The advent of machine learning and cheaper computing power have given rise to a new way to manage your wealth known as robo advisors. Fintech has enabled computer algorithms to do the same job as a human money managers but more cheaply, so here we dig into the question of exactly how cheap robo advisors are and this should help you compare their offerings.
In theory, robo advisors combine the potential to earn above-market returns often promised, but seldom delivered, by traditional active funds while maintaining the low cost of passive funds. The main features of these funds are their transparency, the use of visually pleasing apps to track investment returns on a daily basis and a low investment threshold. Robo investment has gained huge popularity in the US but is only starting to get a foothold in the UK.
Before we look at the robos we need to understand what these companies do and how they fit in the wealth management ecosystem. You need to know four words: advisor, fund, discretionary and advisory.
Here we review the main features and pricing details of the major robo investors. When we talk about a percentage fee it is measured as an annual percentage charge on the amount you invest. For example if you invest £10,000 and the fee is 1% then each year you will be charged £100.
Robo Fund Name
Robo Fund Name
These charges were last updated on March 2020.
Cost is not the only factor to consider. The actual services provided by each robo investor differ widely and it's worth digging deeper into their websites to get a feel for the company ethos as well as their approach to investing before you commit any capital. For example some provide an app for your phone so that you can monitor your investments on the go. Some have a minimum investment, but others allow you to invest as little as £1.
For a more general comparison of active vs. passive vs. robo funds see our article comparing the three here. To get more in-depth insight into robo advisers by hearing the views of the people who build and run two of the largest take a look at the following:
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If you decide you do want to use a financial adviser it really pays to do your research and make sure you fully understand how much financial advise costs before you commit.
In addition to paying ongoing adviser fees there are plenty of other costs that may not always be obvious.
For example If you have £500k to invest, a financial adviser could easily charge you 2% (£10,000) to set-up your investment and 1% (£5,000) as an ongoing yearly charge.
In addition to this you may also have to pay exit fees, platform costs, performance bonuses and product fees. Which means, when you add these all together, you could be giving away a large amount of your hard earned cash just for the privilege of investing.
So before you make any decisions ensure you are happy that your investment can absorb all these costs and hopefully still go on to beat inflation.
Of course you don’t have to use a financial adviser unless you are looking at transferring a £30k+ defined benefit or defined contribution benefit pension with a guarantee about what you’ll be paid when you retire.
PensionCraft is here to give you the skills, knowledge and tools to control your own investments. So if you decide against going the financial adviser route, want to understand the advice you've been given or just want to learn more about investing then please join our supportive community of like minded investors for as little as £3.83*+VAT ($5) per month (Become a PensionCraft member)
Before starting out you need to decide what kind of financial advice you want and understand the pros and cons of each option.
A quick Google and you can find plenty of sites you can use to search for a financial adviser but the one I liked the most was VouchedFor*.
Not only did I find this site easy to browse, but I also liked the verification and customer review aspects of it.
VouchedFor* are currently offering a free pension check and you can find this by clicking on the affiliate link above.
Financial advisers charge in a number of different ways, so it's critical you understand how much you will be charged and exactly what you can expect to receive before committing to anything.
Some financial advisers even charge an exit fee which can come as a nasty surprise if you decide you are not happy and want to leave.
I find it fascinating that in the UK we are not as cost sensitive when it comes to financial products and services as they are in other countries.
In the PensionCraft interview with Mark Polson of The Lang Cat he describes how it seems that in the UK the most expensive things are often the best supported and uses the wealth management company St James Place as an example. You can find our blog of this Interview in full here (Vanguard SIPP Preview)
Advisers often offer a free initial consultation which is an opportunity for you to ask questions, find out what they are offering, how much it costs and see if you think you would be happy working with them.
The different methods of charging are listed below but they could use a combination of any of these which also adds to the confusion.
Advisers can also benefit from Indirect charging, which means they receive commission for recommending their clients use specific products.
Independent Financial Advisers can’t get commission for recommending specific investments, products that provide income in retirement or pensions, but they can for products such as mortgages and insurance.
For services like tax advice some financial advisers may also charge a percentage of the amount they save you.
Financial Advisers are legally obliged to be transparent about what they charge and this is described on the FCA website as follows:
“Advisers need to disclose all costs and charges that relate to their retail recommendations. Indications of expected (ex ante) costs and charges need to be provided pre-sale, and details of the actual costs and charges need to be provided post-sale (ex post), where applicable on at least an annual basis. These need to be aggregated, and expressed both as a cash amount and as a percentage.
In broad terms, therefore, the following must be disclosed: all one-off and ongoing charges, and transaction costs, associated with the financial instrument; all one-off and ongoing charges, and transaction costs, associated with the investment service; all third party payments received, and the total combined costs of these three categories. These disclosures must also be accompanied by an illustration that shows the cumulative effect of the overall costs and charges on the return.”
Although it is a legal requirement for financial advisers to adhere to these standards, in the 2019 review by the FCA they found that whilst there had been some improvement in the market, they were still identifying numerous problems.
A number of online resources already estimate the average prices they think people pay for financial advice.
I believe these could be misleading as the estimated prices tend to vary widely and having a price to aim for leads people down the path to think if they find someone charging the price quoted then they are not overpaying.
Given the service you will receive may differ so much and that there may be charges in addition to the average price quoted, I believe the best way to approach finding a good value financial adviser is to carefully shop around and negotiate on price when you find one.
According to the consumer group Which? The cost of financial advice can vary by as much as 1,000%.
According to the report published in The Sunday Times the costs quoted for someone with £100,000 in savings, a £150,000 pension pot and a £100,000 investment ISA to draw a retirement income ranged from £5,000 for the most expensive to £500 for the cheapest.
What is crucial here is to understand exactly how much time you will need to pay for. If you imagine one financial adviser charges £100 per hour but charges you for three hours work and the other charges £200 per hour but it only takes one hour….
So before you commit to anything make sure you are clear what you want and get as much clarity as possible from the financial adviser about how long they think it may take. Also make sure that when you do receive the bill they give you a thorough breakdown of how they have spent their time.
This is still the most frequently used method of charging which means the more money you invest the more you pay.
Some advisers do charge a lower percentage for investors with larger amounts, but you could find if you are a smaller investor that financial advisers may not be willing to take you on.
There are firms out there that charge a fixed fee for ongoing advice rather than a percentage of your investments but these tend to be tiered depending on how much you have invested and/or the level of service you get.
I have seen prices vary greatly from five hundred to many thousands of pounds per year. Potentially investors with a large amount in investments have the most to gain from this kind of charging but again the devil is in the detail so check it out carefully.
The average amounts quoted as set fees for specific pieces of work also vary and are very dependent on your own personal circumstances as well as the financial adviser you choose. Therefore it is difficult to get a benchmark but you could look at the estimated percentage fees quoted and see how they translate.
It's difficult to draw any meaningful conclusions from the information out there as an individual's requirements can vary so greatly. If you are in doubt about whether you are getting value for money or not then ask the financial adviser to go through exactly what they are going to do for you and how much time it will take them.
Employers can pay for financial advice for their employees without paying income tax. The current threshold for this is £500.
If it’s pension advice you are after then the Pensions Advice Allowance means that you may be able to take £500 once a year and up to 3 times in total from your pension pot tax free to pay towards the cost of financial advice.
There are some free services that can provide you with information and allow you to talk through your options but these provide information and guidance not advice. Some of these are:
Also it goes without saying shopping around can save you money but also when you do find someone you want to work with do try and negotiate the fee as you might find you can save even more money this way.
*Links marked with * are affiliate links and we may receive a small payment if you choose to use them. Affiliate links help to support PensionCraft to produce free content, but they do not influence our views regarding the services and products we talk about. Remaining impartial is of the utmost importance to us and we will continue to include links to any resources we think you may find useful.
**Correct at January 2020
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The global economic outlook for 2020 is one of slowing growth. In this blog we look at the central case for the global economy in 2020 and also at some of the most significant tail risks.
I believe these central case forecasts are useful, not because I believe in the precise numbers, but more because it provides us with a gist for what's going to happen in the year ahead.
Tail risks are lower probability events, however if they were to happen they could potentially have a very large impact on your investments.
This forecast was published in October 2019 IMF World Economic Outlook
What's noticeable from their figures below is that for advanced economies there's a marked deceleration of growth in 2019 and 2020 but in emerging markets there is a bounce back from 3.9% to 4.6% growth in 2020.
The IMF explains this as follows:
“The global economy is in a synchronized slowdown, with growth for 2019 downgraded again—to 3 percent—its slowest pace since the global financial crisis. This is a serious climbdown from 3.8 percent in 2017, when the world was in a synchronized upswing. This subdued growth is a consequence of rising trade barriers; elevated uncertainty surrounding trade and geopolitics; idiosyncratic factors causing macroeconomic strain in several emerging market economies; and structural factors, such as low productivity growth and aging demographics in advanced economies.”
The World Bank Economic Outlook published in June 2019 is slightly different in terms of specific numbers to the IMF, but the general trend is the same.
They show global growth as falling to 2.6% in 2019 and only rising slightly to 2.7% in 2020 and 2.8% in 2021.
They also see the same upswing in emerging markets as the IMF; 4% in 2019 and 4.6% in 2020 and 2021.
In the graph below you can certainly see the slowdown in manufacturing since the beginning of 2018 and also that business confidence has been eroded.
The World Bank states in their report:
“Global growth in 2019 has been downgraded to 2.6% reflecting weaker-than-expected international trade and investment at the start of the year. Growth is projected to gradually rise to 2.8% by 2021, predicated on continued benign global financing conditions, as well as a modest recovery in emerging market and developing economies (EMDEs) previously affected by financial market pressure. However, EMDE growth remains constrained by subdued investment, which is dampening prospects and impeding progress toward achieving development goals. Risks are also firmly on the downside, in part reflecting the possibility of destabilizing policy developments, including a further escalation of trade tensions between major economies; renewed financial turmoil in EMDEs; and sharper-than-expected slowdowns in major economies.”
So far in this blog we have covered what you can think of as the central case. The central case is what forecasters say will happen if nothing catastrophic goes wrong.
However it's always worth thinking about the tail risks. These are lower probability outcomes that are worthwhile considering because they could have a significant impact on your investments if they do occur.
If you would like to talk to me one-to-one about how any of this may impact your investment or ask me any other questions, then you can do this by signing up on our website for a Power Hour with Ramin
The US Central Bank’s (Fed's) tail risks are taken from the US Federal Reserve's Financial Stability Report, which was published in November 2019.
One job of the Central Bank is to maintain stability of the financial system. In this document rather than ignore the vulnerabilities the Fed goes into them in great detail and tries to quantify those risks.
The table below from the report is interesting as it shows the size of each of the US markets.
The US residential real estate market is about $37 trillion and has been growing pretty much in line with its growth since 1997.
The US equity market is about $36 trillion and has been slowing down relative to its growth since 1997.
One of the problematic markets is leveraged loans. Leveraged loans are only a $1 trillion market but what really catches the eye is that its growth is phenomenally fast at 15%. Although that's in line with its long term growth, it's well above GDP growth, so at some point growth the leveraged loan market is going to become unsustainable and inevitably the market will suffer a large correction.
The Fed’s analysis is broken down into four sections.
The first one below is "Asset Valuations", which tries to gauge how expensive a particular market is.
It cites three markets which look expensive; corporate debt, commercial real estate and farmland.
If you look at the spread, which is the additional income you receive to take US corporate bond risk, these have been fairly small and falling through 2019. This is despite the fact that leverage has been increasing, which should certainly be a cause for concern.
The next section is "Leverage (borrowing) by businesses and households". The pattern here is that businesses have become more leveraged whereas household leverage isn't as extreme.
Business leverage is now historically high relative to gross domestic product (GDP) and the parts of the debt market which have been growing most rapidly are for the riskiest firms.
The report also says that household borrowing remains at a modest level relative to income.
You can see this in the top graph (below), where the darker line is non-financial business borrowing as a proportion of gross domestic product. This has been gradually creeping up, then falling every time there's a recession and now it is at a level which is above where it was just before the global financial crisis.
You can also see from this graph that household borrowing relative to GDP has fallen.
In the bottom graph you can see the leveraged loan market. The top shaded bar shows you how much of the debt multiples are above six times (these are the most leveraged companies) and you can see that is has been gradually increasing since 2016.
The third section of the report is "Leverage in the Financial sector".
The Fed has made very sure that US banks have been strongly capitalised because they don't want to repeat what happened in 2009. Life insurance companies also haven't taken on too much leverage but hedge fund leverage is elevated relative to the past five years.
If you've watched the Big Short you'll know what CDOs are and the issuance of this and other securitised products fell off a cliff in 2008.
Now a lot of companies get their money through the door via leveraged loans. These are packaged up inside a collateralised loan obligation or CLO. Both the Fed and other central banks have cited leveraged loans as being problematic.
If you want to find out more about how CDOs and CLOs are packaged then take a look out my blog Michael Burry - An Index Bubble? where I give you a detailed explanation.
The fourth area of the report is "Funding Risk".
One of the jobs of the Fed is to stop runs on banks. Funding risk is important so the Fed wants to ensure that banks don't have too many assets which they can't shift in the event of a run. They have got to have enough liquid assets to be able to pay back their customers' money.
The wholesale funding market which dried up in 2008 and 2009, is used much less now than it was just before the crisis. The Fed has done its job which is to ensure that the ratio of high-quality liquid (easy to sell) assets make up a large part of the balance sheets of banks.
However mutual funds, which in the UK we call an open-ended investment company (OEICs), are holding a great amount of high-yield debt. These are the riskiest bonds and that's largely as a result of yields being so low. This is a problem because if there is a downturn in the high-yield market those mutual funds may not be able to sell their high-yield bonds quickly enough to meet the redemptions of their clients. This may lead to funds being gated as we saw for Woodford in the UK.
You can find out more about what went wrong with Woodford by watching my video Woodford - What Happened & What Can We Learn
The holdings of US corporate bonds has reached $1.5 trillion (that's well above where it was before the global financial crisis) and the lowest credit quality bonds (high-yield bonds) and bank loans make up a large proportion of those mutual fund assets.
The Fed conducted a market outreach program where they asked several banks and fund managers what they consider to be the biggest risks. Trade frictions rated first with global monetary policy efficacy second. The question with monetary policy efficacy is whether low interest rates and quantitative easing will actually help the global economy.
Liquidity is also a concern e.g. how easy it is to sell assets in the event of a downturn.
Iran, further down the list, would probably score more highly now given recent news.
The least worrying factors were a passive investing bubble, politics and household debt.
In the report the Fed also went on to cite the following tail risks:
If the US economy were to slow unexpectedly...
In the Bank of England Financial Stability Report – December 2019 they have a useful heat map (below). This breaks down the data into households and companies and it ranges from just before the global financial crisis in 2007 to the latest data.
The region which comes up red for household data is China, where the debt to GDP for households is at elevated levels.
In the corporate space the United States has a very high debt to GDP ratio. Those worries are focused in the leveraged lending space which are the leveraged loans which I talked about earlier.
Just as it is in the household space, China's is flagged as red in the corporate lending space.
A large amount of lending in China is by non-banking entities (the shadow banking sector) the size of which can be quantified with the total social financing number in the graph below.
You can see from the graph that China has been trying to reduce the rate of growth of total social financing very gently to avoid popping their credit bubble.
However, The Bank of England still has concerns about the Chinese credit bubble popping. This is because of the strong linkages to the UK financial system where UK banks have a large exposure to mainland China.
Drilling into the corporate debt story, the Bank of England flagged the US as having a very high corporate debt to GDP ratio. They also flagged France as reaching its historical highs on that measure despite French authorities trying to address this problem.
Again we see that one of the worries for the Bank of England is US leveraged loans, where credit quality is deteriorating with over half of the leveraged loans issued in 2019 having very high debt to EBITDA.
EBITDA is the amount of debt a company has relative to its earnings before interest tax depreciation and amortisation and when it's above six then it's time to worry.
It is however reassuring to see that Italy's corporate indebtedness continues to fall.
Household and corporate credit growth isn't too bad in the euro area but the amount of sovereign debt in some countries, particularly Italy, is still an issue.
The sovereign debt crisis that we saw in Europe in 2012 has still not truly been resolved and there are still strong linkages between banks and sovereigns. If there was a sell-off in Italian government bonds it could severely impact Italian banks who hold a lot of that sovereign debt.
The ECB's has been very careful to make sure that the balance sheets of European banks now have more loss-absorbing capital than they did just before the financial crisis. The CET1 ratios (core equity tier 1, which is the regulator's core measure of a bank's financial strength) have now improved but this is partly due to a financing fiddle where the banks risk weights are being adjusted on their assets.
The European Central Bank (ECB) have outdone themselves with some impressive flowcharts in their Financial Stability Review, published in November 2019.
In the illustration below they point out that there is a very low yield environment in Europe. Given the weak growth that we're seeing in Europe, that creates a worry about debt sustainability and in particular the amount of BBB debt (the lowest rating for investment grade debt). In other words there's a huge amount of debt which is just one credit rating notch away from being downgraded to junk.
Banks are also less profitable. Ironically that's largely because they can take less leverage due to regulation by the central bank. Three-quarters of euro area banks have a return on equity of below 8% and that's far below what it was when they could take more leverage before the financial crisis.
In this low-yield environment there's been a reach for yield. That means that investors have had to take greater risk either by buying lower quality credit or taking more duration risk to get the yield they want. Some of these high-yield assets are very illiquid, which means that if there's a crisis the asset managers may not be able to sell the assets quickly.
Given the weak GDP growth in the euro area, that doesn't sit well with companies increasing the leverage on their balance sheet.
Because of low interest rates house prices in many of the euro area countries are rising rapidly. Valuations are contingent on there being very low interest rates. As a consequence if interest rates do increase then this asset miss-pricing could cause a rapid correction. That correction will apply to the equity market which has benefited from low interest rates but also to gold and other safe-haven assets such as government bonds.
Negative yields have been a real problem for banks in the euro area and that has reduced their interest margin, which is the difference between the rate at which they lend and at which they borrow. The ECB thinks that return on equity could fall further in 2020.
Insurers still have fairly liquid assets but investment funds have been forced to buy the illiquid high yielding assets which could cause problems in the event of a market turnaround. Also almost three-quarters of insurance and pension funds bond holdings now yield less than 1% in the euro zone.
Finally let's look at the International Monetary Fund’s (IMF) Global Financial Stability Report, published in October 2019.
Below, In the top left graph you can see that the effect of US tariffs on global markets are very marked. Each round of tariffs reduced world equity prices, particularly in those sectors exposed to trade and technology tensions. This means that every time there has been a new round of tariffs you can see equity markets sell off. Whilst in contrast you can see that markets rally when the Fed has made speeches as monetary policy applies a band aid to the global economy.
Below, in the top middle graph you can see the credit markets were also affected by tariffs but probably to a smaller extent. Whilst in the graph to the right, you can see volatility which in the United States is measured by the VIX index, some people call it the fear index and this was also affected by the tariff announcements.
In the bottom left graph you can see the round trip of Fed monetary policy. They started hiking rates in 2017, it plateaued for a while in 2019 and now they have reversed course and have started cutting. Market expectations are that the other central banks will follow suit; in Canada, the UK and even for central banks where rates are currently negative.
In the bottom centre graph you can see the trend has been a steady fall in yields since October 2018 in advanced economy government bonds.
In the bottom right graph you can see that negative yielding advanced economy government bonds now make up a large proportion of the total amount of bond outstanding, but the market expectation is that that will fall over time.
Although it's not such a large market, leveraged lending in Europe has also grown rapidly. At the same time the credit quality, which is called a covenant protection, has generally weakened. These are called covenant light loans and the percentage of new issuance of these has grown dramatically.
There has been a huge rise in non-bank lending in the United States since 2012. With a larger percentage of those loans having very high leverage and greater risk of bankruptcy.
Markets have been largely driven by the China US trade war. Whenever there have been signs of progress in the US China trade deal negotiations equity markets have rallied and bonds have sold off, but when there has been a deterioration in the relationship we have seen the opposite occur.
It looks like we're going to get a signing of the Phase One trade deal on 15th of January. Although that's promising it may open up a new front in the trade war with Europe.
Trump's decision to kill Qasem Soleimani could also have a very large impact depending on how Iran chooses to retaliate. A war in the Middle East certainly has the prospect of destabilising global financial markets depending on what the form of retaliation is and how the dispute escalates.
One source of dispute has been how much US tech giants pay in tax in Europe. The US has threatened trade tariffs in retaliation for those decisions in Europe and this has the prospect of triggering a new front in the trade war.
A more long-term worry is the effect of climate change on investment. The bushfire emergency in Australia is one example of this and what’s interesting is that now even central banks are also starting to talk about climate change.
The economic impacts of climate are very real. For example below is a lady who works in a museum who simply couldn't work because even inside the museum she was still affected by the smoke. It's hard to expect people to be productive if they can't breathe.
So while this isn't an immediate threat to investment, it's certainly something to consider as a longer-term risk.
In conclusion, the trend for the 2020 the economic forecasts seem to be one of slowing global growth.
The biggest red light at the moment in respect to tail risks seems to be too much borrowing in the US leveraged loan market, with too much triple B debt. In China there's the credit bubble which also has us worried but never quite seems to materialise.
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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We finally have details on the Vanguard SIPP which will launch early 2020. It has been a long time coming, but if it launches on time, and Vanguard says it's very confident that it will, it will set a new standard for low-cost self-invested pensions with few hidden costs, a low platform fee and simplicity.
In this blog we look into the Vanguard SIPP in detail and interview Andrew Marker, Head of Retail Pensions from Vanguard UK and Mark Polson of The Lang Cat to hear what they have to say about the new offering.
A SIPP is a Self Invested Personal Pension and if you want to learn more about these and how they are different from ISAs then there is a video all about this in my UK Investment for Beginners playlist (here)
For the purpose of this blog I will explain the key points you need to understand about a SIPP.
Below is an illustration with a lifeline starting at age zero when you're born, going up to the age of 86, which is the average UK life expectancy.
Your pension tends to come in two phases. The first phase is when you start work you're going to start accumulating a pension and the size of that pension pot grows as you get older.
The second phase of your pension is called drawdown. At age 55 you can take out a lump sum in your pension but as you take money out of your pension the size of the capital reduces. Ideally the money won't run out before you die.
The money is locked up in a pension until you're 55 and then at 55 it's released so that you can take money out.
Below is the announcement from Vanguard and the most important thing is that the fee is 0.15%.
There is also a really important footnote that states that it's capped at £375 and that applies across all your holdings on Vanguard. That includes your SIPP, ISA and general account, but it doesn't include the Junior ISA for your children.
As with the Vanguard ISA, you can only invest in Vanguard funds. For me that's not a problem because I tend to stick to fairly standard funds but if you want something more esoteric then this might not be for you.
The minimum investment amount is very small, so you can either pay a lump sum of £500 or you can put in £100 pounds a month.
The announcement also includes a release date which is early 2020 but that only applies to investors who are accumulating their pensions. If you are in the drawdown phase then the product for you will become available in the 2020/2021 tax year.
You can see below that with Vanguard not only is the fee very low but you also don't pay at all for transactions when you buy and sell products.
The only time you do have to pay is when you use the quote and deal service for ETFs and you can see more details about that in my blog on how to open a Vanguard account
The illustration also lists all the things you don't have to pay for. There is no wrapper charge, no setup charge, no exit fee, no transfer fee into the fund and you don't have to pay for valuation statements.
Additionally you don’t have to pay for a lot of life events such as what happens when you die or get divorced. This really throws down the gauntlet for other platforms which do charge you for these niggly little things.
What I've shown below is the fee you pay in pounds versus the amount you've got invested with Vanguard.
You can see from the diagram that if you invest a very small amount you pay a very small fee, but they've capped the fee at £375 per year. This means if you invest £250k or more then you'll hit that cap and you won't have to pay any more in fees.
As a percentage of the amount you invest per year the fee is 0.5% but when the cap kicks in you're paying less and less as a percentage as the amount your investment increases.
Based on the latest data from HMRC, illustrated below, that wasn't much of an issue for most people because the average size of an ISA was between £25k and £30k.
So for that average investor, whose fee will be around £37.50 a year, the cap was never very helpful. But now that the amount invested includes both the SIPP and the ISA, I suspect more people are going to be interested in this cap because as you get to later life you will have more money invested.
If you want to find out more about Vanguard's products I've written a Review of Vanguard's LifeStrategy Funds
There's a great company in Scotland called The Lang Cat and they provide beautiful guides such as the one below published in 2018.
This heat map illustrates the fee you pay based on the amount of money you invest in Self Invested Personal Pensions in the UK.
It lists the SIPP provider on the left-hand side and the amount you invest is along the top. Green means the fee is fairly low and red means it's fairly expensive for the amount invested.
Notice how if you invest more money the platforms which charge a fixed fee in pounds become the cheapest. If you invest a million pounds, the Halifax fixed fee for their SIPP amounts to just 0.02% of the amount invested per year, whereas a company which charges a percentage fee becomes much more expensive.
Now let's look at where Vanguard will be cheaper than these platforms.
If you invest less than £100k Vanguard is cheaper than all of these platforms. If you invest more than £250K Vanguard in many cases is still cheaper, It is just the fixed fee platforms where Vanguard doesn't compete.
If you have an independent financial adviser they often have their own platforms onto which they put your money. The Lang Cat also reviews these independent financial adviser platforms in the form of heat maps.
If we block out where Vanguard is cheaper this will be the case for most people, certainly if you invest less than £150k and often if you invest more than £250k.
It's no accident that Vanguard uses Nelson's flagship as its logo as, make no mistake, this is war and it's a war that's good for you and me! it's a price war that will make platforms more competitive in the future.
In fact looking at those heat maps reminds me of the game Battleship. With this announcement I expect Vanguard will ultimately sink many of its competitors. But of course it will depend on the quality of service which Vanguard provides, as a platform is not just about cost.
Mark Paulson is the head honcho over at The Lang Cat and this is what he had to say about the Vanguard SIPP announcement.
Mark, Lang Cat; "The Vanguard SIPP is definitely sharply priced but I think we're in danger of saying it is the cheapest in all possible circumstances absolutely everywhere and that isn't necessarily true. But, do you know what? It is extremely well priced and it's going to cause some furrowed brows around lots of different places.
A couple of things to bear in mind, first of all it's taken Vanguard a jolly long time to come out with this. I think I remember hearing from them how great their SIPP would be about two or three years ago. I was very much looking forward to it very much, but it is a good thing that I wasn't waiting for it before I had my lunch because I'd be pretty hungry right now!
So we hope it's worth the wait and that’s an important point. Because what the UK financial services landscape tells us, particularly for direct investors, is that price generally is a really bad determinant of flow and success.
The cheapest things are often not the best supported things. Very often the most expensive things are by far and away the most supported things.
It is like a market in reverse. People go to St James's Place on the advice side and Hargreaves Lansdown on the platform side if you're a direct investor.
These are, I'm going to be friendly and say "premium" propositions, I believe premium is a word that people use when they mean that things cost a lot.
The reason I think that people go with those providers is because they perceive that there is going to be great service. They may feel that they are with a reliable name that’s been trusted and tried by their their friends and colleagues and it feels like a low risk option.
Vanguard is a huge name, but not necessarily that well known by the British investor at the moment. Those of us in the industry feel completely fine with Vanguard, of course we do, I think it's got the GDP of a large country under administration but it doesn't necessarily follow that something cheap will be well supported so we'll have to wait and see."
Ramin, PensionCraft; "Why has Vanguard introduced this product to the market?"
Andrew, Vanguard; "Vanguard was looking to really help investors that's one of our key things. We acknowledge that pensions are probably one of the largest savings vehicles that people have in the UK, so we wanted to introduce a pension that will be delivering a low cost simple SIPP that will help investors reach their retirement goals."
Ramin, PensionCraft; "Why have Vanguard split the Vanguard SIPP product into two launch dates, one for accumulation and one for drawdown?"
Andrew, Vanguard; "There are two reasons. Looking at our current client base we think the majority of our investors at the moment are building up their pensions. It is growing into the decumulation space but there are a lot more savers out there and we wanted to ensure that we delivered a low cost simple SIPP to help those saving investors.
We have also acknowledged that we are getting closer to the tax year when this launch is happening. There will be customers who will be trying to transfer into drawdown to try and access their taxable income towards the end of the tax year. We didn't want to put those customers at risk of not achieving this, as transfers can take some time in the market.
Another reason for splitting the decumulation date was that we were cognisant of the fact that investment pathways are coming along at the moment. We really wanted to get our drawdown solution to work with them, so we decided to put that into the new tax year rather than in this current tax year."
Ramin, PensionCraft; "There's been a lot of frustration amongst my clients, the PensionCrafters, who were very desperate to get on to a SIPP provided by Vanguard and their low fees. Why has it taken so long and why were there so many delays?"
Andrew, Vanguard; "Yes it has taken longer than we would have liked. What we are trying to do at Vanguard is really look at how we simplify pensions. We understand pensions are very complex, we know our customers find buying pensions very complex, so it's taken a bit longer for us to try and simplify that. That simplification has been one of our key goals; How do we simplify the online journey, because it is a fully online pension. It is not just targeting sophisticated investors but it's actually targeting all investors who might not be as sophisticated.
The other really key thing that we focus on at Vanguard is making sure it's right for customers. We have spent a lot of time testing to ensure that it is 100% right for customers and we're getting very close to that now."
Ramin, PensionCraft; "Are you fairly confident that you will hit the deadlines this time? The beginning of next year for the accumulation product is a fairly loose deadline"
Andrew, Vanguard; "We are fairly confident. We are in the very final stages of the test execution at the moment and it is looking very good from our point of view. So yes we're very confident!
We wouldn't have released it out to our clients and tell them about it if we weren't confident."
Ramin, PensionCraft; "I've been with Vanguard for a while now and one of the things I like about the Vanguard platform is the service. There is always a very quick reply to my questions. How does that work?
I've heard that the senior managers also man the phones just to get a feel for what's going on on the ground. Is that true?"
Andrew, Vanguard; "Yes absolutely, service is key to us at Vanguard. Everything is about delivering for our clients, that's effectively what we live for.
What we've done for pensions is we have added additional experienced pensions people on the phones to help with those calls.
We really have acknowledged that people are going to call in and ask more questions about pensions because they're complicated, even though we've tried to simplify it. So we have put more people on the phones in order to be able to answer questions in a quick time frame.
Yes we do have senior managers sit on the phones on regular occasions and speak to clients. You have to listen to the clients and speak to them one to one to understand what’s going on."
The final point, which is made by Mark Polson from the Lang Cat, is an interesting one.
It relates to the mechanisms that independent financial advisers have on their own platforms which allows their clients to pay their fee straight off the platform. This is not in place for Vanguard, so a client would have to pay them separately which may be an incentive for advisors not to put you onto the cheaper platform.
So here is Mark describing it in his own words.
Mark, The Lang Cat; "This is about which tail wags which dog!
If an adviser is going to recommend something like Vanguard LifeStrategy or a Vanguard Target Retirement fund then why wouldn't they use the Vanguard platform? The answer is that at the moment the Vanguard platform at the moment isn't really set up for advisers, and specifically it can't pay adviser fees from the clients’s pot.
You have the chance here to get your Vanguard LifeStrategy fund held in a structure which might charge half or less than where you are at the moment. Now that's pretty compelling; like for like but half the price!
Assuming that the Vanguard pension works well and assuming that when it gets drawdown then that works well (and there's no reason to think it won't), then I think advisers are going to have to have a really good think about how they present this to clients.
Just imagine ...”You can choose this one Mr Client, where you can pay me through the pension and you don't need to worry. Or you can choose this one Mr Client, where you have to write me a cheque (pay me an explicit fee) but we cut your custody fees in half. Which would you rather do?”
Vanguard have given us all kinds of things to think about so it's a great development. Lots of fun and lots of trouble making, which we love to see.
I suspect Vanguard won't be the only story here. I've been watching the US very closely where now trading and custody is often free as long as you're using the funds from the provider. So the next step in this fight is free."
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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Investing for income is possible even in this environment of low interest rates. Income investing means that you have to take some risk with your capital to achieve these returns so it is important to understand the risks. In this blog we discuss current dividend yields and the risks involved.
The problem for income investors is low risk-free rates
Below is a graph from the Bank of England since its foundation in 1694. Notice how it spent centuries bouncing around a 5% rate but at the moment it has fallen to record lows.
One way to think of risk-free rates is as a foundation on which are layered all other rates.
Those other rates are like boats on a tidal river. When the risk-free rate falls as the tide goes out then so do the rates on those other investments.
At the moment the tide is pretty much completely out because those risk-free rates are very close to zero and in turn that's pushed down the other yields to very low levels.
In the graph below the blue line represents the US 10 year rate. You can see from this graph that the tide was going up to about 15% in the early 1980s but since then it has been steadily falling until it reached record lows recently.
Below in red is the yield for AA corporate bonds in the United States. This is a little bit above the US 10 year rate because you would be taking a credit risk and the extra yield compensates you for that risk.
Notice how when the risk for yield falls on the government bonds the yield on AA corporate bonds fall in line.
The same is true of junk bonds (below in green) they have the biggest spread to those risk-free rates but when the risk-free rates fall so do those of junk bonds.
As of October 2019, In the UK and in the US we don't have negative rates yet. At the 5 year point in the UK we are not too far away from it as it is below 0.5%.
In Japan rates have been negative for some time and more recently they've also become negative in the Euro zone, particularly for Germany, which has a very low credit risk.
In this blog I won't be talking about individual bonds, I will only be referring to bond funds.
If you would like a good explanation about any of the jargon I use in this blog or want to find out more about bonds in general, then please take a look at my course "How to Choose a Bond Fund" (here)
Below you can see how to work out what the dividend yield is for a fund.
The dividend yield is just the payments that you've received over the past twelve months divided by the price today.
This means if you want a higher income, you need the dividend payments to be as big as possible over a small price that you would pay for it today.
In the example below, if the income on your investment over the past twelve months was £5 and you paid £100 for that investment then the dividend yield would be 5%.
A very important question is how long will we continue to have very low rates?
This isn't fully understood but one factor is low productivity (e.g. how much each worker produces per hour).
Long-term rates are very much driven by both inflation and growth expectations. If growth expectations are lower (low productivity would tend to push expectations down), then it also pushes down interest rates.
Below you can see just how bad productivity has been in the UK since the global financial crisis. The trend from 1994 up to 2008 shows fairly steady growth of productivity but notice how after 2008 that rate of growth suddenly comes to a halt. If we had seen that upward trend continue we'd be well above where we are today in productivity terms.
This seems to be a structural change (e.g. a very long term change), so it's very unlikely that we'll see productivity growth shoot up in the near future.
There is a very good article from the IFS (Institute for Fiscal Studies) by Jonathan Cribbs and Paul Johnson.
It says that in the last decade we have seen record after record broken. These are not good records; low earnings growth, low interest rates and low productivity growth. There has also been record public borrowing alongside record cuts in public spending with economic growth remaining sluggish.
The demographics are not in our favour because the population is ageing quite rapidly and this points to continued low productivity, low growth and low yields. This productivity story isn't specific to the UK it is a global phenomenon
In this low yield environment the natural response from investors is to “reach for yield”. The reason for this is that there are fewer assets which generate high income and so those assets become extremely popular.
As all the good quality assets get bought up their yields go down. The outcome of this is that you then have to reach for ever more risky assets which is also sometimes called “dash for trash” or slightly less politely the “flight to s...”
It is not just retail investors, like you and me, which do that reach for yield, it's also institutional investors like pension funds, hedge funds and insurance companies.
The reasons why emerging market debt gives you such a high yield is because it's risky. Emerging market sovereigns do default on their debt and you don't have to look far in history to see examples.
In a low yield environment investors are quite willing to risk their capital in order to get their hands on that extra yield. You can see in the diagram below the movements of capital as investors buy emerging market debt.
The natural response of companies in emerging markets is to say fine there's a demand for my debt so I'll issue more particularly if that debt can be issued at a very low borrowing cost.
We saw that rise between 2000 and 2008 and then there was a dip during the global financial crisis. It then started again and there has been huge issuance in emerging markets of corporate bonds.
One of the risks of these reaches for yield is that we have a buildup of low quality debt. At some point there has to be a day of reckoning, so it pays to be cautious when you see this kind of behaviour.
Below we look at the set of funds which are issued by Vanguard we that has been sorted according to their dividend yield. This ranges from 1.1% at the bottom of the table up to 5.2% at the top for the highest dividend yield fund.
We should always bear in mind that the inflation target for the Bank of England is 2%, and at the moment we're not far away from it, so anything below that yield will be negative in real terms. Ideally we'd be looking to get a yield which is much higher than 2% and that restricts our choice of funds.
UK Equity Income at the top of the graph is a fund that specifically selects stocks which have a high dividend yield. What is interesting about this is that because the price of UK stocks hasn't been great that tends to flatten the dividend yield for UK stocks and that is why this one has the highest yield at the moment .
Vanguard's FTSE 100 tracker isn't far behind with a yield of 3.6%. Other high income funds tend to be sovereign bond funds from emerging markets, such as VEMT.
Regular readers will know that at the moment VEMT is part of my portfolio and I bought it for this very reason. You can read my "How I invested 20k - Q3 update" (here)
Pacific ex-Japan equity also tends to be very generous with its dividends. This is very much dominated by Australia and that has many mining stocks and financial companies which are typically high dividend payers.
Given the relatively high risk-free rates in the US, investment grade corporate bonds also give a fairly good yield of 3.4%
Then we have a couple of European equity funds; one tracking the EuroSTOXX 50 index and one that tracks the FTSE Developed Europe index
This all means that your choices at the moment are very much dominated by UK equity or Pacific ex-Japan equity which is mostly Australian equity and US corporate bonds and emerging market government bonds.
Another way of looking at that is in terms of the risk that you have to take.
Below on the x-axis we have the volatility of each of those funds, with high risk on the right and low risk on the left. On the y-axis we've got the income, with high income at the top of about 5% and low-income at the bottom at about 1%.
If we consider inflation is at 2% that rules out the very bottom of the graph because those funds would currently give us a negative real yield.
I've shown equity as triangles and you can see that equity dominates the right-hand side of the graph because equity tends to have a high risk and a high volatility. Bond funds I've shown as circles and you can see those are on the left of the graph because they tend to have lower volatility.
Ideally we'd be looking at low-risk high-yield funds in the top left corner but as you can see there aren't many of them. US dollar denominated emerging market government bonds are fairly good but they do come with quite a high volatility of almost 10%. US investment grade bonds have a much lower volatility but also a much lower return of about 3.2%.
The colours on the graph tell you the cost of the fund and I've split it into three groups. Blue have the lowest ongoing charges, green is intermediate charges and red is high charges.
Unfortunately many of the high-yield funds tend to also be red and that's partly because the underlying bonds are quite illiquid. In order to track an index the fund manager has to continually buy and sell the underlying bonds and that's more expensive when the underlying bonds are illiquid.
Below I have done a more general exercise with a list of exchange traded funds (ETFs). I have whittled down a universe of several thousand ETFs.
Using this filter I only look at Sterling denominated funds so they can be bought on the London Stock Exchange in sterling, I only consider large funds which have assets under management of over 800 million and I've created a yield cutoff so anything with the dividend yield of less than 3% doesn't appear on this list.
Below in more detail you can see the list is dominated by iShares funds and the yield goes up to about 5.6%.
The top choices in this list are:
Then, as before, further down we get some UK equity and finally some property funds from iShares.
If we repeat the plot with volatility on the x-axis and dividend yield on the y-axis what's interesting is that we finally have something in the top left hand corner!
This iShares high-yield sterling hedge fund doesn't take currency risk because it's sterling hedged but what you are taking here is a US junk bond credit risk. The volatility is low but the credit risk is high.
In the credit world volatility is not a particularly good measure of risk. Instead you need to watch out for is a widening of credit spreads and a deterioration in credit quality. If you can get access to the rate at which companies are being downgraded this tends to pick up when you get a credit sell-off.
PIMCO has an even lower risk fund which unfortunately comes with quite a high fee. It is sterling hedged (no currency risk), short term bonds (less duration risk) but you are taking a high credit risk.
There is also an emerging market sovereign bond fund which is sterling hedged, but the yield on this is a little bit lower at below 5%.
I've talked a lot about the risks so now we'll go into a bit more detail on some of those funds to see what kind of risks you're actually taking.
We can start with emerging market government bonds. Below is the iShares JPMorgan emerging market local government bond fund. It is dollar-denominated so you would be taking the dollar currency exposure versus sterling.
This fund is buying emerging market government bonds denominated in their own currency; this means that if it's a Brazilian bond it would be denominated in Brazilian Reals. It is good to see that this fund is quite diversified so there's not a huge exposure to a single country.
If we look at that geographic breakdown you can see that it's only 10% Brazil which is the biggest allocation. If there is an emerging market sell-off then at least you'll have some degree of diversification.
Generally when there is a risk-off move in the markets, as equity markets sell-off and investors get more cautious, emerging market currencies also tend to sell-off. This would create a double whammy for your fund because people would be pulling money out of the currency and the individual emerging market bonds.
If we look at the maturity then they tend to have fairly long durations. This would mean you are certainly taking some duration risk which results in making a loss if yields rise in emerging markets and a gain if yields fall.
Because this is an emerging market fund the credit ratings tend to be fairly low.
Anything below triple B is a junk bond and that's about a quarter of the allocation. There is also about one third of single A highly rated debt in the fund and that’s a fairly substantial proportion.
Another type of risk which you can take in order to get some dividend yield is developed market credit risk, which is developed market junk bonds.
Below is an example of an iShares dollar denominated high-yield corporate bond fund, which is sterling hedged so you're not taking the currency risk.
This fund gives you diversified exposure to sub-investment grade rated bonds, known as high-yield bonds or junk bonds. You also get some sectoral diversification through different groups of companies; industrials, utility companies and financial companies like banks.
Because the underlying bonds are quite illiquid the ongoing charges figure is quite high at 0.55% but if the yield is above 5% you're not so worried about the ongoing charge figure.
It is a dollar denominated bond fund so the US dominates the geographic exposure at 93%.
If we look at the credit quality breakdown of the fund versus the benchmark, you will see the fund is in blue the benchmark's in black. Anything that's below triple B would be considered a junk bond. Most of this fund is at the highest credit quality of junk which is BB, but there is one third of it at single B and some triple C
PIMCO also has a short term high-yield corporate bond fund so you do have this alternative to iShares
Below is another example but of a sterling hedged passive fund which is tracking this ICE Bank of America Merrill Lynch 0-5 five year US high-yield constrained index.
Property is another source of income but the yields aren't as high as they are for the emerging market bonds, junk bonds or for some of the equity funds.
Below we look at this example iShares Developed Markets Property Yield ETF. This is sterling hedged and it gives you exposure to developed market real estate companies.
It has a lower bound of forecast dividend yield of 2%. The fund buys listed real estate companies and real estate investment trusts (REITs) from developed countries excluding Greece which comply with this minimum 2% dividend yield criterion
The geographic breakdown is again dominated by the US at 57%. There however some global diversification with Japan at 9%, Hong Kong at 6%, Germany at 5% and UK's at 4%.
It is also reassuring that you get diversification across different sectors of real estate. For instance if you're worried about retail taking a plunge as Amazon comes to dominate the retail space then that only makes up 20% of the fund. There are also industrial and office REITs, development companies residential REITs and hotel REITs.
Finally we will look at an example of a UK equity fund.
Below is the iShares FTSE 100 tracker, it is in sterling and it distributes dividends as cash payments.
The capital gain on the FTSE 100 has been poor compared to other developed market equity markets.The benefit of this is that it pushes up the dividend yield to 4.7% as of 20th October 2019, but unfortunately the volatility is high because it is an equity fund.
Because it is a developed market equity fund the ongoing charges figure is a tiny 0.07% per year. With such a small fee this will be less of a drag on your long term returns.
You will have seen from this blog that "Yes" it is possible to get a reasonable dividend yield even in this low yield environment. You do however have to take some risks with your capital otherwise you're just not going to get those returns but please do remember to make sure you understand the risks before you take them.
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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
There are 3 main reasons for buying bond these are:
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.
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 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.
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.
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 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.
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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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?
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".
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.
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.
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.
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.
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?
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.
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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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.
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.
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.
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.
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.
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
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.
In this section we will look at the comparisons between buying a house versus renting a house and investing in the stock market.
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.
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 https://www.bbc.co.uk/news/business-50056177)
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.
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.
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.
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.
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
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.
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
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:
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%.
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 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.
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?
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:
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.
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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.
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.
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.
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!
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
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.
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.
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.
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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