October 2011

Thoughts…….

I sit here at the dawn of Keats’ season of mists and mellow fruitfulness having just played rugby in 30° (we lost, but simply playing was a triumph of sorts). Outside the leaves are falling but the grass is looking parched and in the part-finished extension the swallows are busily toing and froing to their nest in what will become our bedroom (I said it would be finished by Christmas – fortunately I didn’t say which Christmas) with supplies for their latest brood. I’m no ornithologist but shouldn’t they be packing their bags and heading due south for the Sahara or somewhere by now? Something doesn’t seem quite right and it’s all very confusing.

My confusion is hardly lessened by going into work. To say the markets have been like a rollercoaster-ride is for once not hyperbole – following the freefall at the beginning of August there have been very high levels of volatility as any good news is swiftly followed by a sharp tug back to reality – a bit like unexpectedly catching your reflection in a shop window and seeing an old man looking back at you. Any pretence that anyone knows what is happening has long since been abandoned.

All eyes are on the G20 summit in the first week of November (if a week is a long time in politics, a month is an eon in the markets) by which time hopefully Sarkozy, Merkel and Lagarde will have managed to cobble together a solution for the Eurozone debt crisis that will go some way to reassuring the markets. My opinion is that it will be too little, far too late to avoid the current downturn becoming entrenched – which will not be helped by Boy George’s insistence that there is no Plan B. I can see him now, bobbing around in his Mae West as the good ship Britannia slides stern-first into the watery depths, spluttering ‘but the markets approved…’ I suspect he had a hard time at school – he doesn’t seem to have picked up that if you give the nasty boys your sweets it doesn’t make them your friends – it just makes them people who’ve got your sweets and they’ll still come back and punch you. What is needed now is growth and to continue to promote an austerity agenda in the face of such overwhelming evidence is at best indicative of a lack of ideas, as worst blind dogmatism.

Of course we cannot return to the spend, spend, spend of the last decade but a reduced debt is no less of a problem if the income to service it has reduced by more. The cuts to the public sector and the resulting fiscal and economic contraction need to be balanced by targeted stimulus funded by increased taxation. For several reasons these tax rises should be aimed at the wealthiest. Morally - the effects of cuts in public spending fall over-whelmingly on the less-wealthy; politically - the austerity agenda will lose all support if the wealthy are felt to be dodging their fair share; and economically - money left with the wealthy is more likely to end up in capital items such as property whereas the less-wealthy will tend to spend it on goods and services meaning each pound is used time and again. Of course, the problem is we rely on the wealthiest to generate more wealth. And the very wealthy are also pretty mobile – if taxes get too high they’ll be off before you can say ‘two first classes to Nassau.’

The Economist has an interesting solution to this conundrum:

Imagine a tax system which made the top rates on wages and capital more equal, and which eliminated virtually all deductions. To avoid taxing investments twice, such a system would get rid of corporate taxes. It would also allow for a much lower top rate of income tax. The result? A larger overall tax take from the rich, without hurting the dynamism of the economy. (Taxation and Class War- Hunting the Rich, The Economist, Sept 24th 2011)

Probably a bit too radical and for the moment we may have content ourselves with the Liberal Mansion Tax.

Meanwhile, back in our little bit of the world we welcomed Radi to our team in August. Fresh from completing her Masters she’s been working hard at extending the research that led to our trend following investment option. The success of the approach during the current turmoil has been marked – it has both reduced losses and volatility. Those who took up the option when we first muted it have seen falls over the last three months, but these have been very modest and typically less than a quarter of those experienced by the FTSE.

We’ve been putting together a research paper that forms the basis of the current thinking behind our investment proposition. (If you want to have a copy of the paper or are interested in the trend following option please let me know). It’s opened some interesting debates not least because in this area, as in most, there is no one right or wrong answer.

One question we have been asking is ‘What if active fund management actually creates the investor behaviours that lead to poor returns?’

This grew from a statement from JP Morgan (who were promoting actively managed funds over passive funds) that for a top decile fund in any period there is between a 51% to 55% chance that they will be in the top quartile the following year and over a 70% chance they will be in the top 2 quartiles for that year. We’re always fairly sceptical of anything with numbers attached to it released by fund management houses – they are close cousins of those masters of obfuscation, the insurance industry - and so decided to look deeper into their claims. We drew on a couple of pieces of research from Lipper and Dalbar. When Lipper looked at fund performance over two 10 year periods it found the top performing equity fund in 1988-98 came 1485th out of 2322 in the following decade. Funds which ranked 2nd through 10th in 1988-98 ranked as follows in the following decade: 1977th, 1991st, 620th, 1699th, 2066th, 1460th, 2154th, 2274th and 2123rd. Dalbar meanwhile found that, on average, investors switched out of funds after just over three years – a strategy which saw their returns pretty much halved compared with a buy and hold strategy.

To see what may be happening here let’s take two investors. Max is an active investor. Eddie is, well, steady.

Max is sensible in his investment selection, choosing only those funds that are top decile over the previous five years. At the end of the first year he is likely to be disappointed – he has only around a fifty percent chance (according to JPM) that his chosen fund will be still be in the top quartile and an even lower chance that it will still be in the top decile. Go to the end of the second year and probabilities that the fund will meet his expectations will be still lower. After around 3 years (Dalbar) he will throw in the towel on this fund and reinvest in another top decile fund and start the merrygo- round again. This strategy slashes returns.

Eddie, on the other hand, has invested in trackers and lost around 20% of his return to charges and tracking error, as opposed to Max who has lost around 50% due to his strategy. Of course, if Max had been prepared to accept average performance he would have been far better off.

We’ve only just started looking at this area but our preliminary findings suggest (where active funds are preferred) it is better to select a fund that has moved from underperformance to marginal outperformance (i.e. has positive momentum) rather than a top-performing fund. As I said – we’re still working in this so it’s not a conclusion yet.

I thought, by way of introduction, I’d leave it to Radi to finish this note with some of thoughts of her own.

RICHARD ROSS MBA MCSI DipPFS

It’s been several years since I started my journey around the world and I think I’ve finally found the right place for me here in Chadwicks.

It started out as an innocent little dream in the head of a 15 year old student in Varna’s Trade School in Bulgaria. The beginning of second year at the new school, first class – Investments. Before she even introduced herself to the class, the teacher decided to give us a test. ‘Write down the names of the people on each banknote and no peeking in your wallets!’, she said, although a peek wouldn’t have helped at all since coins were our only weapon available at that time. Now, while this test would’ve been really easy in a country like the United Kingdom, in Bulgaria, at Varna’s Trade School, in the 9V class only two people knew all the names. I was as surprised as anyone that I was one of them! Amazed that someone actually knew them, our teacher proudly declared ‘Students, although I’m sure all of you will become respected financial and economic professionals, those two know money’. From that point in time, I was convinced that this is what I want to do – know money.

Well, the specifics of ‘knowing money’ got clearer much later in life, but in the meantime that dream was moulded by the school teachers and later on by university lecturers at The University of Economics in Varna. Showing us graphs of the billions that big banks and market players control, the complex tools and systems that they use, the theoretical concepts behind all market operations (strongly Efficient Market Hypothesis focused), the history of their creation and the world power that they now possess made us believe that all the bankers are all-knowing, over-achieving, gogetting, machine-like geniuses. The pictures of the shiny skyscrapers in the City and Wall Street’s big shots wearing “Insert Brand Here” suits in our textbooks didn’t help much in changing that idea. But something else did.

While my journey has always seemed a tad coincidental (or as Mr Ross, sorry – Richard, would perhaps say “destined”), my summer in the United States at the peak of the World Crisis in 2008 seemed like no coincidence. Even in the remote rural area of Missoula, Montana, in front of most bank offices there were long lines of people waiting to withdraw their funds from their accounts. Panic was written on all of the bank employees’ faces as the nationwide wave of distrust in banks reached even the mountain peaks of the small town.

Living in a complete informational eclipse that same summer, me and my two friends, unsuspecting of the events, walked past the long line in front of one of the banks to enter and upon mentioning the magic words “we want to open an account and make a deposit” were treated as Her Majesty herself might be in an area such as this.

How far did the crisis actually go? As far as the City of Lights – Las Vegas, decided to save money on electricity and turn off all the lights after 12 PM. But unlike the gamblers in Vegas, the market gamblers weren’t disappointed by the outcomes of the World’s crisis. Instead, they bet on it. Banks and market players contributed for the burst of the housing bubble and the deepening of the crisis by flooding the markets with CDOs1 and insuring them with CDSs2. Did they think about the effect on the average tax-payer? Not really.

Eventually, the crisis came back knocking on the banks’ door. Little did we know that in a few months the people from the lines would be going to the banks again to deposit back their money as encouraged by government speakers. Furthermore, not only did the nation contribute their savings, but the taxes they paid were redirected for big banks’ bailouts. Now, did the banks and market players think about the effect on the average tax-payer? Yes, they did, if he pays the bill. How’s that for customer relationship!

At the end of the summer, I went back to Bulgaria for my final year at University. And it seemed like the crisis was a game-changer. The common private joke amongst finance university students that “God created market analysts to make weather forecasters look good” has turned sour. No more pictures of Wall Street, no more praise for the City Banker, no more efficient markets concept. It seemed that the all-knowing banks and market players did not know what’s happening at all and were blindly betting on regaining their old-time glory. Any lecturers’ attempt, both in University of Economics in Varna and later at the University of East Anglia, to explain the markets turned to a modern version of Chaos theory. And indeed, the new emerging theory of Lo and the Adaptive Markets tries to explain that markets are a natural phenomenon because they depend on the behaviour of each of its participants. As long as the markets consist of many gamblers and few rational investors, the risk of a downturn such as the one in 2008 is high. We see similar bubbles are inflating in many different countries (Portugal, Italy, Ireland, Greece, Spain) and it is just a matter of time before one of them bursts and spreads contagion across the World all over again.

This is where my journey led me to Chadwicks. There is no longer such a thing as a “risk-free” investment – if there ever was. Even keeping your money under a mattress carries its own risks too. At Chadwick’s I’ve learned that it’s better to try and avoid those risks than gamble on them. I was given the opportunity to contribute to the research of a number of investment strategies that avoid general market and downturn risk. Amongst those our research, based on historical values testing, indicated that Momentum Investing and Trend Following are the most consistently successful. The empirical evidence shows that they would have avoided the huge losses on the equity markets during the World Crisis in 2008 and the Dot Com bust of 2000.

1 Collateralized Debt Obligation – a bond-like security that is asset-backed in theory, but mortgage-backed in practice

2 Credit Default Swap – derivative that insures against the default/bankruptcy of an entity (such as banks, financial institutions or entire countries)

We’ve critically analysed research evidence that leads us to conclude that they would continue to perform well in potential future crises or market downturns. Furthermore, our research expands on the debate between active and passive funds and the volumes of theoretical concepts behind this issue. To be more specific we elaborate on the Efficient Market Hypothesis conflict with the Behaviouralists’ movement. The results from this research indicate that, as often happens, the best solution lies in the middle – a combined approach of passive core portfolio and active satellite investments seem to be the best risk-adjusted strategy.

At first sight, the behind-the-curtain processing at Chadwicks can seem a bit chaotic and somewhat daunting as the number of elements involved in monitoring a client’s portfolio are brought together. But as I am settling in I am starting to see “the bigger picture” and the evolving systems that the company uses. I am enjoying the challenge of helping to develop and improve both our processes and our interaction with our clients.

RADOSTINA DENCHEVA BSc. MA
October 2011

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This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The information in this newsletter was correct as at Oct 12, 2011 but may not apply at the time of reading.