Yellowtail Blog

Over the years I’ve had to listen to people telling me what they think my job is.  In reply I find myself debunking several myths about the mysterious world of investment.  Many believe that someone like me, working in the investment world, somehow has hidden knowledge – an ‘inside track’ – on which investments are ‘hot’ and who the best fund managers are.

When I admit to not knowing, people become disappointed.  It seems to be beyond belief that we wouldn’t know something.   It doesn’t help that some myths are perpetuated by an investment world that wants you to believe in secrets and mercurial talent.   So I want to tell a short story, a true story, about how hard it is to forecast the future.

Many people will have heard of Anthony Bolton, arguably one of the UK’s best fund managers.   He used to run the Fidelity Special Situations Fund from 1979 until 2007 – 28 years in total.  Over this period his fund achieved an average annual return of 19.5%.  An impressive return, though as Mr Bolton points out, very few investors in the fund got anything like that kind of return.  Too many bought close to the top, and sold near to the bottom.  But that’s a different story altogether.

The story I want to tell is about what happened when Bolton decided he wanted to retire.  In 2006 it was decided to split his fund into two because it had grown so large. By now it was the UK’s largest fund with almost £3 billion under management.  It was decided to split it into a Global Special Situations Fund and a UK Special Situations Fund.

The Global Fund was passed over to a younger manager, Jorma Korhonen, and the UK fund continued under Bolton’s stewardship for another year. Then in January 2008 management of the UK Fund passed to Sanjeev Shah. I imagine Bolton and the chiefs at Fidelity were able to choose from the cream of crop when deciding who should manage the funds. In short, they had the time, the resources, and the contact list to find and appoint the best fund managers for the job. All they had to do was appoint someone to manage the Global fund, and someone else to manage the UK fund.   How hard could that be?

Well the investment results for Bolton’s hand-picked replacements suggest it’s a lot harder than it appears.  5 years after being personally chosen by Bolton, Jorma Korhonen has been replaced as manager of the Global Fund. He underperformed the market and underperformed his peers.  He didn’t even deliver average returns, so bad was his performance. For all his promise, Korhonen chose to bet on struggling investment banks in 2008, and the fund lost over one third of its value.

Sanjeev Shah hasn’t found it easy either, though he’s still in the job. He also bet on the banking sector and has had a disastrous last year. The result is that over his tenure his fund has also turned in a below average performance.

The message is, trying to select the best fund managers in the hope of superior investment performance is a flawed strategy.  If Anthony Bolton and the other ‘experts’ at Fidelity couldn’t pick the right people, what hope is there for a financial adviser? Not only that, we’re expected to pick the right people across a wider range of funds and sectors.  It’s a mug’s game.

Far better to concentrate on the things we have more control over, like fund charges, investor behaviour and matching the right asset allocation to someone’s capacity for investment risk. That way there are fewer disappointments and more expectations met.

It’s that time of the year again, when newspapers call investment professionals to cobble together their top predictions for the coming year. These are fun to write.  But for readers, they’re more entertaining a year later.

A year ago the Barclays Capital Global Macro Survey asked more than two thousand institutional investors to predict the top performing asset class.  Their pick for 2011 was shares (with 40% support), followed by commodities (34%) and bonds (less than 10%). On top of this they were asked to predict the gain in the US S&P 500, an index used to measure the performance of the US stock market.  The consensus prediction was for a 15% gain for the S&P 500 this year.

A year later we can see how well these two thousand professional investors did – not very. To the beginning of December, diversified fixed income was the best performing asset class of the year, followed by government bonds.  The returns on commodities and shares (the most popular choices among these professionals) were both negative, and the year-to-date return for the S&P 500 was close to zero.

Meanwhile, one investment magazine was telling readers this time last year that smart investors were “looking eastward” in 2011.  According to them, the year would be dominated by fast growth and rising inflation and the smart thing was to reweight toward China and other tigers.
That didn’t really turn out to be such a good idea, as China had another bad year.  The Hong Kong Hang Seng index was down nearly 17% to early December. The Shanghai Composite was down by a similar amount.

Conversely, the majority of professional investors were gloomy around bonds in late 2010.  One survey of 10 top strategists and investment managers found nearly all expected shares to outperform bonds in 2011.

Their logic might have been impeccable, but the strategy wasn’t. Bond yields might have been seen as unusually low a year ago, but they have fallen even further since driving up bond prices. Those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price for doing so.
So if the experts can’t get the broad asset class movements right, what chance on earth have they of correctly and consistently predicting individual stock or commodity performances?  But year after year, that doesn’t stop them from trying.

One example – a prominent investment bank team was quoted by The Australian Financial Review last January as saying that platinum was the metal to back in 2011.  As of early December, the spot platinum price was down nearly 14% for the year.  On the Australian stock exchange, platinum stocks Platinum Australia and Aquarius Platinum – both recommended by the bank – had delivered total returns to the end of November of minus 83% and minus 53% respectively. Ouch!

It’s a tough business isn’t it? And remember these are major financial institutions with armies of expert analysts, mountains of data and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future!  You can do all the analysis you want, but events have a way of messing with your assumptions.

The second lesson is you don’t really need forecasts to succeed as an investor.  Yes, shares were rocky again this past year.  However, a portfolio of good quality bonds would have provided excellent returns. Therefore, an investment portfolio diversified across different assets, and within asset classes, provides a cushion in down times, and ensures you are still positioned to reap returns when riskier assets come back into demand.

It’s human to feel anxious about bad news because we fear loss more than we like gains.  But in this case, the loss isn’t real unless you realise it.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that things change.  What’s more they often change in ways we least expect.

We recently discussed  renewed volatility in the stock market.  A month or so later and things haven’t changed much. 

If anything the news sounds worse rather than better. I’ve been receiving some emails about what is happening so I thought it would be worth looking at this again.
Truthfully, nobody really knows what the short term holds. This isn’t unusual. People generally don’t know what’s happening until long after it’s happened – which is when the books are written telling us what we should have done to avoid it all – hindsight is perfect vision. Everything seems so obvious when we’re looking back.

I don’t know whether the current market conditions will continue, or whether the next movement will be up or down. But I’ve spent a lot of time listening to, and reading the thoughts of the wisest sages I know. The thing is, stock market investments are looking reasonably priced when compared to the long term average. There’s no reason for markets to go down, but sentiment – greed and fear – are strong drivers of behaviour.

Even if markets continue to go down (as they did in 2009) they will eventually recover. In our experience once markets do recover the upswing is usually quite quick. If you’ve got out of the market what will be the trigger to return to the market? Behavioural Psychology suggests that people will wait on the sidelines too long. Fear breeds inertia, and my worry is that people will find it difficult to reinvest because they won’t know where the bottom or the top is.

In fact, what I believe we are seeing is greater volatility. In simple terms this is the amount stock markets move up and down. Theoretically it shouldn’t matter how far up or how far down the markets swing, so long as they are up when you need the money. Volatility then, isn’t a true measure of risk because it doesn’t tell you the likelihood losing your money – it simply tells you how bumpy the ride is.

The problem is we are able to see volatility fairly easily – the market goes up by 3% it goes down by 3% – and the papers and TV are full of it. We experience volatility and we equate it to risk. It’s like sailing across the channel to France – we’re comfortable when the waters are smooth, and we get sea-sick when we hit big waves. We’re experiencing more big waves these days and sometimes it’s a scary journey, but we’ll reach the other side.

We know that companies are still producing goods, they have less debt, and they’re leaner and fitter as a result of the past few years. We’ve been through storms like this before, and the best advice then, as it is now, is not to make any rash decisions. The markets are a long way off the lows experienced in 2009 and anyway, most of our investors have a split between shares and bonds.  They are already cushioned against the worst of the market wobbles. In my opinion having diversity in your portfolio is the best defense for when in markets are like they are today.

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors – feelings of anxiety, fear and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

The increase in market volatility is an expression of uncertainty. The concerns over sovereign debt in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading investors to discount riskier assets.

So share prices on the developed world’s stock markets, oil and industrial commodities, emerging markets and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold and Swiss francs.

Whilst this feels reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction, the focus of concern this time has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

• Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating should have caused US Treasury bond prices to fall.  Unexpectedly their prices rose.

• Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks”, remember someone is buying them. Those people are often the long-term investors.

• Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009 – when market sentiment was last this bad – the S&P 500 turned and put in seven consecutive months of gains of almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

• Remember the power of diversification. While equity markets have had a rocky time in 2011, fixed interest markets have flourished–making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road. All of our clients have diversified portfolios.

• Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving, and a globally diversified portfolio takes account of these shifts.

• Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.