Tardiness aside, leaving it the best part of two years to review performance of the 10-asset portfolio, makes for a true case study in ‘no-thought’ investing. In that time, the system, which uses 10 exchange traded funds (ETFs) for exposure to a blend of shares, bonds, property, commodities and cash, has lost money in real terms. This is disappointing and highlights the difficulty in scratching out returns at this stage of the economic and credit cycles.
Without rebalancing the portfolio – after all we just forgot about it – the total return was 2.9 per cent. Factor in consumer prices index (CPI) inflation and that becomes a -1.8 per cent loss since March 2017. (With a rebalancing in March 2018 the portfolio would have made a nominal return of 2.5 per cent.) What are the reasons for this weak performance? Well, simply put, just as all asset returns rose together in the long bull market, so they have all stalled in unison as monetary policy around the world has been tightened.
The B word bad for UK mid-caps
With many in the media turning the hysteria up to 11, we need no recap of the UK’s political predicament, but there has undeniably been nervousness in sentiment towards the typically more domestically-focused companies that comprise the FTSE 250 index. Overall, our FTSE 250 ETF is up nearly 4.5 per cent in nominal terms, but it has proved volatile in the period. Cumulative returns from the mid-cap index are now ahead of the FTSE 100 (3.5 per cent), but have been lower at times, reflecting a risk-reward trade-off for smaller companies.
The emerging markets ETF is up 6.6 per cent, although the risks remain the uncertainties emanating from China and potential foreign-exchange pressures on companies with dollar-denominated debt repayments. Developed Global Equity is represented by the Lyxor SG Quality Income strategy ETF (SGQI), which tracks a unique quant strategy investing in stocks that demonstrate value based on their dividend yield, but also back this up with quality characteristics. This system has been less rewarded than market cap-weighted investing in the MSCI World or just in US equities, but as dispersions rise it is possible that the value-style tilt (especially with balance sheets vetted) could outperform going forward.
The performance of the bonds allocation is interesting. The UK gilts ETF has lost money, due to price falls as yields (which move inversely with prices) rose around October. The total returns are down since March 2017, reflecting the Bank of England’s (BoE) brief phase of monetary tightening. We also include an inflation-linked ETF in the portfolio, which is due to the long-term purpose of this 10-asset system. Generally, ‘linkers’ are aimed more at large institutions such as pension funds that have to match liabilities in real terms. Many of the issues are more expensive than standard bonds and often start out with longer maturity dates, so benchmarks for these bonds typically have a higher average duration, meaning their prices are more sensitive to interest rates. This makes linkers a riskier investment than many investors realise.
Positive returns for our index-linked gilt ETF has implications for the rest of the portfolio, though. UK CPI inflation is currently at 1.8 per cent, below the Bank of England’s (BoE) target of 2 per cent. The returns aren’t due to yields – prices have risen, but this is due to investors being prepared to tie up their capital for longer. The falling price on short-dated bonds, while prices rise on longer-dated issues, is a sign of weak confidence in the economy. On a graph, the yield curve, showing the yield on bonds of differing maturities, becomes inverted and is often seen as a precursor to recession.
Linkers do well when there is weak confidence because their yields will rise with inflation, so when economies pick up so will the rate of return. Linkers may also be popular among UK investors who may fear the dreaded combination of recession and imported inflation, thanks to the possibility of price rises post-Brexit. Fears of stagflation may strengthen the case for linkers and they could maintain a negative correlation to our UK equities positions – especially the FTSE 250 – which are exposed to this risk.
Inevitable equity risk
The UK’s FTSE 100 index is made up of many companies with a global bent, who also diversify UK currency risk by the translation effect of reporting earnings in US dollars. Taking this into account, the UK blue-chip index is arguably cheap right now, as the idiosyncratic risks the UK faces in 2019 may have overly tainted investors’ view. There would, however, be nowhere to run for equity investors in an international downturn.
China’s slowdown is alarming, as is the prospect of US growth dropping off as tariff disputes bite and the so-called ‘sugar rush’ of Donald Trump’s tax cuts wears off. Global recession would clearly be bad for all our equities holdings, but there is the hope that the tilt towards value will spare us the worst of any falls.
The UK FTSE 100 is, as discussed, already discounted and the Quality Income strategy avoids those companies that are on a less robust financial footing and could suffer badly in recession. There is no getting around the fact that equities investing carries the risk of peak-to-trough drawdowns, however, and emerging markets could be expected to take a hammering if there is any worsening in the China situation. That said, the reason for this long-term asset level buy-and-hold strategy is to maintain exposure with the optimism that periodic episodes of pain will be rewarded.
Gold – sacrificing income for a hedge
Our gold ETF holding has lost money and been one of the more volatile investments, but this asset can reasonably be expected to act as a portfolio hedge in a period of equity and bond market turmoil. The problems with gold are that it pays no income and changes in value are based purely on speculation. Weighed against these negatives is the fact that gold has been virtually immune to inflation risk and, on the flipside, thanks to its safe-haven status as a store of wealth, it offsets deflationary risk, too. The presence of gold can seem pointless when other assets in the portfolio are doing well, but like any form of insurance, it’s not until you need it that you see its value.
Gold has continued to underperform even as equity markets and sovereign debt have stuttered, but could help steady the overall value of the portfolio if a real sell-off were to take hold.
Industrial commodity prices are more susceptible to recessionary pressures and therefore are subject to the same factors that cause company earnings to disappoint and stock market falls. There are many short-term variables affecting the prices of oil and industrial metals tracked by our commodities ETF, so this doesn’t behave in the same way as an equities index. The reason for holding it is a more speculative play on global economic growth. The timings of economic and stock market cycles don’t move in unison, however, so this position should be expected to behave differently to equities at times. This may protect against downside at times, but there is also the chance that both assets will move in the same direction, although rises and falls will be of a different magnitude.
Global real estate has held its value over the past couple of years but this could be another asset class that unwinds on the back of a slowing world economy and a less accommodative stance by monetary policy-makers. The ETF we use tracks an index of listed real estate companies (with assets in Europe, North America and Asia), so will have a positive correlation to equity markets, when share prices fall.
Finally, the portfolio’s cash position has a dilutive effect. This can be good in times of weak asset performance but of course it also acts as a drag on the portfolio in times of upside for risk assets. Having a cash position is worthwhile in uncertain times, however. Given the global nature of equity investing, we can expect markets to fall together if there is a serious negative shock. With government bonds expensive, following years of quantitative easing (QE) and low interest rates, there is far less scope for prices to rise and offset any equity falls. The linkers allocation may work slightly differently, but these can be volatile investments subject to duration risk (price sensitivity to interest rates). Gold acts as a diversifier of risk thanks to its low correlations, but it is subject to wild swings. The value of cash gets eroded by inflation but this is the price of portfolio insurance. Just as we hope the risk assets will help us outpace inflation over time, however, so cash plays a role in diminishing fear in periods of peak-to-trough drawdown in other asset classes. This is psychologically important as investors who don’t panic and stay exposed to some risk assets never miss out on gains when those assets recover.
|Asset||ETF||Total percentage return (17.03.17 to 13.02.19)|
|UK Large Cap||iShares FTSE 100 (CUKX)||3.45|
|UK Mid Cap||Vanguard FTSE 250 (VMID)||4.48|
|Global equity||Lyxor Global Quality Income (SGQI)||1.05|
|EM Equity||iShares MSCI Emerging Market (IEEM)||6.64|
|UK Govt Bonds||Lyxor FTSE Actuaries 0-5yr gilts (GIL5)||-0.13|
|Inflation-linked Gov Bonds||iShares £ index-linked gilts (INXG)||5.50|
|Property||HSBC FTSE EPRA Nareit (HPRO)||9.39|
|Gold||ETF Securities physical gold (PHGP)||1.80|
|Commodities||x-trackers commodity swap (XDBG)||-3.56|
|*Cash returns compounded and based on one-month Libor rates|
Source: Bloomberg & Investors Chronicle