Investment techniques have evolved dramatically over the last fifty years and markets have never been so competitive, so generating good returns consistently is more difficult than ever. EQ is a discretionary investment manager who can take away the hassle of constantly reviewing markets and ensuring that portfolios are optimised.
The most important decision we make as Portfolio Managers is the distribution between each of the main types of investment such as:
Equities (shares in companies based anywhere in the world)
Commodities (metals, oil and gas, agricultural products)
Alternatives (such as hedge funds)
The amount we invest in each will vary depending on the level of risk you are happy to take and on our opinion of the relative attraction of each asset. Typically we will reduce the amount invested in Equities for lower risk profiles.
We periodically adjust the amount allocated to each asset depending on our views on the various markets. Periods when the trend in stockmarkets is upwards are called Bull markets and the opposite Bear markets. It would be very helpful if we could predict accurately when Bull phases are coming to an end but markets don’t work like that. They constantly reflect the views of all those participating, so attempts to predict the timing of changes in direction are futile. In fact they can seriously damage your wealth: the Dalbar Quantitative Analysis of Investor Behaviour measures the impact on US investors and the conclusions are stark.
Although we are sceptical of the potential to time accurately when markets will change direction we do take a view on their relative attractions. We focus on the Cyclically Adjusted Price/Earnings Ratio (‘CAPE’) developed by Nobel Laureate Robert Shiller. Shiller has shown that if you buy assets when they are cheap and wait long enough you will earn excellent returns. We supplement this by also looking at other measures, such as Momentum. Once markets start to move in one direction they usually carry on for a while.
Our aim is try identify the very best fund managers in each specialist sector, whether that be Japanese Smaller Companies, or US High Yield Bonds or Property. Fewer than 1 in 10 active managers beat their benchmarks in the long term, so it is essential to be highly selective.
Identifying the best managers is more complex than most people realise. Numerous academic works have shown that simply looking at past performance is next to useless in terms of predicting the future, mainly because more than 90% of stock market price movements are believed to be random noise. Therefore, we have developed a bespoke screening system to make sense of the performance numbers and to act as an initial screen to weed out those who show no evidence of skill.
Fewer than 1 in 10 active managers beat their benchmarks in the long term
Then we meet the fund manager and quiz them on their techniques, trying to establish if their process is sound and repeatable. Over time we can build up a clear picture of their thought processes. This leads to the production of a detailed report which is then reviewed by our Fund Selection Committee.
Every fund manager will have periods of poor performance from time to time when their style is out of favour. Our job in those periods is to try and make sure that nothing fundamental has changed. Perhaps the manager is spending too much time on marketing, or the fund might have become too large to manage in the same style? In the investment world circumstances change continually and it’s our job to keep reassessing.
The final part of our investment process is to build a portfolio in line with the asset allocation guidelines that have been set from the small universe of funds that meet our quality standards. Typically we will hold at least 20 different funds in each portfolio to give us the optimal balance of quality and diversification.
Selecting the right combination of funds requires a knowledge of their ‘style’ characteristics. If we build a portfolio that is biased sharply towards a particular style then this will affect the performance when that style is in, or out, of favour. Building a portfolio a bit like designing a gourmet recipe: it’s not just the quality of the ingredients, its the way in which they work together.
Building a portfolio a bit like designing a gourmet recipe: it’s not just the quality of the ingredients, its the way in which they work together
The most important style factors are:
Value vs. Growth – value stocks (those that trade on a low rating) outperform in the long run but can encounter long periods when they lag
Capitalisation – smaller companies generate larger returns in the long term but are more risky
Momentum – stockmarket trends usually persist (but when they do reverse it can be savage!)
Yield – high yield stocks seem to perform better
In order to do this analysis our team make full use of a number of industry leading analytical tools, including Bloomberg, Morningstar and Style Research. We also need to check that the risk profile of the portfolio is compatible with the parameters.
Monitoring & Rebalancing
Over time the allocation of assets within a portfolio will change as various markets move in different directions.
As part of our review process we will regularly rebalance portfolios. This is a very important process that helps to improve the risk/reward profile of the portfolios.
In effect it involves selling assets that have become expensive and reinvesting in those that are cheap.
We will also be alert to any changes in circumstances, both in the big picture and at the fund level. If a fund manager moves, or we sense that a fund has become too large to be managed efficiently then we will make changes.
How we invest
The EQ investment process has been designed to reflect the best practices of investment managers around the world.
Investment markets are changing constantly. Portfolio managers need to be alert for the need to rebalance to take account of new circumstances and to rebalance following large market movements.....more
Actively managed funds rely on exploiting inefficiencies in markets. This is harder to achieve in some areas, especially when investing in the largest quoted companies where there is a multitude of high quality research available.....more
Active or passive funds?
Actively managed funds rely on exploiting inefficiencies in markets. This is harder to achieve in some areas, especially when investing in the largest quoted companies where there is a multitude of high quality research available.
EQ is agnostic about the merits of passive funds: if we are not convinced that the extra costs of active management can be compensated by superior performance, we will invest in a low cost passive fund. We also offer a range of ‘passives only’ portfolios to suit clients who want to keep costs down to a minimum.
The benefits of each approach include:
Over the long term most actively managed funds underperform their benchmark. Therefore a passive fund can provide some certainty of above average performance.
Some markets, notably US large cap equities are highly efficient and therefore difficult for active managers to exploit anomalies.
Passive funds are cheaper and this has a direct impact on performance.
Are not confined to investing in the largest companies. Therefore they can seek out great investment opportunities and exploit valuation anomalies in less researched shares.
Are able to avoid expensive or hyped up companies and sectors, hence minimising the impacts of ‘bubbles’ such as the tech boom. They can also hold cash (to some extent) if they believe markets are overvalued.
Good fund research can identify that small number of fund managers who are capable of delivering long term performance.
We are not the homogenous, rational participants envisaged by the creators of the efficient markets hypothesis.....more
Emotion is good but not for successful investing
We are not the homogenous, rational participants envisaged by the creators of the efficient markets hypothesis.
Successful investment requires cool rational thought at all times. Sadly, the human brain is badly equipped for this. We overreact to fear because the amygdala, a part of the brain that controls our responses, has only evolved a little from the period when threats came in the shape of sabre toothed tigers. The consequences of a market decline are considerably less serious but our brains don’t really understand that.
We also tend to be overconfident about our level of knowledge and the quality of information we possess. That can lead to greed taking over and affecting our judgement. If things then go badly we suffer remorse, which also disrupts behaviour.
All humans have these failings but the very best investors, like Warren Buffett, have found ways to control their emotions to minimise errors.
EQ tip: Don’t panic when the markets enter a period of turbulence and make sure you’re happy with the characteristics of your portfolio
The tendency to retain a losing position may cost an investor dearly.....more
Face up to losses
The tendency to retain a losing position may cost an investor dearly.
If you make an investment and it drops in value your reaction is likely to be to resist selling until it at least returns to the purchase cost. Humans are poor at coping with errors and so our approach tends to be to ‘anchor’ ourselves at the price we originally paid. We persuade ourselves that we will eventually be proved right.
There is nothing shameful about making a mistake, professional investors do it all the time. It’s how you deal with it that counts. The pros try to look at all their holdings dispassionately with no regard at all to whether they are standing at a profit or loss (unless there is tax payable on disposal).
EQ tip: ask yourself: would I buy this investment today? If the answer is ‘No’ then you probably should not continue to hold.
Academic studies have demonstrated that even for professional investors a strategy of trying to second guess market moves is unlikely to be successful.....more
Market timing is futile
Academic studies have demonstrated that even for professional investors a strategy of trying to second guess market moves is unlikely to be successful.
In April 2015 academics studying the performance of multi-asset funds managed by professionals concluded: “we find overall that asset class timing skills ….is rare, existing only among a tiny minority of funds.“ (source: Clare, O’Sullivan, Sherman and Thomas)
For the private investor timing decisions are most commonly linked to concern that markets are going to fall and thoughts that it might be beneficial to sell now, or defer an additional investment. Human brains cope badly with financial stress and start to fear the worst, even though it hardly ever happens.
Most people only start to worry about the direction of markets when there has been a flow of bad news. When we read about it in the press, prices will already have dropped because markets react instantly to known facts. If you do decide to sell, or defer a purchase then it will only be profitable if you are prepared to buy when the news is even worse. Most people are not that brave. Consequently, they miss the market bounce and then become ‘anchored’ on the level at which they sold. Many only get round to buying when prices are much higher.
This behaviour has been measured in the USA for over 20 years in the Dalbar Quantitative Analysis of Investor Behaviour (QAIB). It shows that this behaviour has cost investors a large part of the returns they would have earned by just staying the market.
EQ tip: over the long run it’s not market timing that wins, it’s time in the market.
Regularly adjusting the mix of investment assets in your portfolio to keep it in line with your goals is critical.....more
Portfolios need regular rebalancing
Regularly adjusting the mix of investment assets in your portfolio to keep it in line with your goals is critical.
Investment portfolios have some characteristics in common with gardens: they need regular maintenance to keep them in order. Just as some plants grow faster than others, the same will happen with your investments, which increases your exposure to the more successful constituents. This might appear to be a good thing but it means that your portfolio is losing its original balance and probably becoming more risky.
For example, over the long term equities should perform more strongly than bonds and cash. If you start with an exposure of 60% to equities, this will rise over the long term, in turn increasing the level of risk you are taking with your money.
Rebalancing should be carried out at least annually
Simple rebalancing effectively means taking the top off your winners and topping up the laggards. In effect you will tend to be selling down holdings that have become overvalued and buying more of those that appear cheap.
Rebalancing should be carried out at least annually. As long as you are not paying transaction fees then a more frequent approach can help, especially if there have been some big market movements. It is also important to consider any taxation implications – it might not be worthwhile to incur Capital Gains Tax.
EQ tip: rebalancing is one of the few ‘free lunches’ left in markets. It’s an essential part of efficient portfolio management.
When it comes to investing, playing it safe can mean only generating modest returns.....more
Downside of being excessively cautious
When it comes to investing, playing it safe can mean only generating modest returns.
Investing money is very different to holding cash in a bank account. When we place our first investments, we need to teach ourselves to understand the concept that we could lose money. If we let our apprehension take precedence we can end up with a relatively cautious portfolio, even though the timescale of our investment could be decades (e.g. for a pension). This is likely to result in significantly lower returns.
First it’s important to understand that market fluctuations are an essential ingredient of investing. If you are investing for a long period (over 10 years) via regular savings then you should actually welcome market setbacks. They result in your new contributions being invested at a more favourable price.
The evidence historically has been that the highest returns are generated by ‘real’ assets
If you are investing a lump sum then you can replicate this effect to some extent by phasing your investment, possibly into four tranches over the course of 12-18 months. Again, this protects you from the understandably disappointing result of investing all your money just ahead of a big market fall and then rueing the day for years.
When it comes to the underlying content of your portfolio, the evidence historically has been that the highest returns are generated by ‘real’ assets, namely equities and properties, rather than fixed interest bonds (though the latter did perform extremely well for 30 years after 1982). Therefore, if the timescale is long it usually makes sense to have a high exposure to real assets.
When your attitude is risk is assessed look carefully at the results. If it suggests that a Cautious portfolio is recommended even when your timescale is measured in decades it will be worth double-checking some of the answers to your questions. However, if you are a beginner and likely to panic when markets drop then it may be better to tolerate lower long-term returns.
EQ tip: if you are investing for the long term try to come to terms with volatility – it’s an inevitable consequence of maximising returns.
You need to ensure that your portfolio is a mix of different asset classes and globally diversified.....more
You need to ensure that your portfolio is a mix of different asset classes and globally diversified.
Investing in assets such as equities will generally provide the best returns over the longer term, but your returns only matter when you want to access your capital. These investments will fluctuate in value and those that do so most will (generally) have the greatest potential for return.
Not all investments fluctuate in the same way or indeed in the same direction. Some investments might be rising in value whilst others are falling. We call this ‘negative correlation’. By combining assets that correlate differently, we seek to build diversified portfolios that will maximise returns for a given level of risk.
One of the problems with diversification is that correlations between different assets vary over time. Usually fixed interest bonds represent a source of protection during equity market falls but that’s not always the case.
EQ tip: the overwhelming view of professionals is that broad diversification is a sensible approach.
Avoid risk by spreading out your contributions or withdrawals at regular intervals.....more
Benefits of phasing large contributions & withdrawals
Avoid risk by spreading out your contributions or withdrawals at regular intervals.
Since 1983 the FTSE 100 index has fallen by more than 10% within 3 months (or sooner) on more than 35 occasions. If you had invested your life savings just before this happened, you’d be unhappy and probably less inclined to invest again. You might think that a skilled adviser will be able to predict falls of such a magnitude but the reality is that markets operate in a way that makes that impossible.
The only reliable approach for mitigating your risk of being unlucky with timing is to spread your bets. A common approach might be to split the investment into four chunks which can be invested at regular intervals over 12-18 months.
If the timing of a phase is in the middle of a period of market turbulence you might be tempted to wait but this must be resisted. Stay rational and stick to the plan.
EQ tip: phasing takes much of the stress out of large new investments or withdrawals.
EQ Investment Services
EQ provides discretionary investment management services to clients ranging from those with a few thousand pounds to those with tens of millions. Find out how EQ can help you with your money.
10 Common Errors
Investing successfully is difficult and time consuming. In this guide EQ illustrates some simple errors made my many investors that can have a big impact on returns.
Despite the resilience of the UK economy since the EU referendum we are concerned about the implications of rising inflation on consumption and political uncertainty. more...
Despite the resilience of the UK economy since the EU referendum we are concerned about the implications of rising inflation on consumption and political uncertainty.
The UK economy remained resilient after the Brexit referendum vote, but data is now becoming less positive. We are concerned that rising inflation will reduce consumers’ ability to spend. In addition, the government’s position has been weakened after losing their majority which can only add to uncertainty going into the Brexit negotiations. We expect this to continue to weigh on business investment. While valuations remain reasonable and momentum is strong, we remain cautious and are not adding to our UK exposure.
While political risks are present, the improvement in growth, reasonable valuations and light positioning are hard to ignore. more...
While political risks are present, the improvement in growth, reasonable valuations and light positioning are hard to ignore.
Investors substantially reduced their allocations to European equities over the last few years as the European recovery lagged that of other developed markets. This now appears to be reversing with improving economic growth and corporate earnings drawing money back in to the region. Emmanuel Macron supported this narrative by winning the presidential and parliamentary elections in France, a big pro-EU vote. These elections had caused significant anxiety so this gave a real boost to investor sentiment towards Europe. However, political risks may continue to present concerns, we have German elections this summer and Italian elections are likely in 2018. Assuming political stability remains, European equities look to be well positioned for growth. We have increased our European exposure – our most significant shift this quarter.
US equities have performed strongly in the wake of Trump’s victory, but investors are now looking for actions to justify the optimism. more...
US equities have performed strongly in the wake of Trump’s victory, but investors are now looking for actions to justify the optimism.
US equities performed strongly in the wake of Trump’s victory, in anticipation of pro-growth policies and deregulation. However, these policy promises have not yet materialised and investors are growing frustrated at a lack of action. As such, we’ve seen many of the ‘Trump Trades’ fall away over recent months. If Trump fails to deliver and sentiment continues to fall, we could see a variety of US equity sectors underperform. So, in spite of strong US growth, we have a neutral view on US equities and have slightly reduced our allocations.
We have a positive view on Japanese equities. more...
We have a positive view on Japanese equities.
We maintain a positive view on Japan due to strong momentum (momentum refers to the current market trend – an important indicator of future performance). There are signs of economic recovery in the form of wage increases and higher credit demand. This, alongside attractive valuations, drives our moderately positive view on Japanese equities.
Reasonable global growth and steady US rate hikes create a good climate for Asian equities. more...
Reasonable global growth and steady US rate hikes create a good climate for Asian equities.
Asian equities have performed well since Trump’s election, buoyed by improved global growth, steady US rate hikes and stability in China. This is a marked improvement from a few months earlier, when investors were concerned Asian economies would buckle under the weight of US rate hikes and protectionism. We view this period as confirmation that Asian equities can perform well in the current market, and are maintaining our exposure.
We still hold a slightly negative view on government bonds, and remain mildly positive on high yield bonds. more...
We still hold a slightly negative view on government bonds, and remain mildly positive on high yield bonds.
Government bond yields increased sharply after Donald Trump’s election, rising on expectations of fiscal stimulus, deregulation and increasing US growth. However, markets are now taking a dimmer view after his first few months in power, and we have a reversal with yields falling sharply and prices rising. We have slightly increased our allocations, but our overall view is still negative.
High yield bonds offer both greater yields than government bonds and a lower sensitivity to interest rates. We see both high yield and investment grade as expensive versus history, but remain slightly positive on both as in a world of low returns their yields are attractive. We marginally prefer high yield due to the higher yield and lower sensitivity to interest rates and our allocations remain unchanged.
We are now neutral on property, a slight improvement on our previously negative view. Although we have concerns about the trajectory of the UK economy, the yield on property is attractive relative to other asset classes.
We are overweight alternatives, mainly due to our negative views on other asset classes. more...
We are overweight alternatives, mainly due to our negative views on other asset classes.
We see risks to many equity and bond markets, and could even envisage a situation where both move down together. Given these concerns, we’re maintaining a higher allocation to alternatives, which typically exhibit a low correlation to conventional asset classes.
We have limited exposure to energy equities. more...
We have limited exposure to energy equities.
Industrial metals and energy performed very well over the past year, as the oil market recovered and China extended their fiscal stimulus. But these forces appear to be reversing with the US producing more oil than a year ago and China tightening both monetary and fiscal policy. Oil is now down significantly from its January peak and there is little to suggest that this will reverse. Overall, we do not feel positive about commodities. We do not hold either gold or silver in our model portfolios. As these assets can benefit from high uncertainty and political shocks we may include them in our Bespoke clients’ portfolios on a case by case basis.
We are holding higher levels of cash than normal. more...
We are holding higher levels of cash than normal.
Our analysis shows many developed world equities and bonds to be expensive versus history. Investor sentiment has improved substantially since the US election with commodity prices and inflation both rising. But we believe this sentiment could reverse sharply which would have a negative impact on equities. As a result, we feel it is prudent to maintain a higher than average level of cash.
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