The Grand Old Duke of York

31st May 2013

"Oh, the grand old Duke of York,

He had ten thousand men;

He marched them up to the top of the hill,

And he marched them down again.

And when they were up, they were up,

And when they were down, they were down,

And when they were only half-way up,

They were neither up nor down."

I am sure this popular nursery rhyme brings back some childhood memories. Can you still remember those actions? Standing up, sitting down and then hovering halfway!

The market has been on a march for the last six months, another leg of a liquidity-fuelled rally supported by global central banks. Last week Ben Bernanke's testimony hinted at the beginnings of a QE withdrawal as the US economy sustains a recovery led by the housing market and the consumer. However, the market reaction must have terrified Bernanke and his fellow Fed members. Clearly the Fed is still walking in the shadows of the two previous occasions when QE was withdrawn in 2010 and 2011.   Both led to sharp market corrections. I am not sure whether this latest reaction is enough to shake the bull markets out of their complacency, but I do believe it is time to review the investment style of our equity portfolio. Indeed, in a recent market commentary, Invesco Perpetual's Neil Woodford commented "the overall market is no longer as cheap as it was, but some high quality, dependable, growth companies remain significantly undervalued."

Typically, in Grand Old Duke of York style, the same market leaders, whether it is an index, sector or a stock tend to lead on the way up and then back on the way down. Last week, for example, Japan, which has been one of the strongest market performers over the last six months, suffered one of the biggest falls. From our fund analysis at North Investment Partners, we have found that reliable, high yielding, large cap, defensive stocks have performed well over the last three years and fared particularly well over the last quarter. Sectors such as pharmaceuticals, utilities, tobacco and consumer staples have flourished in a low yielding environment. These are the bread and butter sectors for UK Equity Income managers to construct their income portfolios. Whilst companies in these sectors remain in very good shape, valuations are getting stretched. To make meaningful strides from here we would need to see a more sustained economic recovery.

With signs that the market may be preparing to descend from its recent peak, we are wary of the 'Grand Old Duke of York' effect. There are opportunities which are yet to reach their peak and some of these sit within the UK equity income fund universe. Many quality businesses have raised net cash and at some point need to decide whether to reinvest or return to shareholders. Furthermore there are companies that have strengthened their balance sheets post the credit crisis and remain undervalued. Consequently, we are reviewing our funds with a preference for the stock pickers with a robust and disciplined approach to finding undervalued assets.

Terror shocks Big Ben

30th May 2013

The four year equity bull market has been fuelled by a mass of liquidity around the world created by central banks. The US Federal Reserve was the early advocate of this policy with the UK happily tagging along. The Eurozone was more reluctant. Also late to the liquidity party, but now making up for lost time following the change of government last December, was Japan.  More sceptical investors believe this last leg of the equity rally is completely out of touch with the pace of economic growth and a reality check is required.

A crude, yet effective check on any stock, sector or index in the case of equity markets can be gauged by reference to the 200 day moving average. Whilst writing, the FTSE 100 Index is hovering around the 6,800 level whereas the average closing price of the past 200 trading days is around 6,100. So the market is trading around 10% above the moving average, typically perceived as a significant overbought position. The more serious technicians of Technical Analysis would calculate the standard deviation of the gap between the current price and the moving average, seeing significance greater than one standard deviation. For me a simple chart of these two indices tells me all that I need to know - and currently, I agree with the sceptics.

The calculation of the moving average supports the theory of mean reversion, the investment industry's answer to Newton's Law of Gravity, although in this theory when the current price is either above or below the moving average it will eventually fall or rise. Typically there are two ways to achieve this, either a short sharp market correction or a sideways moving market which allows the two lines to converge. I don't believe that the current overvaluation will lead to a 10% fall in the FTSE 100 Index, more likely a gradual convergence over the next few months. The UK equity market remains relatively good value on historic terms, whereas government bonds are not.

The US equity market, (I use the S&P 500 Index), was, before Ben Bernanke's recent testimony, around 12% overvalued on a 200 day moving average basis. No doubt his testimony caused some panic last week near this peak. Supporting asset prices has been a clear strategy since the credit crisis to sustain an economic recovery. Mean reversion is a powerful force, as investors witnessed when QE ended in 2010 and 2011. When the time comes to start withdrawing liquidity Bernanke would obviously prefer a less violent reaction to those previous occasions. Last week he hinted at slowing down QE as the economy recovers.  The market reaction must have petrified him and his colleagues on the Fed. Weaning a market addicted to central bank liquidity was never going to be an easy task.

One last observation on moving averages - I calculate that the current gold price in US dollars is nearing 20% below the 200 day moving average. With inflation being the long term threat, perhaps this could be a buying opportunity.

Investing by Numbers

25th April 2013

In a post RDR world, independent financial advice is increasingly being repackaged to incorporate a range of wealth management solutions. Many advisers believe that their core competency and, indeed, their added value is giving financial advice to their clients rather than constructing and monitoring investment portfolios, an activity which to them can be onerous in terms of time and resource. No wonder there has been a growth in the outsourcing of investment management to discretionary fund managers.

In terms of investment solutions, we see that once an advisory firm has segmented its clients and taken into consideration the new regulatory environment, there are four investment options: first, advisory portfolios where advisers buy into strategic asset allocation and fund research, often available via a suitable platform; second, managed fund solutions which will frequently be actively managed and may follow either a multi manager or multi asset approach and  two other options which fall into the category of discretionary managed portfolios - either on a model or bespoke basis.

For each of these outsourced investment solutions, there is a range of investment objectives, from capital preservation to capital growth. Whichever objective is recommended by the adviser, it will be as a result of an assessment of risk, usually via a risk tolerance questionnaire. What is important in this process is that the recommended investment solution remains - from initial investment and through duration - aligned to the client’s risk appetite. Hence the recent proliferation of risk graded managed funds and discretionary managed portfolios. These are easily identified as they typically, although not always, carry a number rather than a name.

This market is being established in a post RDR environment so there are very few discretionary fund managers who can boast a five year track record. In seeking to achieve a risk rating from a third party some providers have reversed engineered existing investment products and services. However, advisers recommending this route should be aware that risk ratings have proven inconsistent over time. The investment manager historically may have been more focused upon return which would have led to a variable outcome in risk metrics. If this is the case, in choosing one of these funds, the adviser will in the future consistently need to review for client suitability.

Finally, there is another consideration for the adviser when seeking an appropriate investment solution. Some non-investment management companies offer risk graded strategic asset allocation models. These provide a wide range of outcomes and are usually linked to risk tolerance questionnaires. The temptation to adopt the given strategic asset allocation model is best avoided if outsourcing to a discretionary fund manager. For, in doing so you allow your investment manager full use of all the tools to construct and manage a risk graded fund or portfolio by mapping out the range of outcomes. For any given outcome, there are a number of ways to construct a portfolio.  It would be a mistake to herd all investment managers into the same strategic asset allocation.   

When is a duck not a duck?

26th April 2013

If it looks like a duck, it walks like a duck and it quacks like a duck, then logic suggests it must be a duck.  If you apply this simple test to index funds, it could end up costing you a lot of money. For although most investors believe that these passive investments provide a transparent, low cost return on a stated market index – and it may be so of some early index and exchange traded funds - it is not necessarily true for new generation products.

In a low interest rate environment, the actions of central banks have forced investors to seek higher returns in riskier asset classes. An increasing percentage of this money flow has been captured by passive investments, particularly Exchange Traded Funds, with investors aiming for low cost market returns. According to BlackRock, the providers of iShares, there is US$2.04 trillion invested in ETFs around the world, with US$387 billion invested in Europe. With rapid growth in the last five years, new entrants have been tempted into the ETF market, some focusing initially on price to gain market share and then innovation. However, product development has created increasingly complex ETFs, also a willingness to venture into less liquid markets where trading costs are sometimes less transparent.

Institutional and professional investor demand has led to ETF products being created beyond developed and emerging market indices. Today, there are fixed interest, property, commodity, currency and other alternative ETFs to construct part or all of a multi asset portfolio. Furthermore, actively managed ETF offerings have been introduced.  These are a far cry from the original concept of index less fees. This is a result of the inconclusive debate on active versus passive investment, with many institutional and professional investors preferring a blend of each approach.

New generation ETF products require considerable expertise to understand what exactly is going on under the bonnet. That’s not to say they are not worth looking at, merely that closer examination is required,less so for the traditional ETFs which continue to be refined with more efficient tracking methods and reducing fees. These are market timing investments and treated by many investors as core portfolio holdings. It is these products - designed for active investors seeking to add value from tactical asset allocation, or style and sector rotation - that require more analysis. Typically these investments support a portfolio strategy such as risk reduction, enhanced income or alternative capital growth potential. These specialist strategies can often be cyclical and as such will underperform at points in the investment cycle.

The development of both the ETF and index fund market, particularly with the likes of Vanguard entering the market, is most welcome. However, aside from the traditional index products, there is concern that less sophisticated investors will be attracted to increasingly complex ETFs.  Less transparent products may contain hidden fees and charges. Be warned, when a duck is not a duck, it may be a cuckoo come to spoil a nest egg.  

Time Flies

28th March 2013

I am penning this as I sit on a train travelling from London to Manchester.  The guard has just confirmed my journey time - two hours and eight minutes. If the Government succeeds with its plan for a new high speed rail link, HS2, then in twenty years time my journey will be reduced by an hour. Although the exact route has not yet been decided, the proposal is to build from London to Birmingham, and then in phase two, on to Manchester and Leeds. No matter how controversial, ministers are keen to support a project that potentially both improves the transport network and boosts the economy.

And right now, with the UK close to a triple dip recession, a boost to the UK economy would certainly be most welcome. Last week during his Budget speech, the Chancellor was forced to halve his economic growth forecast for this year. Four months ago he had predicted 1.2% growth in his Autumn Statement. The UK’s real economy remains below pre-crisis levels, noticeable amongst other major economic peers. There seems very little chance of a controversial scheme such as HS2 contributing much to the nation's GDP in the near future. Therefore the Government and the Chancellor are still left looking for other more tangible routes to foster growth.

The Government's latest ideas for growth were outlined in the Budget, although it was a vain hope that Plan A would be scrapped. The underlying path of fiscal tightening has been left untouched and ahead of the arrival of its new Governor, the Bank of England has been given a little more flexibility to carry further unconventional monetary policy. This is the primary lever for growth along with some increase in infrastructure spend and policy to accelerate the housing market. The downgrading by Moody's last month confirmed that fiscal austerity rather than stimulus is the order of the day - although in real terms, public spending has actually risen, particularly in healthcare and education. Indeed, the public sector has made a positive contribution to economic growth over the term of this Government.

Overall the Budget was seen as neutral, no budging from Plan A which is still reliant upon a recovery in the private sector - a private sector which continues to be mired in its own tough austerity, squeezed by a lack of credit, higher inflation and tax rises. Fixing the banks has taken longer than expected, whilst the nation's living standards have fallen as a result of a substantial devaluation of sterling with successive rounds of Quantitative Easing. QE has helped the Government to fund its borrowing at very low interest rates, but has also hit the spending power of savers and increased the deficit of private sector pensions. So no surprise that the Budget giveaways were aimed at the private sector - raising the minimum income tax threshold, scrapping petrol tax rises, helping people buy homes and cutting corporation tax. Time flies and we are more than half way through this parliament with the Government still searching for growth.