On Target Newsletter
2022.11.12
In this issue:
- Risk in investing
- Xi Jinping’s China
- Money management when abroad
- UK pension funds
- Europe’s energy oil crisis
- Investing in oil
Risk is a Measure of Investment Potential
Risk assessment should be the first step when choosing any investment.
You cannot avoid risk entirely, nor should you – it’s the price you pay for the prospect of higher returns. Equities generally deliver higher total returns over the long term than bonds because they’re riskier.
Sometimes the type or scale of risk you’re taking on is not obvious. In Britain more than a million people suddenly discovered their savings – held through with-profit policies and pension plans – were at risk in Equitable Life, a giant mutual life insurer that was long regarded as one of the most secure. Equitable got into trouble because it misjudged its risk in guaranteeing future investment returns – an expensive mistake for most of its policyholders.
On the other hand, most investors are too frightened of risk.
Investing in equities can be less risky than it seems, as the longer you hold them, the lower the risk. The US stock market has lost as much as 30 per cent in a single day, yet over 20-year periods has never failed to deliver a positive real return.
Hedge funds have the reputation of being high-risk, and some are — yet many are particularly low-risk. They can be effective instruments for reducing the average risk in a portfolio.
There are many different kinds of investment risk. Here are the more important ones:
Specific. The risk that a company or sector will lose value because of circumstances which only or mainly affect them. Examples would be the loss of a contract accounting for most of a company’s earnings, or the catastrophic impact of the 9/11 terrorist attacks on airlines.
Market. The values of a whole category of assets, such as shares, may plunge because of changing conditions or perceptions not specific to the particular asset in which you’re invested. An obvious example would be the bear market in global equities that began in the first half of 2000.
Default. You lose your money through fraud, a suddenly adverse business environment or managerial incompetence that devastate the asset you’ve invested in.
Currency. The risk that the exchange rate of the currency in which your investment asset and the income from it falls in terms of your own monetary unit.
Interest rate. Unexpected increases in rates hit the value of many investments for several reasons. One little-understood but important one is that it tends to boost the rate used to discount the future returns from an asset, which has the mathematical effect of cutting the present value of that asset.
Political. Unwelcome surprises such as riots, a terrorist incident, the outbreak of an epidemic or the election of a radical government can have a sudden adverse impact on the value of assets directly or indirectly linked to the country concerned.
Management. The risk that your company investment loses value because the managers have lost focus or drive, perhaps because of the unexpected loss of an outstanding chief executive, leading to loss of market share, erosion of profit margins and balance-sheet deterioration.
Liquidity. The danger that you won’t be able to sell your investment with ease, without sustaining significant loss. This is greatest when investing in “narrowly-traded” markets – there are few buyers and sellers at any time – such as the shares of small companies.
Purchasing power. The risk that the return on a “locked-in” investment – one that can only be cashed after a set or minimum holding period — will be poor after adjusting for inflation.
Some risks are less well-known, or only apply to specific assets:
Opportunity cost. The risk that you’ll lose out from failing to invest in a fast-rising asset because you don’t have the cash or the nerve to do so.
Last-day or critical-day. Where much of the redemption value depends on asset prices on the last day of its term, or where there is no certainty about the date when it will accrue, such as on the death of the investor.
Manager selection. The risk that the performance of the management to whom you have committed long-term savings, as in a pension fund, turns out to be far worse than the past record on which you based your choice. There can be many reasons for this, such as focus on sectors that go out of favour, or loss of a talented manager.
Individual investors often base their strategies on fallacious perceptions of risk. For example, they are worried about the risk of a 5 per cent loss of original capital but ignore the risk of failing to get a 5 per cent gain when the market moves up. Professionals judge both as similar levels of investment risk.
An American study showed that the risks of primary concern to mutual fund investors are the chances of loss of original capital; of fluctuations in the value of their investment; of loss of real value because of inflation; and of not having enough money to achieve set goals (such as paying for a child’s university education at a future date).
There are several ways in which the risk in a security can be measured:
Volatility. This encompasses all the factors which have contributed to movements in price in the past such as interest or exchange rate fluctuations, profits, tax rates and changes in market perceptions.
The metric most used by professionals to gauge this is standard deviation (SD), which measures the ratio of average upward and downward movements in the price of an asset in relation to its mean or average price or return, typically over the past 36 months.
By comparing the SD of a fund, for example, with its peers’, you can determine whether or not greater or even undue risks have been taken to achieve a higher return.
However, SDs share with other ratios based on historical experience, the deficiency that they may not be a good guide to the future. Volatility over the period considered may have been unduly high due to special factors, as happened with American bonds in the mid-1990s when the US Federal Reserve unexpectedly raised interest rates and there was a financial crisis in neighbouring Mexico.
Correlation. A portfolio invested in a greater number of securities will nearly always have a lower risk than one invested in a smaller number, even if all the securities are high-risk.
Diversification is a basic strategy for reducing investment risk. Good managers ensure that any strategic move into higher-risk assets is accompanied by greater diversification.
The benefits of spreading risk in this way are enhanced by selecting assets which do not have a close correlation with one another – that is, their values do not move in the same direction, or at least not simultaneously.
A share listed in Turkey, for example, is likely to have a very low or even a negative correlation with one listed on Wall Street, as the forces moving its price are likely to be location-specific, such as consumer demand, political instability, or changes in the exchange rates of the national currency, interest rates or tax.
A company depending entirely on export sales is likely to do well precisely when a firm depending on imported products or components is suffering from a weak national currency. Putting one in your portfolio would neutralize the risk in the other.
The metric used to gauge this kind of risk is the correlation coefficient (CC), which shows the extent to which changes in the value of one asset have been linked to changes in the value of another.
A ratio of 1 shows a complete positive correlation (the values of both securities have in the past moved in the same direction, to the same extent, at the same time). A CC of 0.40 would show only a weak linkage, while a negative one of 0.80 would indicate a strong tendency for values to move in opposite directions.
For practical purposes, any CC above 0.70 is regarded as strongly positive, in the range down to 0.40 only moderately positive, and figures below that level to show little linkage.
By careful selection of assets in different markets, managers seek what is known as the “efficient frontier” – the point at which return of the portfolio as a whole is likely to be highest relative to overall risk.
Managers of indexed or “tracker” funds, however, actively seek a perfect positive correlation with the benchmark they are committed to tracking.
Performance. Several measures are commonly used to gauge whether a fund manager has been taking on undue risk relative to the return he has delivered, and relative to his peers’.
The most popular is the Sharpe ratio. It’s the extent to which there has been a return in excess of a notional risk-free rate, such as the yield on 90-day US Treasury bills, divided by the fund’s standard deviation. A simpler modified form, commonly used, ignores the deduction of a risk-free return.
A deficiency of this ratio is that it can be very high for completely different reasons – because of aggressive, relatively high-risk fund management, or because of very cautious, low-risk management.
The Treynor ratio is similar to the Sharpe, but instead of the return in excess of risk-free rate being divided by the standard deviation, it’s divided by the Beta – which is a measure of how a fund has performed relative to a benchmark, usually a sector average or an index.
Another measure of performance-related risk is maximum drawdown. This shows the maximum amount an investor could have lost had he bought or sold a share or fund unit at the worst times. It is expressed as a percentage of purchase capital, and is a kind of worst-case scenario based on historical experience.
Consistency measures the risk that a fund is likely to underperform relative to its peers in any one period, such as a year. It is based on the frequency that a fund manages to achieve outperformance, such as appearing in the top quartile, quintile or even decile (25, 20 or 10 per cent). Funds’ “star” ratings are often based on a combination of Sharpe and consistency measures.
There are other aspects of risk to be considered, such as exposure to exchange rate or interest rate changes.
However, all standard measures of investment risk suffer from the limitations of being based on history (the future may not mirror the past), and of not taking into account the situations and attitudes of the individual investor.
Not only will different investors have different views on what constitutes risk, but also their capacity to accept risk will differ. Clearly a retired couple with little income and a small amount of assets will be less able to risk fluctuations in their investments than a young couple years away from retirement.
Assessment of individual sensitivity to risk should be the starting-point of planning any investor’s portfolio.
China’s Future Under an All-Powerful Xi Jinping
China is now living with the consequences of president Xi Jinping’s mistakes and paranoia, says The Spectator.
The zero-Covid policy has trapped its 1.4 billion people is a series of stop/start lockdowns that have squeezed annual economic growth below 4 per cent – the lowest rate in 30 years.
His savage clampdown on speculation in the property industry, which accounts for two-fifths of the economy, continues to spread its pain. Sales of residential space declined by 18 per cent (annual rate of change) in September.
His “wolf warrior” diplomacy has badly backfired, motivating the Americans to introduce harsh measures to torpedo China’s development of the critically-important microchip industry. Because of these, every American executive and engineer working in China’s semiconductor plants resigned in mid-October.
The Belt and Road Initiative, Xi’s bid for global domination by sponsoring infrastructure projects in 150 countries is imploding – most of the foreign governments which banked Xi’s $1 trillion in loans are in financial distress. He has built an empire of debt, not of influence.
He has failed to defuse the time-bomb of the disastrous one-child policy – far too many Chinese are living in an inverted-pyramid family structure in which one grown-up child supports two elderly parents. The working-age population is in fast decline.
His shift towards policies that emphasize ideology and national security, downplaying the importance of economic growth, are forcing foreign investors to change their thinking about their future involvement with China.
For years multinationals devoted a huge amount of management effort and capital to developing business ties with China. That has gone into sharp reverse as ties between America and China have worsened.
Companies that put “too many eggs in the China basket” are being forced into a painful and costly reorientation. If they have too much manufacturing in China – Apple for example makes 90 per cent of world supply of iPhones there – they will have to relocate; if they are too dependent on Chinese consumers they will have to brace themselves for very slow growth for the foreseeable future.
China’s elite are also re-thinking their futures. The wealthiest families are planning to establish themselves outside their homeland as pessimism builds about the outlook for the world’s second largest economy as president Xi tightens his grip, appointing his acolytes to all the top jobs. They have become increasingly worried about Xi’s negative power-plays such as zero-Covid, property squeeze and increasing party control over business management.
A favoured destination for establishing family offices to manage offshore assets is Singapore, where the number of such offices doubled last year to 700.
First Money Moves to Make While Living Abroad
By Chad & Peggy Creveling
Living overseas or pursuing your career while moving from country to country can be exciting and filled with adventure, but it can also add several layers of complexity to your financial affairs.
There are some basic financial steps worth taking that you might not think of before becoming an expat. Even if you’re assisted by your company’s HR department, the added complexity can make day-to-day money management and long-term financial planning a time-consuming and often overwhelming burden.
Below are a few tips to help simplify the management of your finances, save time, and remove some of the stress so that you can focus on the more enjoyable aspects of expat life.
1. Limit the Number of Financial Accounts
Many expats get into the habit of collecting bank, investment, and credit card accounts as they move from country to country, as well as maintaining accounts in their home country. It can soon become an overwhelming task to keep up with it all.
Limiting the number of accounts you maintain will make managing your finances easier. Start with a global brokerage account (or for Americans, a US brokerage account that will work with expats) to hold your investments.
Next, open a premier account at one of the international banks serving the offshore marketplace to meet your commercial banking needs. If you maintain property in your home country or a third country, you may also need to hold an account in that country to collect income and pay expenses.
2. Get a Local Credit Card
If you earn a salary in local currency and can maintain the discipline of paying off your balance each month, then having access to a local currency credit card can make sense.
The card allows you to avoid the foreign exchange charges and international transaction fees that typically come with a home currency credit card. To get a local currency credit card, you may need to show greater proof of your credit worthiness than in your home country (granting banks worry that foreigners could disappear without paying).
An easier option, but with fewer benefits, is a local currency debit card, which functions like an electronic cheque with funds drawn immediately from your bank account.
3. Get an Online Brokerage Account
Using an online brokerage to hold your investments will allow you to manage and access your investments in one account, rather than having them scattered over a number of accounts.
Look for a broker who will provide you with a greater range of investment products at a significantly cheaper cost than your commercial bank or the insurance-linked savings/investment plans that are heavily marketed offshore.
For Americans, the best bet will be a US-based discount broker to avoid the tax complications of holding non-US-domiciled investment products. For non-Americans, look for a global discount broker in an offshore jurisdiction that doesn’t tax nonresidents.
4. Maintain Joint Accounts
There are exceptions, but generally both spouses should have access to the main household financial accounts to ease financial management and to handle any emergencies. If accounts have to be individually owned, consider giving your spouse a power of attorney over the account.
To preserve a degree of financial independence and marital bliss, each spouse can maintain an individual bank account for discretionary spending.
5. Use personal finance software to track spending
It’s easy to lose financial perspective when living overseas and operating in a different currency. Tracking your finances using a multi-currency personal financial planning software program like Quicken can be invaluable.
When you have clear information on your savings and spending, you can make good decisions so that you achieve financial success over the long run and avoid running out of money. If needed, consider taking an online Quicken course to learn the program.
This list is clearly not exhaustive, and many expats have come up with a number of creative ways to simplify life overseas. Use this as a start and add your own.
The Crevelings are Thailand-based CFAs who advise expats on personal financial planning. To learn more, visit their website.
Pension Funds Are Badly Run
The British central bank took me by surprise by stepping in to stem a crisis in financial markets by offering £65 billion to support pension funds. This came about when interest rates soared as market took fright at the prospect of seriously unfunded government spending and income tax cuts. That forced the funds to sell assets (government bonds) to cover their holdings of so-called liability-driven investments.
Years of ultra-low interest rates have driven pension schemes to seek growth to meet their obligations to pensioners by speculating in publicly-listed equities, private equity and hedge funds, with disguised borrowings or leverage.
“By increasing leverage, many UK pension schemes have been operating as badly-run hedge funds, increasing risk for themselves and the whole financial system,” says the well-known pensions fund expert John Ralfe.
Some schemes have been investing in leveraged gilt funds – instruments providing leverage that allow holders to exchange government bonds for cash. If a fund has a typical three times leverage for every 10 per cent fall or rise in the value of the underlying gilt, the value of the fund falls or rises 30 per cent.
As government bonds fell in price the value of the leveraged units fell more. This triggered calls for pension schemes to stump up more collateral on their trades. To meet the collateral calls, pension schemes sold their most liquid assets — gilts. This aggravated the fall in gilt prices, increasing collateral calls in a “doom loop.”
This forced the Bank of England to step in. Having embarked on a policy of quantitative tightening – selling bonds — it suddenly found itself forced to go into reverse, buying assets instead of selling them. Faced with the choice of fighting inflation or rescuing an ailing pension fund system, it had to fight the immediate emergency first… and kick the inflation problem down the road.
Eoin Treacy says that leverage in the pension fund system has been building up for years without causing even a whisper of dissent from regulators. Now that has imploded. This is “a perfect example of how financial sector regulation is about box-ticking and virtue-signalling rather than addressing clear risks in the system.”
Europe Mishandles Its Energy Crisis
Natural gas prices have been falling sharply in Europe as milder weather and continued filling up of storage eased immediate supply concerns, taking stockpiles to 94 per cent. But 2023 is expected to be a tough year. The current winter is likely to avoid a crisis, but without any repeat of the inflow of gas from Russia that boosted inventories in 2022, the following winter is expected to be very difficult.
Europe is mishandling its energy crisis, The Economist reports. In particular, it has failed to exploit its own gas reserves.
The Netherlands boasts a gasfield in Groningen which could, without any new infrastructure, provide about half as much gas as Russia used to supply Germany, yet production is minimal and the field is scheduled to close by 2024.
The Dutch government fears the wrath of local homeowners who suffered in the past when fracking triggered minor earthquakes.
Only about 22,000 houses are assessed as being at risk of damage should the field produce at full capacity. The costs of compensating those homeowners… or indeed all residents of Groningen… for their losses would be only a fraction of the revenues that could be earned from the field’s gas.
“Closing the Groningen field, as scheduled, would be astonishingly blinkered,” says The Economist.
Tailpieces
Oil: Christopher Wood, Jefferies’ global head of equity strategy, says he maintains his bullish view on oil and energy stocks following years of lack of investment as a consequence of intense political campaigning against fossil fuels.
To two years energy has been the best-performing sector of the stock market – up 55 per cent on a total-return basis last year, and up 58 per cent so far this year.
New Zealand: Its government plans to tax herds of sheep and cattle to cut their methane emissions, a greenhouse gas with 80 times the warming effect of carbon dioxide. Roughly 40 per cent of the world’s methane emissions come from agriculture, from the belching and defecation of animals.
New Zealand intends to introduce a tax based on number of animals (it has five times as many sheep as people), farm sizes and efforts of farmers to mitigate emissions. Livestock forms the backbone of the country’s large meat and dairy industry. Farmers are expected to campaign vigorously against introduction of the tax, which is likely to be an issue in next year’s general election, which prime minister Jacinda Ardern could well lose.
Asylum-seekers: In September the number of illegal immigrants arrested after entering the US reached a new record high for a year of 2.2 million. When Joe Biden took over as president he immediately relaxed measures introduced by Donald Trump to suppress the inflow.
The Federation for American Immigration Reform reports that the total number of people who have entered the US illegally since Biden became president has climbed to 5½ million. That figure includes an estimated more than a million who entered without being detected by US Customs & Border Protection.
Brazil: Although the Leftist Luiz Inacio Lula achieved victory with a wafer-thin majority in the presidential election, he’s expected to have a hard time delivering on his promises to voters. Congress and several of the biggest provinces are controlled by parties opposed to him and powerful groups such as agribusiness and the evangelical churches.
The new government is expected to reshape foreign policy to become more like Turkey in taking a middle-of-the-road position on Ukraine.
Australia: Although it has reopened the borders it closed in a savage response to the pandemic, there has been only a feeble recovery in the volume of backpackers returning to jobs in farms and the hospitality sector.
Before the pandemic, backpackers suppled 80 per cent of seasonal farm labour. The number of visas issued to for “temporarily resident working holiday makers” plunged from 141,000 at end of 2019 to 44,000 in July.
Covid vaccines: Janine Small, a Pfizer director, admitted to the European Parliament that its Covid-19 vaccine was never tested to see if it would stop transmission of the virus before being marketed last year, and wasn’t designed to do so. In other words, the claim made worldwide by governments that paid billions to buy the medicine to encourage their citizens to “get vaccinated to protect your loved ones and those around you” was based on a lie.
Ireland: According to a poll for the National Youth Council of Ireland, seven out of every ten Irish people aged 18 to 24 are contemplating moving abroad in search of a better quality of life. Young people complain about the soaring cost of living, particularly of housing. Property prices have now surpassed the peak of the Celtic Tiger boom in April 2007. The median price of a home is now nearly €300,000. Ireland is now the most expensive country in the European Union.
Japan: The government has unleashed a $200 billion stimulus package to counter the impact on consumers of soaring commodity prices and falling yen. In October Tokyo spent a record $43 billion in an increasingly intense battle to stem the decline in the value of the yen as it plumbed 32-year lows. Like all other currencies, it has suffered this year from a strengthening in the US dollar.
Cryptocurrencies: Like those for other markets, they’re taking a hammering. In its first year as an exchange-traded fund the Bitcoin Strategy unit, which was the world’s most successful new ETF when it listed in October 2021, has lost more of investors’ dollars than any other ETF debut, one year after its record-breaking launch.
Uranium: Prices have been flirting with six-month highs after jumping 9 per cent in October. Canada’s Infrastructure Bank has committed a billion to fund development of a 300 megawatt small modular reactor in Ontario over the next decade.
Sanctions: Japan is refusing to support the anti-Russian policies on oil and gas of America and Europe. Its giant Mitsui and Mitsubishi groups have decided to retain their investments on Sakhalin, the Russian island north of Japan’s Hokkaido.
Turning against woke policies: According to a new study by management consultants KPMG, a majority of American chief executives are planning to suspend, or at least reconsider, their environment, social and governance investments because of growing recession fears.
The US economy: A brutal fall in the stock market saw $1 trillion wiped off the value of a handful of Big Tech stocks in a few days at the end of last month as investors reacted to the increasing likelihood of a recession.
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