Q2 2015 Review

This quarter has seen some relatively exceptional movements in the bond market and the resurgence of the Greek tragedy. The volatility has been a long time in the making and we have commented on this expectation in previous quarterly communications, explaining how we position ourselves to optimize the relative risk and return environment.

The consensus is that this volatility is here to stay, so we need to be disciplined and hold the course. We must do everything we can to avoid selling after a sharp drop in the bond market and stick to our long-term plans.

Predicting Football Results and Manager Returns

I recently attended a very interesting course in London given by some Yale professors about Return Predictability and Tactical Asset Allocation. It was amazing to see the level of sophistication academics are using to test financial theories, and to prove and disprove popular beliefs about the drivers of returns. In the opening lecture of this course, the Yale professor presented a seemly simple challenge: How do you decide who is a better penalty kicker between, say, Lionel Messi and Steven Gerhard? (Two famous footballers for those who do not follow football). The relevance being if you can develop a mathematical tool to decide who is the better kicker, then maybe you can use that tool to see who is a better fund manager.

The professor asked how many penalty kicks does one have to watch to make a purely quantitative decision (i.e. without any subjective criteria) in order to conclude who is a better penalty kicker with a reasonably high level of confidence (at least 95% confidence interval or 2 standard deviations from the mean – for the statisticians amongst you)? The reactions amongst the audience of financial professionals varied significantly from 15 to 1000 kicks. The real answer according to the Professor’s calculations, by the way, is about 150 kicks. Equating this to our world of investment manager selection means we need 150 observations. Therefore, that means either 150 months or even 150 years' worth of data to make that purely quantitative, and yet still not perfect, decision. In practice, we do not have that much data on any fund manager, so we have to blend both subjective qualitative data and quantitative data into the process.

The overall conclusion from this two-day high-level course was that it is extremely difficult to predict both returns and market movements, however there were some reasonably practical take-away lessons. It was very interesting to sit with some of Europe’s top wealth managers who are facing very similar challenges and see such a high level of mathematics used to prove scientifically what many already believe. It is somewhat encouraging to know that even though returns are very hard to predict, volatility and correlation can be reasonably predicted over given time periods. These scientific tools are used in our investment approach to manage your money.

Asset allocation

Following the research above that illustrates how it is extremely difficult to predict returns and market movements; we go back to our core methodology and belief in Strategic Asset Allocation. Our models are built using our own assumptions applied to the Nobel winning laureate Harry Markowitz Mean Variance approach[1]. This process gives us a high level of confidence to predict portfolio volatility.

Most clients in Israel refer to their asset allocation as "80/20", i.e. 80% in bonds and 20% in stocks. This is a terrible over-simplification of the asset allocation process and it stems from what the typical Israeli investor has become used to, rather than having any scientific basis. The implication is that the Israeli investor believes that there is no risk in bonds and all the risk is in stocks. This may have been true 10 years ago in Israel, however the bond market has developed considerably and the interest rate environment has changed so fundamentally that there is a lot of risk in bonds too. Further, when Israeli investors look abroad to invest globally, typically they will use the same allocation weightings, even though this is fundamentally wrong. Conservative portfolios in global terms have at least 20% allocation to stocks (compared to the balanced average investor in Israel); balanced portfolios in global terms have closer to 40% or 50% allocated to stocks; and more aggressive portfolios have 80% to 100% in stocks. Another result of this traditional way of thinking is that investors often believe most investors are similar. Even many local Gemel Funds are predominantly in bonds. Looking abroad, for example at Yale University Endowment Fund or the New Zealand Superannuation Fund, you can see that both use less than 20% in bonds. Yale uses only 5% bonds.

Bond Volatility

The main risks associated with bonds are credit risk[2], liquidity risk[3], and interest rate risk[4]. This last quarter we saw a sudden increase in European Interest Rates. Starting with Germany, which was trading at a ridiculously low number of 0.05% per annum, for the 10-year bond and then jumped suddenly due to demand and supply to 0.8%. This means if you held the 10-year German bond, you had a sudden “loss” of about 6%. Global bonds followed, including Israeli bonds. In our opinion, there was no economic reason for this, except simple demand and supply, as the market had overreached to an unsustainable number. Everyone focused on the short-term losses, however using the same logic bond holders “unfairly” gained as the bond rates went lower and lower. I say "unfairly" because in theory bonds are very mathematical: if you bought a bond with a longer-term view, then all that happened was that you earned some future profits earlier and then gave it back. As hard as it is to experience, we should not focus too much on the short-term losses as this may cause us to make the wrong decision for the future.

What does this mean for my portfolio?

Interest rate risk is generally controlled at the level of the portfolio including all the fixed income instruments. We monitor this risk using a tool called duration, which is the maturity of the bond adjusted for the relative size of the coupon. Generally, accepted rules of thumbs are a short duration (being very conservative on rate changes) is under 3 years. A moderate duration is from 3 to 5 years and an aggressive position on interest rates would be positioned at 5 years and above. We suggest you discuss with your advisor what is your portfolio duration.

Brief Summary of Asset Classes Performance in Q2 2015

Following the market reversals in June, the key US stock markets are relatively flat with S&P 500 marginally up year to date[5] at 0.2% and the Dow Jones slightly negative at -1.14%. Nasdaq Biotech has done exceptionally well this year, so far with a 21% gain YTD. Many experts are warning that this sector is looking over priced.

Internationally, Japan has done very well at around 16% YTD and European stocks have done reasonably well, even after the June Greece crises, with the Eurostoxx 50 index returning about 8%. Russia and China's stock markets have all done extremely well returning healthy double-digit returns. This is after both these regions had serious loses at the end of 2014.

As mentioned in the introduction above, bonds have had a bad second quarter with the longer duration bonds ending in the negative territory YTD.

In the commodities asset class, Gold and silver have remained relatively flat, however platinum prices are down about 10%. Oil prices have slowly climbed up about 10% YTD since their sudden sell-off at the end of 2014.

If you held Euros in a dollar reported portfolio at the beginning of the year and still hold those Euros then you would have a translation loss of about 8% on the currency alone.

Outlook for rest of 2015

There are a number of factors influencing how the rest of 2015 will roll out. Firstly, there is the Greek debt debacle, the pressure from which is building every day. Regardless of the various outcome’s which include a Greek default and exit from the Euro, or staying in the Euro with some last minute compromise and a whole host of variations in between, we do not regard this as a systemic risk and therefore we maintaining our strategic allocations to Europe and to Equities in general. If Greece is forced out it will be because of a very tenacious Greek leadership and it will undermine a lot of the work the that the European Central Bank has done since 2012 to create stability and confidence and the result is expected to create a lot of volatility.. Secondly, the main issue for the markets is whether the US Federal reserve will start to increase rates and our base assumption is that they will, but only once. We do not expect the long-term rates to increase, however we do expect continued volatility in the bond market. Investors must remain disciplined.

We anticipate that the equity markets are likely to continue the trends so far this year without any major reversals. We do not expect energy prices to recover to their 2014 levels and since we do not expect inflation, we do not expect any upward pressure on gold.

Israel at a glance

2015 markets in Israel started the year strong off the back of further reducing bond yields. Even though the Israeli stock market finished Q1 with a positive 10% Q2 finished flat. However this is after a 5% gain in April/May and a ~5% loss in June. Even though the TA 25 broke several records during the quarter it finished the quarter slightly negative.

Similar to global markets, the main story of Q2 was the Israeli bond market where much like Germany and USA fell sharply in May and June.

• The government bond index decreased by 3.6% over the quarter and finished at 0.4% YTD.
• The Tel Bond 60 lost 1.6% from the beginning of the quarter and 0.16% from the beginning of the year.

The local bond market is expected to continue to follow the global markets by showing increased volatility. Our view is generally that bonds yields will stay low in Israel longer, following Europe more closely than the USA. There is no way to predict this so we remain only slightly underweight on interest rate risk.

[1] Mean Variance Optimization is a quantitative tool that aims to optimize the tradeoff between risk and return.

[2] Credit Risk – the risk that the issuer cannot repay.  

[3] Liquidity Risk - refers to the price movements because of demand and supply.

[4] Interest Risk - refers to the fact that in theory, bond valuations are mathematical and if rates go up, bond prices go down.

[5] YTD = 30.6.15

The aforementioned information is not a substitute for personal Investment marketing, which takes into account the particular circumstances and special needs of each person. The views expressed in this Review should be considered as market comment for the short term for information purposes only. As such the views herein may be subject to frequent change, are indicative only and no reliance should be placed thereon. This Review does not constitute legal, tax or accounting advice, or any investment recommendation, or any offer to buy or sell financial instruments of any kind, and does not take into account the investment objectives or needs of specific investors. Although this Review has been produced with all reasonable care, based on sources believed to be reliable, reflecting opinions at the time of its writing and subject to change at any time without prior notice, neither Pioneer Wealth Management nor any other entity or segment within the Pioneer International Group makes any representations or warranties as to the accuracy or completeness hereof and accepts no liability for any loss or damage which may arise from its use. The writer and the company are unaware of any conflict of interest at the time of publishing the above commentary.