here’s the fact sheet for... 

  • The FTSE Time-Weighted US Fallen Angel Bond Select Index is designed to measure the performance of “fallen angels” – bonds which were previously rated investment-grade but were subsequently downgraded to high-yield
  • The index is based on the FTSE Time-Weighted US Fallen Angel Bond Index which includes US Dollar-denominated bonds issued by corporations domiciled in the US or Canada that meet additional inclusion criteria.
  • Any such bonds with a rating changed from investment-grade to high-yield in the previous month are eligible for inclusion in the index and will be held in the index for a period of 60 months from inclusion provided they continue to meet the inclusion criteria.
  • If a bond exits and then re-enters the index, the inclusion period is reset.
  • Unlike traditional indexes where constituent weights are based on market value, the constituent weights of the FTSE Time-Weighted US Fallen Angel Bond Select Index are determined based on the time from inclusion in the index. Higher weights are assigned to bonds that have more recently become “fallen angels.
  • This time-based weighting approach aims to capture the potential price rebound effect that fallen angels may experience soon after their initial downgrade to high-yield. 

  • Intuitively this outperformance makes sense
    • Selloffs in credit are like those in equity, markets overreact then the price bounces back
    • Institutional investors are forced to sell a bond that is sub-investment-grade because their mandate is to buy only IG debt. They tend to hold very large amounts so selling makes a huge price impact due to the illiquidity of high yield credit.
    • The time-weighted index benefits from the bounce back in price that usually comes after a selloff
    • Correlation with equity of HY credit tends to be high, but is lower for fallen angels
    • Long duration could be a problem if rates rise, a benefit if rates fall
  • This article is by Robin Marshall who’s in fixed income research at FTSE Russell

Is there any relationship between volatility and credit risk or duration risk? If not, does it still make sense to use volatility as risk proxy for corporate bonds?

  • Bond volatility for corporate bonds
    • Doesn’t capture credit risk
    • Does capture duration risk
  • Watch out on FRED for credit spreads e.g. BB spreads are here and if credit conditions worsen this spread will increase almost immediately
  • The Merton model makes a beautiful link between equity volatility and credit risk
  • It treats equity like a call option on the assets of a company at a future time T
  • If the assets are worth more than the debts at time T you profit from the excess
  • If the assets are worth less than the debts at time T you lose all of your investment as the company is bankrupt
  • The distance to default is the amount by which the assets exceed the liabilities in standard deviation units

Equity Price equals delta times asset value minus debt value times p open paren survive to cap T without default close paren⁣


E sub 0 equals A sub 0 N of open paren d sub 1 close paren minus D e raised to the negative r T power N of open paren d sub 2 close paren⁣

d sub 1 equals the fraction with numerator l n the fraction with numerator A sub 0 and denominator D plus r T plus one half sigma sub A squared T and denominator sigma sub A the square root of T⁣

d sub 2 equals the fraction with numerator l n the fraction with numerator A sub 0 and denominator D plus r T minus one half sigma sub A squared T and denominator sigma sub A the square root of T⁣

sigma sub E equals sigma sub A N of open paren d sub 1 close paren the fraction with numerator A sub 0 and denominator E sub 0⁣

p sub default asymptotically-equals the fraction with numerator s and denominator 1 minus R asymptotically-equals the fraction with numerator l n N of open paren d sub 2 close paren and denominator T⁣

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November 7, 2019

Michael Burry Interview – Are We In An Index Bubble?


Money has flooded into the cheapest, largest passive index funds. In an interview with Bloomberg, Michael Burry, who successfully predicted the Dot Com Bubble and US Housing Bubble, says this has created an Index Bubble. In this blog, we explore some of his comments from the interview and see whether it describes an investment opportunity.

Who Is Micheal Burry?

Michael Burry has a huge amount of experience with financial markets. In 2000 he founded Scion Capital and he very effectively called the dot-com bubble. By shorting stocks he managed to make a profit even when the S&P 500 was falling, but most impressive of all, in 2005, he forecast that the real estate bubble would burst in 2007.

In 2008 he had returned over 22% on average per year to the investors of Scion Capital, but you probably wouldn't have heard of him if he hadn't been mentioned in Michael Lewis's book "The Big Short" which was then turned into a movie where Michael Burry's character was played by Christian Bale.

What is Burry's Point About Price Discovery?

In the interview Burry starts off talking about how banking regulations have reduced the amount of risks that banks can take and in turn that has reduced the liquidity of markets because those banks can carry less inventory. You can think of reduced market maker inventory like a supermarket with just one can of beans or just one bottle of milk.

Burry says that "..passive investing has removed price discovery from the equity markets" - Price discovery is the ability of markets to sort out the good companies from the bad companies, where good usually means profitable and able to return value to shareholders.

His point being, If you just passively follow an index then you are not looking at value at all. You simply buy companies in proportion to the size of the company. Therefore by removing the requirement for security level analysis, which active managers perform, he's saying that we're not going to get true price discovery.

James Seyffart from Bloomberg research has shared the two pie charts below. These compare 2013 with 2018 based on the amount of money which was run in active mutual funds versus passive exchange-traded funds and index funds. While active represented about two-thirds of the market in 2013 by 2018 it was roughly 50/50. Given the rapid growth of passive funds we are likely to have passed the point where passive makes up more than half the US market in 2019. 

Jack Bogle made a really interesting point about price discovery in 2017. He said that you could still have price discovery even if indexing was around the 70, 80 or even 90%  level as a proportion of total funds. The reason for this he said was that people would always be looking for value so active wouldn't have to be a huge proportion of the market in order to have effective price discovery.

Can you compare a CDO to an ETF? 

Many people have made that point about price discovery, but what is much more shocking is Burry's comparison of CDOs with ETFs. 

In the interview Burry compares what he calls the indexing bubble with the bubble in synthetic asset-backed CDO’s just before the Great Financial Crisis. But comparing an ETF with a CDO is a bit like comparing a cheetah with a hippopotamus, they're very different beasts!

What is a CDO?

A CDO is not something most of us are familiar with.  CDO stands for Collateralised Debt Obligation.

At the heart of a CDO is a pool of assets, in the case of the diagram below it is residential mortgage backed securities (RMBS).

They start with a  pool of assets out of which is created a set of CDO tranches which are based on the risk from the pool of assets. 

The word tranche comes from the French word for "slice" and the key thing here is that you are slicing up the risk.

When you sell these tranches to clients you have the low risk, low yield tranche at the top, which is supposedly AAA or very high credit quality. You only lose capital on the top tranche if all of the tranches underneath have been completely eaten away by default but because the top level is low-risk it will also earn you the lowest yield.

The next level is AA which gives more risk but also higher return. This continues down the CDO until you get to the bottom "equity" tranche (which is sometimes compared with toxic waste) but it also gives you the highest yield.

Source: “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States”, page 12

What is an ETF?

An ETF is an exchange traded fund. The fund in the data sheet below is the granddaddy of all exchange traded funds the SPDR SPY fund. This was launched in 1993 and it tracks the S&P 500 US equity index and the contents of the fund are completely transparent.

You can see the top 10 holdings in the data sheet and also the weights held by the ETF. In effect this is just a portfolio of stocks which you can buy off the shelf and the price of the ETF is just a weighted average of the price of the stocks inside the ETF. If the weights of the portfolio match those of the S&P 500 then you also match the price movements of the S&P 500. That is why these are usually called trackers, because they track some kind of index like the S&P 500.

Simple Versus Complex Pricing

The primary difference between CDOs and ETFs becomes very apparent if you look at the pricing. 

To get an intuition of how you price a CDO we can use an analogy which is a medieval castle. Imagine you are selling insurance and you charge people a premium in order to insure the gold they stored in the castle.

The nasty guys are going to try and break into your castle by digging a hole under it, filling it with explosives and then blowing it up!

These people were known as Sappers. If they got it right and didn't blow themselves up first, they would blow up the ramparts (the castle walls) and then the invading army could stream into the castle and steal your gold.

Naturally castle builders built up a defence against this and this was called a concentric castle. A concentric castle is like a castle within a castle with two sets of walls.

Now you can charge two insurance premiums. The highest premium would be to insure gold stored within the outer ward because it is more dangerous and the lower premium would be for gold stored in the inner ward as it’s safer.

To relate this to CDOs we can just change the terminology. The field around the castle is called the equity zone, this is the most dangerous region as there's no castle wall protecting it.

The area within the outer wall is called a mezzanine zone and the area in the middle is called the senior zone.

Now where would you attack this castle? You can probably see the design flaw in the diagram below. The arrows are where the walls are very close together, so if a sapper breaches the wall at that point they could breach both walls at the same time.

To stop the correlation of the walls falling together you would move the inner wall away from the outer wall and in that way the sappers couldn't blow up both walls at once and that's why correlation is key to pricing a CDO.

When correlation is high then all of the tranches could default at the same time. The pricing of all three tranches converges on to the same expected loss but if the correlation is lower there is a divergence between the equity tranche which is the most risky and the senior tranche which is the safest. 

To be able to price a CDO you do need to do some fairly hardcore maths or at least Monte Carlo simulation to price it accurately.

This is a far cry from an ETF where the price is just the weighted average of the prices of the stocks.

What is the impact of leverage on an investment?

Another huge difference between CDOs and ETFs is leverage. 

Leverage basically means investing borrowed money. This has the effect of increasing your profits in good times but it also has the effect of increasing your losses in bad times. In other words it amplifies your risk and your return.

In the Financial Crisis Inquiry report, which went through the reasons for the financial crisis, it outlined how leverage and CDOs go hand-in-hand.  

The CDO’s introduced leverage at every level. Firstly a mortgage for a home loan is itself leveraged,  particularly if you make a low down payment because most of your investment will be borrowed money. Next the mortgage-backed security which packaged up those home loans adds more leverage. Then in addition the CDOs into which they were placed produce further leverage because they are financed with debt.

This is even more complex with synthetic CDOs, which instead of containing bonds contained credit default swaps which amplified the leverage further.

The vast majority of ETFs we look at tend to move up and down one for one with the index that they track. That is why ETFs are sometimes called "delta one" products, they have this one-to-one movement with the underlying index. This is shown below in the left hand graph where the index value on the x-axis is plotted against the value of the ETF.

In leveraged assets like a CDO,  if the underlying index increases the asset value will increase by more and in the case illustrated in the right hand graph below this is by almost twice as much.

Leverage is yet another reason why a CDO is very different and much riskier than an ETF.


Now let's move on to Burry's point about liquidity. In investment terms liquidity just means how long it takes to sell an asset to turn it into cash.

In the interview Burry says:

“The dirty secret of passive index funds - whether open-end, closed-end, or ETF - is the distribution of daily dollar value traded among the securities within the indexes they mimic.” 

However, this argument could also apply to any fund,  whether it's active or passive, as long as that fund is benchmarked against some kind of index.

One way to measure liquidity is to look at the difference between the buying and selling price and in the diagram below I've plotted this along the y-axis. A big spread along the top of the graph means that a stock is illiquid and a low spread at the bottom means that the stock is liquid.

On the x-axis I've plotted  the average daily turnover which is how much of the stock changed hands every day averaged over the last 25 days. You will see that large caps are on the right and small caps on the left, illustrating a really clear relationship between large caps having higher liquidity and small caps having lower liquidity. 

In the interview Burry went on to say

“In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those - 456 stocks - traded less than $1 million during the day.”

“Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different - the index contains the world’s largest stocks, but still, 266 stocks - over half - traded under $150 million today”

“That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

He is correct that if everyone tried to get out at the same time then there won't be room in the market,  but this is already a well known fact so that micro-cap stocks usually have huge bid offer spreads as they tend to be very illiquid.

If you look at the bid offer spreads in the morning they're typically worse than they are in the afternoon. This is shown in the data in the diagram below, from Brian Livingston, where there are two orders of magnitude difference in the bid offer spread between the smallest and the largest stocks on the US stock exchange.

ETFs have found a way around this which is called sampling. Instead of buying all of the stocks in the index in the same weight as the index, you only buy a subset of them. You then adjust the weights and through clever mathematical calculations you continue to track the index as closely as possible.

The stocks you miss out are the ones which are least liquid and that would typically be the smallest stocks in the index.

For example if you're tracking emerging markets stock indices, which tend to be less liquid than developed market stocks, you are likely to use one of these sampling methods. You may also use it if you're tracking a huge index like MSCI World where it may not be practical to buy all of the stocks in the index. 

I've Illustrated sampling below with a really simple example. The blue line is the S&P 500 and the red line is a simple portfolio with just three of the biggest stocks in index and of course the approximation isn't very good.

I have used 30 stocks in the graph below and you can see that the approximation improves.

In practice you would use hundreds stocks if you're trying to replicate an index for a real ETF but this does illustrate that you can match the index very closely and you don't need all of the stocks in the index to do that.

An ETF which uses sampling is shown below. This is the iShares FTSE 250 tracker, where the index obviously has 250 stocks in it, but if we look at the number of holdings in the ETF there are only 237 and that's almost certainly because they will have avoided the smallest and least liquid stocks.

A CDO is not an exchange traded security so it can only be traded over the counter. This means if you wanted to buy or sell one you would have to contact a counterparty and trade with them directly.

The way you buy and sell ETFs and CDOs is a bit like the difference between buying a bespoke suit from tailor and buying one off the rack from a high street shop. The high street shop bought suit (ETF) is not tailored exactly to your shape but it is a lot cheaper and easier to buy and sell.

We have seen that in terms of pricing, leverage and also the liquidity, of not just the asset itself but also its constituents, you really can't compare ETFs with synthetic CDOs.

Orphaned small cap value opportunity

In the interview Burry makes and interesting point about orphaned small cap value.

“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally.”

It’s ironic that there are now many ETFs which are designed to harvest this small cap value risk premium. Strictly speaking these are not passive funds they are active funds but they are still wrapped up inside an ETF. The key thing is that they have forced down the fee that you would have to pay to get exposure to this type of factor. You won't have to do the single stock screen yourself you can get the ETF to do it for you.

While in the UK we don't have many of these  small cap value ETFs, Vanguard has created a global liquidity factor ETF and again this is designed to harvest that liquidity premium for less frequently traded shares and those tend to be the small caps.

Can we compare subprime CDOs and ETFs? Probably not, but Burry’s  point about value and about small caps is a very interesting one. There is a risk premium which is out there ready to be harvested but they are also very cheap ETFs which can harvest it for you.

If you would like to learn about the Bond Bubble then follow the link to our blog Bond Bubble Explained

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November 4, 2019