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In this edition…...
Welcome
The third quarter in brief
Asset Class Round Up
What we think and what we’ve done
What is risk?
Why volatility is an imperfect proxy for risk
How many holdings should a portfolio have
We answer a common question we get asked
3
Welcome
If the previous quarter didn’t remind investors that equities can go down as well as up,
the quarter that just finished certainly did.
In our last quarterly update we wrote about China, and why we were avoiding its stock
market despite previously strong performance. Since then the woes of China have
continued, culminating in August’s so called “China’s Black Monday” when their market
fell by 8.5% in one day.
The impact of this was felt elsewhere with almost all asset classes falling throughout
August, and no doubt playing a part in the decision by the US Federal Reserve to leave
interest rates unchanged. At the start of August the market expectations were such that
a rise in US interest rates was seen as nearly 100% certain by the end of 2015. As we write
this update, the same probability is now seen as closer to 33% and dropping and some
market commentators are even saying 2017 after the US elections next year.
The market reaction to this, particularly when the Fed didn’t raise rates in September,
has not been positive. Whereas previously the market would almost celebrate rates
being lower for longer, the market now views keeping rates this low, as a sign of global
economic weakness, possible deflation or an indication of quantitative easing (QE) not
working.
All this volatility prompted us to write about how we consider risk. Later in the newsletter
we talk about the difference between a permanent loss of capital and paper losses i.e.
volatility.
Despite all the market moves over the past quarter leaving many equity indices being
negative year to date, at the time of writing (12-Oct-15) all the Lumin model portfolios
are still positive year to date.
We’ve not made many changes this quarter and instead the theme was to focus on
basics: keep the costs of investing low, stay invested, and hold a diversified portfolio.
As ever, if you would like to discuss the content of this document, please do get in
touch.
Yours Sincerely,
The Lumin Wealth Team
4
Equities
What We Think
Global equity markets had a negative quarter, with emerging market indices being
particularly badly hit. Even the S&P 500 finally hit correction territory (peak to trough fall
of 10%).
The source of most of this trauma was initially China, which is clearly slowing down. The
knock on effects of a China slowdown are felt in the commodity producing emerging
market economies, and at the same time the prospect of higher US interest rates has
drawn capital back into the US. As many emerging economies issue debt in US dollars,
the subsequent rise in the dollar versus emerging market currencies has added yet more
instability.
As the quarter went on, weak economic news started to appear in America. For
example the September jobs report showed the US economy created 142,000 jobs which
was way below the forecast of 201,000.
Yet after this bout of market volatility we had the best weekly gain since 2011, with the
FTSE 100 gaining 4.6% in the first full week of October.
The economic data out of the UK is still strong and whilst the US Federal Reserve has
delayed raising interest rates, we still see positive economic news across most US
indicators. It was noteworthy that the day the disappointing jobs report came out the
market rallied to finish the day up.
It’s also positive to see that our analysis of leverage ratios shows how consumers and
financial institutions have significantly reduced debt over the past eight years. Much of
this debt has moved to the government’s balance sheet, but they are better able to
handle this in countries that are in control of their own currency.
So viewed all together the risk of making a mistake and going over or underweight in
markets this volatile is high. As a result we are remaining neutral on equities and instead
focusing on the basics of sensible investing.
We are not making changes for changes sake. We are keeping the cost of investing low
by only employing active managers when they can add value over the cheaper option
of a tracker. The portfolios remain well diversified, and as mentioned on the opening
page are still positive year to date.
5
What We Have Done
Our only action this quarter was to sell our holding in Odey Opus and reinvest the
proceeds into the CF Woodford and Franklin UK Mid Cap fund.
We decided to exit the Odey Opus fund after our level of conviction in the manager’s
ability to outperform fell. Early in the year Crispin Odey was very vocal about his
expectations for a significant bear market and moved to holding around 30% in cash.
Despite this level of cash, his fund has continued to perform roughly the same as the
global equity index he has as a benchmark. This was surprising as one would expect a
fund with 30% cash to demonstrate more defensive qualities.
By contrast other managers we own have stayed 100% invested, instead of holding a
large cash balance and still outperformed when markets have been falling. These
managers are bottom up stock pickers, whereas Odey is a top-down investor (see box
below for explanation of these terms).
As a result we sold the Odey Opus fund and reinvested within the two UK equity funds
mentioned at the start.
Bottom up versus top down investing
It’s important to understand at the outset, that both approaches have the same goal -
outperforming a benchmark by picking the best stocks. The way they go about it is very
different however.
Top-down investing starts by analysing the ‘big picture’ and then picking stocks and
sectors that will perform best within their view of the world. For example a top-down fund
manager may believe China is going to start growing again, and therefore start buying
mining companies who would benefit the most from such an event. Fund managers we
use that adopt this approach would include Legg Mason WA Macro Opportunities and
Invesco Global Targeted Returns.
Bottom-up investors will not try to predict broad sector and economic conditions and
instead focus on selecting stocks based on the individual merits of a company. Whilst the
individual merits of a company is a very subjective thing, bottom-up fund managers try
to pick companies based on fundamentals and leave business cycle forecasting out of
their analysis. Examples of fund managers we own with this approach include Lindsell
Train UK Equity and Fundsmith.
6
Bonds
What we think
UK government bonds were one of the few assets to go up in value over the quarter. UK
10 year Gilt yields have now dropped back down to the 1.85% level.
Within the corporate bond market the higher quality investment grade sector retained
its value over the past quarter. The duration component (yield change sensitivity) was
beneficial for investment grade bonds as yields fell.
The risk of economic slowdown meant that the yield spread on corporate bonds over
government bonds increased (this is the compensation for bearing the additional credit
risk) and held back the performance of investment grade bonds.
High yield bonds have shorter duration so benefited less from yields falling, but they bear
more credit risk so suffered more from credit spreads increasing.
As a result the year to date performance of investment grade bonds is positive whereas
high yield is flat.
Our exposure in the iShares 0-5 year Corporate Bond ETF is investment grade rated.
The Jupiter Strategic Bond fund contains high yield and investment grade bonds, but
their position in Australian government bonds (currency hedged) has increased in value
as the slowdown in China spread to Australia and prompted falling government bonds
yields (and price appreciation).
We remain happy with our Bond exposure, so we have made no changes.
90
95
100
105
110
115
120
High Yield
Inv Grade
Chart rebased to 100 in
October 2013 for comparison
purposes
7
Alternatives
What we think
Our alternatives exposure held up reasonably well over the quarter despite the volatility.
The majority of our holdings still gained money, although last year’s standout performer
fell back a bit (UK Commercial Property Trust—still up 1% year to date)
The table below shows how the different funds we hold within the alternatives space
performed. Although it’s not a direct comparison, to put the numbers below in some
form of context, the FTSE 100 fell 3.4% over the same time period. Given all but one of our
holdings outperformed this, the diversification benefits of alternatives was justified
through the last quarter.
Fund Asset Class Performance over the quarter
Tritax Big Box REIT Property 13.11%
Aviva Multi-Strategy Income ATS 1.75%
Invesco Global Targeted Returns ATS 0.76%
Bluecrest All Blue ATS 0.64%
Custodian REIT Property -0.35%
Legg Mason WA Macro Opportunities ATS -0.92%
UK Commercial Property Trust Property -5.23%
The holding in Tritax Big Box REIT has been one of our strongest performers so far this year
and is a segment of the commercial property market that is gaining in popularity with
other commercial property investors.
The holdings in Custodian REIT and UK Commercial Property Trust have broader exposure
to the UK commercial property market. Last year saw this asset class return strong capital
appreciation plus income, whereas this year our expectation is for the income return to
be a much larger part of the overall total return.
We did not make any additions or subtractions this quarter to our alternatives exposure.
8
What is Risk?
The recent bout of market volatility had almost every asset class falling in August and for
more recent investors that haven’t already accumulated the gains of previous years no
doubt had some portfolios falling below initial cost.
As such we felt it would be a good time to write about what ‘risk’ really is.
Volatility is commonly referred to as risk, yet really is only a measure of how much the
price of an asset moves over time.
Consider the two hypothetical investments A and B below
Investment A is highly volatile but goes up over time, whereas Investment B has zero
volatility but consistently goes down. So if you are only planning to hold an investment
for a shot time period, your chances of losing money are potentially higher with
Investment A. As you extend your time horizon you can see how Investment B proves to
be riskier, despite the lower volatility.
Now clearly if we had an investment like B but it was going up over time, it would be the
best of both worlds and this is why we still try to contain volatility within portfolios so we
can smooth the journey.
As it stands however the less volatile Investment B has the highest chance of the investor
losing money when they sell their investment. In other words the highest chance of
suffering a permanent loss of capital, which is how we think about risk.
The best way to minimise this definition of risk is to first only choose investments that have
a low chance of ever going to zero.
Investment A Investment B
9
The best way to achieve this is to:
Avoid unregulated vehicles
Invest in collective vehicles, rather than individual assets e.g. Tesco, BP etc..
Avoid investments employing excessive amounts of leverage
Thoroughly research any investment vehicle and its management
Once the above has been completed the next step is to check the investment isn’t so
expensive any re-rating could leave you waiting an excessive number of years for it to
return to it’s starting value. For example investors who bought US equities (as measured
by the S&P 500) in the year 2000, had to wait until November 2006 to get back to their
starting level following the breaking of the ‘dot com’ bubble. Of course just to further
frustrate these investors, the bear market of 2008 then meant the US stock market fell
further. In fact if you invested in 2000, the S&P 500 index was at the same level in late
2011.
The way we minimise the risk of the above happening to us, is by including long term
valuation metrics in our investment process. The valuation metrics for the US stock market
in 2000, and 2008 were very stretched giving plenty of potential for the market to fall and
return to more realistic valuation levels.
For this reason we favour markets like the UK equity market as it currently stands on a
Shiller P/E ratio of around 11 to 12. This ratio compares the price of the FTSE 100 index to
the average earnings of the underlying companies over the past ten years. Back in 2000,
this ratio stood at 26 as the ‘dot com’ companies had high share prices, but little to no
profits. This ratio of price to earnings (P/E) spends most of it’s time ranging between 12
and 17 for the FTSE 100, and with it being currently at the low end of this, we believe the
risk of having a ten year period of flat returns is very low. Of course the other reason we
like the UK market is because investors get paid to wait for capital appreciation with an
attractive level of dividend yield. The current dividend yield of around 3.7% gives a
decent income return compared to cash, government bonds and other equity markets.
To conclude, volatility is an imperfect measure of risk and investors should be more
concerned with the risk of suffering a permanent loss of capital. To minimise this risk the
best way is to choose sensible, well researched funds and pay attention to the valuation
at which you buy in.
What is Risk?
10
How many holdings should a portfolio
have?
From time to time, we get asked why we have so many or so few holdings within
portfolios. As a result we thought we would address the question of how many holdings
a portfolio should have.
The answer depends on how big the portfolio is, market conditions and the approach
the investment manager is taking.
If a portfolio is still being built up and falls below say £50,000 in value then a smaller
number of holdings is generally used. With dealing costs of £2 per trade, rebalancing 25
funds four times a year at £2 a time, would add 0.4% to the costs of a £50,000 portfolio.
On a £400,000 portfolio however this cost falls to only 0.05%.
Research suggests that regular rebalancing can add value over time. If the cost of
doing this is 0.4% it takes away some of the benefit. At 0.05% cost the majority of the
benefit remains.
So with smaller portfolio sizes it doesn’t make sense to have a lot of holdings, but as the
portfolio grows in size many more holdings can be held, the benefits of which we will
come on to shortly.
When it comes to the percentage we put into a portfolio holding we have a two
guidelines we utilise. Firstly, we like to have holdings above 2.5% of a portfolio so the
impact on portfolio performance is meaningful. Secondly, we have a limit of 10% to all
of our actively managed holdings (as oppose to for example the passive vanguard all
world exposure). We do this so we are not over-exposed to any one fund house or style.
The question of how many holdings within these limits we should have then depends on
the outcome that a particular manager of diversified portfolios is trying to achieve.
An investment manager that is trying to aggressively beat a benchmark will typically
have a concentrated portfolio so if their views are proved correct they will be beating
their benchmark by a good distance. The potential downside is that when they are
wrong about the majority of their views, they risk appearing significantly behind the
benchmark.
Here at Lumin we use the benchmark simply as a reference point and a way of
checking we are running portfolios to the risk levels we expect. We are not taking
excessive risk to appear top of a performance league table and don’t want to be at risk
of being at the bottom. We are more interested in safely stewarding client money and
consistently doing a bit better than the average wealth manager. As a result we will
hold enough funds to smooth out performance, without letting the number of holdings
get too large to monitor.
11
Glossary
Correlation - a statistical measure of how two securities move in relation to each other.
The higher the number, the more related the moves.
Diversification - a way of reducing investment risk by investing in a variety of assets. Diver-
sification aims to smooth out unsystematic events in a portfolio so the positive perfor-
mance of some assets neutralizes the negative effects of others.
Exchange Traded Fund (ETF) - ETF's are listed securities that track an index, but can be
bought and sold during the day. By owning an ETF, you get the diversification of an index
at a low cost.
GDP - Gross Domestic Product, a key measure of economic performance. Defined as
the value of a country’s overall output of goods and services, typically during one fiscal
year.
Alternative Trading Strategy - a managed portfolio of investments that can use different
investment strategies to generate high returns (either in an absolute sense or over a
specified market benchmark)
Volatility - a measure of dispersion of returns. Can be measured using the standard devi-
ation or variance of returns. Commonly, the higher the volatility, the higher the risk.
Total Expense Ratio - usually shortened to TER, this figure gives the overall cost of a fund
including the fund managers charges admin and dealing costs.
12
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies
described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to
provide, and should not be relied on for, accounting, legal or tax advice. We believe the information provided here is reliable, but do
not warrant its accuracy or completeness. Opinions and estimates offered constitute our judgement and are subject to change with-
out notice. Past performance does not guarantee future results. Any forecasts contained herein are for illustrative purposes only and
not to be relied upon as advice or interpreted as a recommendation.
Lumin Wealth Management Ltd is authorised and regulated by the Financial Conduct Authority. FCA No. 580185