Benchmarking and Why Insurance Backed Investment Projections are Bad for Your Financial Health

jamal-investme2It is standard that all investment managers who either have separate investment mandates or mutual funds will benchmark their performance against an index.

This helps the client and advisors in setting expectations and giving themselves the ability to compare an active investment manager vs a passive investment.

However, Insurance backed savings and investment schemes do not do this.

They take a gross performance of an underlying asset class and then make projections on the return of your savings or investment plan.

These projections have nothing to do with reality and as such set the wrong expectations for the investor.

It is a well-known fact that 50% of investors do half of what the market does. Also, the projected returns by the insurance companies do not include the fee structures which at the time of writing can be as high as 4-5% p.a.

It is not surprising that clients are feeling disappointed. In this instance, the wrong expectations are being set and, it is most unlikely the client will achieve his or her goals.

Why are these projections from insurance companies not based upon the average return of their clients?

Take time to absorb that statement.

The insurance companies have empirical data to be able to benchmark their clients returns against the index’s so it is not a lack of technology.

I will make an intelligent assumption, if they showed the average performance of client’s vs the projection, no one would invest this way.

Protection and Investments do not belong together. They contradict themselves. Investments are a cost conscious structure, insurance is not.

Wanted to invest and save in the UAE but heard too many scare stories? – Use these tips for successful investing

investment

There are new UAE rules regarding insurance products about to be introduced. They will benefit the consumer but I still think they do not go far enough.

Most of my readers know that I am not a fan of insurance backed investment products, due to the lack of flexibility. The fees involved, the punishing exit fees, the lack of clarity no disclosure and almost impossible to make money.

It is because I believe that the costs still far outweigh any service received. To quote one of my favourite investors Warren Buffet:

“Price is what you pay, value is what you get” jam

If clients knew what they were paying for a typical insurance backed savings account. They would run a mile. 18 months’ premium in fees? Redemption fees that almost wipe out your savings. Total fee structures that can work out about 6% p.a.

There is a change coming, the industry is fighting this change, but it will come.

Let’s look at alternatives.

There are three ways we can invest or save.

a. DIY investing: cheaper and can be fun with lots of risk and most likely underperformance.

b. Advisor directed: a qualified advisor giving advice, you say yes and “caveat emptor” is the result.

c. Discretionary investment management which should only be offered by individuals who have extensive experience in the investment industry and advanced educational credentials, with many investment managers possessing the Chartered Financial Analyst (CFA) designation. Discretionary investment management used to be generally only offered to high net worth clients who have a significant level of investable assets. However this is now changing and can even be used on a savings account.

If only it were that simple.

Yes, fees do make a difference, but unless you put all the pieces of the puzzle together it will not work.

What will affect my returns

  • Costs
  • Advisor remuneration
  • Market timing
  • Asset allocation
  • Investor psychology
  1. Costs:

Paying exorbitant commissions does not mean you get value. The higher the total fees, the more you must make just to stand still.

Fees can be broken down to

  • Advisory fees
  • Platform fees
  • Transactional fees
  • Discretionary management fees
  • Fees within the underlying assets such as mutual funds, Exchange traded funds etc.

It is imperative that you get all these fees to below 2% p.a.

  1. Advisor remuneration:

If an advisor is paid commission, he has a short-term goal and little incentive to look after the client long term. As such the investment structure, may be good for today, however where should you be tomorrow?

If an advisor is paid an ongoing fee, he is rewarded if he looks after the client. As client’s needs change then the advisor will be there to help and advise. When the markets get volatile the advisor will be the steady hand guiding you past these difficult times.

Compensation drives behavior, the wrong compensation drives the wrong behavior.

Ensure that the advisors goals are aligned with yours.

  1. Market timing:

I can name many top investment managers, but I am unable to mention one single top market timer for the simple reason that market timing does not work

There is empirical data that shows that market timers underperform the majority of the time.

In fact, market timing is one of the most dangerous words when it comes to investing.

Just as people go to Vegas to beat the bank, some may beat the bank, however most will not.

Market timing will often result in not being in the market when it goes through above average returns.

  • The market returned 8.18% on average during these 20 years.
  • However, if you missed the best 10 days then returns dropped to an average of 4.49%.
  • If you missed the best 20 days during these 20 years, the returns dropped to 2.05%
  • 60% of those best days happened within 10 days of the worst days.

I.e. when the market capitulates, you are either already out or this is where most now leave. They then miss this massive rebound. That is why we have this huge under performance.

  1. Asset allocation:

Asset allocation has a bigger effect on people’s portfolios than one imagines.

Diversification reduces risk and volatility. Many people buy different equity investments and think that they have diversified. However, if they are similar assets all you have is a concentration of risk without even realizing until it is too late.

As an example, we have seen equity draw downs from peak to trough of 54.5% yet a diversified portfolio into low or non-correlated assets would have seen peak to trough of about 25%.

In fact, over a 20-year period an asset allocation model had an average return of 8.27% (20-year average to Dec 2013) while the S&P average was 8.11%

  1. Investor psychology:

We often hear about performance numbers, but as Winston Churchill once said “I only believe in statistics that I doctored myself. Herein lies the problem.

The stock market returned on average 8.18% (S&P 500 1996-2015) however the average investor only managed about 4.5% during the same period.

Why such a discrepancy? A. Investor Psychology.

An investor will use his logical thought process to help determine his risk profile. However, when markets get volatile the investor then reverts to emotional behavior.

The result is panic and exiting the market and beginning to revert to market timing. This is the worst thing that can happen.

One of the ways to prevent emotional decisions is to work with an advisor who will guide you through these tough times or to have your funds managed by a professional discretionary manager. This mistake costs the average investor 4% p.a.

To summarize,

  • Very hard to do yourself.
  • Keep costs low
  • Your advisor is your employee, the advisor is not a friend, he performs a service and is paid for it.
  • Only fools think they will win long term with market timing. It does not work.
  • Spread your risk in different asset classes
  • Remove your emotional buying and selling decisions by having your portfolio managed by professionals.

Gordon Robertson ACSI

http://investme.ae/

Investme Financial Services LLC – Dubai

Investing in Government Bonds would this be low risk or high risk?

I was visiting a friend of mine a few days ago and she showed me a suggested investment strategy offered by her bank. She asked me to have a look and voice an opinion.

She is slightly risk averse as this is her retirement money.

The suggested investment was a mutual fund owning government bonds with a maturity of 20-30 years. The bank suggested that if she leverages this investment her returns could be very attractive.

It is true that the fund has had good performance in the past, and was not very volatile. However, this is where we come to the terminology “past returns are not a guarantee of future returns.”

So, I decided to sit down and explain the way bond markets work. We have had 30 years of declining interest rates, as such the only way for bonds to go, were up, a continual price increase with declining interest rates. We are now already in negative yields and if you were to buy bonds now or invest in a bond fund it would be in the hope of capital appreciation and not yield (interest income). I saw a blank look on her face, so I decided to do some basic explaining how the bond market works.

I wanted to explain the terms coupon, yield and yield to maturity and explain how the interest rate moves affect bond prices.

For the sake of simplicity, I decided to start with simple explanations about what these terms are:

Bonds: governments finance deficits by issuing Bonds. These are none other than an I.O.U. (Promise) that the government will pay you interest and a return of your investment if you lend them money. This will have a fixed interest rate and duration.

Coupon: The interest paid on a bond expressed as a percentage of the face value. I.e. the bond is priced at 100, the interest paid is 7 so the yield is 7%

But bonds prices go up and down and rarely would stay at the price of 100.

We refer to this 7% as the “nominal yield”

Yield: Current yield = nominal yield/market value of the bond.

I.e. The bond is trading at 90 and you are getting 7 coupon, then the yield would be 7/90 = 7.8%

However, the bond trading at 90 would go to 100 at maturity. As such you would receive the coupon of 7 plus an annual growth to 100. This is referred to as Yield to Maturity.

Yield to Maturity: This is the total return expected on a bond if held to maturity.  This is important as this is the true yield and value that you are getting.

Here the calculation gets a little more complicated as it assumes the coupon is reinvested.

To keep things simple, we will assume that the bond is trading at

  1. 90
  2. It has a 7% coupon
  3. and this bond will mature in 20 years.
  4. This will create a rising value of the bond from 90 to 100.
  5. Then the Yield to Maturity is 8.02%

The bond may be expressed as ABC Corporation 7% Dec 30 2028 price 90

The 7% reflects the interest based on a price of 100. The date is when the bond matures and the price is the market price.

  1. You have a 7% coupon
  2. The yield is 7.8%
  3. The yield to maturity is 8.02%

 

We have seen that the price of the bond fluctuates, and this affects the yield and yield to maturity.

To understand how the price is set, it is compared to the current yield in the market plus a certain amount of risk premium.

I.e. Government bonds have a lower yield than a corporate, lower grade corporate bonds have higher yields to compensate for the additional risk.

Let’s now look at that suggested low risk strategy from this bank.

They suggested buying a fund (which has internal costs of about 0.8%), leveraging it by borrowing money and buying more.

Now we have been in a 30 year declining interest rates scenario, where the yields have gone from 18% down to in many cases zero. We are in bubble territory, it could stay like this for years, but it is still a bubble. The only way this fund can continue to create growth is if the yields keep moving further into negative interest rates. This would have to be substantial to cover the cost of the fund, the borrowing costs and any other commission and fees applied.

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Let’s look at the effect of a 1% interest rate movement on a 30 year government bond. Example if interest rates go up, bonds go down. If interest rates go down then bonds go up.

The longer the maturity date the greater the price movement on the bonds. The greater the profit or the bigger the loss.

If the interest rates were to fall by 1% then the value of the bond increases by 19.6%. This explains why for the last 30 years we have seen strong growth in the bond market.

If you believe that the negative or near negative yields will go down further, then prices will continue to rise. However, many people believe we are in bubble territory and this bubble will burst at some stage. In the UK the Prime Minister has said that the wealthy have benefited from low interest rates, but savers and pensioners have suffered. This may be an indication that she is thinking of reversing interest rates. Inflation is due to rise in the UK due to the falling pound, this will also put pressure on raising rates.

We know that if interest rates fell by 1% then we could expect to see a value of the bond rise by 19.6% however if the opposite happened and the rates rose by 1% then the value of the bonds would drop by 20%.

 

Think of this, a so called low risk investment can easily suffer a 20% loss by a mere 1% interest rate increase, and if your portfolio was leveraged two times, then the losses would be 40%

Be wary of the bond market. It has more risk than most people expect.

If you have any questions, please contact Gordon Robertson

gr@me-group.ae

 

 

 

 

Funds: The Dogs of 2014

It has been a while since my last update.

I have recently being reviewing funds from the UK that have seriously underperformed the bench marks for three years, i.e. greater than 10%

It would make sense to switch out of them as they are costing you money.
Here is the list of the worst in each sector.

Continue reading Funds: The Dogs of 2014

Staying In The Stock Market – Making The Right Decision

The current market’s gyrations have provoked many investors into making rushed decisions while some have already exited or are thinking of exiting the stock market. In reality, this is a one of the biggest investor mistakes. We’ve been in this particular situation before we will be there again but history has that an all-or-nothing approach to the market is considered a losing game over time.

Continue reading Staying In The Stock Market – Making The Right Decision

What You Need To Know About Structured Products – or Why I Don’t Like Them!

Today, there are investment products that are offering both growth and deposit protection, but can only provide too little of either. These investment products are called ‘structured products,’ and they are partly blamed for the financial crisis in 2008. Simply because the large banks who are buying these products knew little of what they really are as well as the large banks selling them.

This is also a similar situation when you engaged in buying protected equity bonds, which is considered as one form of structured products. The main issue involve with structured products is the fact that they are not protected by the Financial Services Compensation Scheme. Although we don’t have the necessary tools and info to thoroughly analyse these products.

Continue reading What You Need To Know About Structured Products – or Why I Don’t Like Them!

Mirror Funds vs. Actual Funds

Thousands of savers are most likely to be missing out on significant gains because their money was invested in mirror funds based on a new research conducted by the Worldwide Financial Planning or WFP.

Basically, investor’s money should be directly invested in a particular fund, for example Invesco Perpetual High Income or Fidelity UK Special Situations Fund. However, several pension firms offer access to these fund via their own products, so rather than putting the investor’s money into the actual fund they will invest it in the life company’s ‘copycat’ version. With this scheme, the investors can only expect lower returns compared to the money being invested in the real thing according to WFP. Pension firms such as AIG, Friend’s Provident, Life Offices, Canada Life and Scottish Mutual offer these types of schemes.

Continue reading Mirror Funds vs. Actual Funds