I was at a meeting last week with a client (a top man) who in his usual polite and gracious way asked me a seemingly simple but actually quite a complex question.
“Why would a client (in this case him) be pleased with the 20% return for 2013 on a portfolio (his) when the US market was up 30%, the UK mid 250 35%, the DAX 28% and the Nikkei 50%?”
PORTFOLIO THEORY AND HINDSIGHT
After we had discussed the various elements of the answer I wondered if we (LWM) had been guilty of not clearly explaining the fundamental practices that we have identified as those of the most successful investors and how we have adapted them.
So here goes an attempt to do so.
One of the most successful long term multi asset investors is David Swenson who achieved remarkable results with the Yale Endowment Fund (the US Ivy League University). He wrote a fantastic, if long and in depth, book explaining his theories and how to apply them. (We have also found similar strategies with other top managers.)
1. Assets in different classes (equities, property, debt and commodities) will perform differently at different times in the economic cycle.
2. No one has ever consistently predicted from year to year which assets will do well or badly but it can be predicted that some will do better than others and this will balance out over time to give normalised returns through the whole cycle. This is to say, for example, that equities may be up 30% one year; down 20% in another but over a complete cycle the return will average around 5-7% above the risk free (cash) return. This being the same for the other asset classes although not at the same averaged returns.
3. A portfolio which invests in all the major asset classes is preferable to only having a single asset class as diversified holdings provide the benefits of reduced correlation (that different assets react differently to the same stimulus) and therefore lowers portfolio volatility.
4. It is vital to rebalance portfolios consistently, taking some of the profits from the winners and reinvesting them in the losers.
5. This appears contra intuitive but in fact produces consistently better long term performance.
6. This has been the case with the LWM portfolios. In 2009 and 2010, Commodities and Emerging Markets had great returns, and Europe and the US were laggards. Profits were reinvested in these poor performers which then outperformed in 2012 and 13.
7. This year exactly the opposite will probably happen with profits being recycled back into EM’s and Commodities from the US and Europe.
8. The aim is to consistently outperform the benchmark as the compounding effect will be significant.
The LWM portfolios have achieved between 70 – 90% outperformance since launch so the continued compounding effect should be considerable.
9. It is crucial to remember that investors will always be naturally biased towards the prevailing sentiment. In 2009 we had many conversations with clients where we highlighted the market opportunities due to poor sentiment and confidence. There was an understandable reluctance with some to invest in risk assets at that time. As markets have risen investors in general have become more confident. We have however become more cautious simply because the future returns, whilst still probably being more than satisfactory, will certainly not be as high as those enjoyed in the recovery phase we have now come through.
10. The consistent rebalancing to buy the lagging assets is the antidote to sentiment bias.
HINDSIGHT (it’s behind you)
2013 was a wonderful year for equity investors as it turned out but:
1. The US had a potential debt default crisis averted only at the 11th hour
2. The Japanese market at one point dropped 24% in a few weeks
3. Gold fell by 40%
4. The Brazilian market fell 18%
5. There was potentially a Syrian war involving both the US and the UK (and biological weapons were used)
6. Emerging market currencies were hammered (India, South Africa and Turkey)
7. There were growing concerns about China and this in part caused commodities to weaken substantially
If one looks at the UK market (and few predicted the level of improvement to its economic figures) the FTSE 100 index finished up 14% whilst the 250 was up 28%.
This was caused by the fact that the FTSE 100 ‘very commodities’ heavy including Rio Tinto, Xtrata, BHP and Glencore which all had bad years.
The 250 was unaffected by this so performed much better, and was far more sensitive to the improved economic data that came through, which was not anticipated.
The Nikkei was up 50% but that was in Yen terms, for a UK investor the fall in the Yen would have halved the return to 25%.
In Europe the best two performing markets – Ireland and Greece, both in the 30%’s; France by comparison 17%.
I could go on but the fundamental point is that nobody really knows what will happen or when it will happen and they don’t know the effects of these unknowns on assets and their prices.
The hedge fund industry, populated by the best of the best of the investment industry charging fees of 2% flat plus 20% of the profits annually had an average return in 2013 of ….. around 6%.
The self-proclaimed “masters of the universe” plainly didn’t have a clue but on £1m invested they still would have charged £34000. To put it another way, on a 6% gross return (£60000) they would have made 3.2% and the client 2.8%, so maybe they do know what they’re doing!
The final point is to flag up the supplementary question asked at the meeting referenced at the beginning of this note (it probably seems a lifetime ago you read it if you’ve made it to here).
“How do you work out benchmark returns and are they a fair comparison to the portfolio performance?”
George touched on this in the latest quarterly update but we have not properly explained how we do this. So the next blog will do so, and as an added highlight, feature one of my favourite words, sophistry (no, no, don’t email in, you’re going to have to wait a week).
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.