Have we lost our way? – May 15th 2015

As an industry we seem to have forgotten our roots and have become obsessed with trying to manage risk by hijacking mathematical models that can never accurately map the emotional investment landscape. Risk is all about losing money and the attributes attached to that outcome are almost entirely emotional!

Ask investors in a “Cautious” fund, with a high weighting to “safe” low volatility bond funds, populated with supposed triple AAA rated paper, post the Lehman bust, how they felt. As a result the regulator embarked on a series of heart searching exercises that culminated in the retail distribution review and so the quest for suitability and a formula for determining portfolio risk began anew.

“Modern” portfolio theory on which a great number of “risk” based portfolios are managed was the brain child of Harry Markowitz and came into existence over 50 years ago; modern it isn’t! Although human emotions have remained the same markets have moved on. We now have more asset classes than he could have ever dreamed of and in theory the more asset classes the more diversification and hence less risk; in theory…

One of the many spanners in the works of MPT is globalisation. Everything is connected with everything else instantaneously; in HFT world even quicker than that… The emotional journey is as ever the same. A market is unloved and there are few buyers, apart from the canny (uncanny some would have you believe) value investor who sees an opportunity and knows that eventually he will be right – as Jeremy Grantham once said, “Value investors are rarely wrong, just early.”

Some of those early adopters will get shaken out in the inevitable corrections that accompany market bottoms, but slowly the pace of buying will increase and we have ourselves a trend. The momentum investors are now in play and the market marches serenely onward and upwards. Retail investors now smell the coffee and join in. All the while, as the market rises steadily, volatility falls and your “suitable” risk defined portfolio needs to take on more risk to remain suitably suitable. The value investor at this stage is more than happy to sell to the unwitting band of risk “controllers”, who are buying near the top of a market, thus turning rational investment practise, of buying low and selling high, upon its head.

In days of yore, and perhaps to this very day, this distribution phase in the market could take some time. Then there would be a trigger, which tipped the balance in favour of the sellers, and the market revalued in smart fashion, with many late buyers forlornly holding on for a return to the peak. Plunging markets mean higher volatility so the risk “controllers” sell near the bottom to “reduce risk” to those canny value buyers and the cycle starts all over again, followed by another regulatory review to make sure that clients in suitably unsuitable portfolios don’t suffer the same fate yet again…

Investing comes automatically with the risk of loss of capital. There will be occasions when you will lose money, no ifs or buts, and if you continue to buy high and sell low then disappointment is guaranteed. An application of common sense is required and that discipline is aided in a significant way by adding in a value component to any analysis of risk. We really don’t want to hear any more that, over 15 years, bond volatility is low and therefore a high weighting is the “optimum” strategy for a “cautious” investor. So far this year the bond “rout” has been confined to sovereign issues and, in the UK, an investor in a gilt tracker has now lost around 5% since the market peak in early February. Long dated funds, which have done so well for so long, have lost around 10%, which, in both cases, has wiped out the paltry level of income on offer for some considerable time to come.

So far the rapid rise in yields has not been as evident in the corporate bond and high yield sectors, quite possibly because these are the home for much retail money in search of an income and it takes them a lot longer to realise that a sea change might be afoot. There is also the “small” question of market liquidity and should investors decide to sell they may find that the rather large door marked “exit” has turned into a rather small cat flap. We cannot of course rule out an end to this “corrective” phase, but to highlight what volatility in bond world could mean, here is an example of what we might expect if the setting of interest rates were to return to “normal”.

The UK 10 year gilt saw a low in terms of yield of 1.4% on the 25th March. It currently stands at 2%. Were it to rise to 3% where it stood on the 30th December 2013, only 15 months ago, the loss of capital would be around 13%, from the low, and if 4% were reached, last seen 4 years ago, the loss could be over 20%. If these rate changes were to be translated over into high yield the losses would be even greater. The typical bond fund currently has a duration of less than 10 years, but you get my drift.

Regardless of the market direction in the short term, all these sectors remain insanely over valued and carry a very high risk of capital loss and at best can be described as speculative investments and not for the risk intolerant. Measuring risk using historic volatility can only be used as the most basic of guidelines and should not be the main or only input into constructing a portfolio. Applying a value based orientation makes much more sense when combined with a reasoned approach to asset allocation taking into account the current, and anticipated, twists and turns of the global economy. Value will out in the end in direct contrast to paying a high price for assets divined from an archaic mathematical formula.

Fund managers who employ this approach will have periods of under performance, but they also have preservation of capital in mind, which is the characteristic of the risk aware and you just can’t put a number on it. Fund volatility will naturally rise and fall, but if the investment philosophy is sound and well-articulated to the end user this phenomenon can be relegated to the category of background noise. Let’s stop putting numbers on portfolios and funds and get back to understanding what the fund manager is about and explaining that to the investor. Isn’t that what we should be doing?

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