April 2021

If you have ever been fortunate enough to swim in the azure tropical waters of the Caribbean, or on Bondi Beach amongst the surfers, or in the chilly waters of Cape May (where the film ‘Jaws’ that scared the 1970s generation out of the water was filmed) in the back of your mind may have lurked the thought that a large shark might just be out there looking for lunch. What was that shadow? Yet most of us don’t think twice about the risks of sitting under a coconut tree, which urban myth suggests is far more likely to kill you from a falling coconut than a shark attack, as is the malaria-carrying mosquito that lands on bare flesh as the sun sets in paradise.  Nor did we consider the risk of a deep vein thrombosis from the long-haul flight to get there.  We fixate on the shark.

Humans are irrational and find it hard to place risks in perspective, in part because they involve numbers (which many people hate), are influenced by fear or recent news and often depend on the way in which they are framed, to name just a few of the challenges.  We have a very clear recent example of our confusion with the extremely rare possible side effects of some of the Covid-19 vaccinations.  Latest estimates, suggest that the risk of dying from the vaccine due to blood clots is 1 in 1 million, which is similar to the chance of being murdered next month (nasty) or dying in a road accident on a 250-mile road trip[1] (bring it on!).   And that, is the point.  Life is full of risks and those that we deem to be everyday consequences of modern life, we take, usually without batting an eyelid, such as: driving, using ladders, drinking alcohol, climbing mountains, and walking through fields of cows (nearly 100 people were killed by cows between 2000 to 2020)[2].  Yet other exceptionally low risks we deem ‘too big’ to take.

It is similar with investing.  Investors tend to worry about equity market crashes, perhaps not surprisingly, as equity markets can and have fallen by more than 50% in the past. Yet owners of equities should not be looking to sell them in the next few years but relying on fixed income assets to meet liquidity needs.  In most cases, markets recover relatively quickly over say 3-5 years, sometimes more slowly.  With horizons well beyond these falls and recoveries, investors who stay the course should be rewarded – as they have been in the past – with strong returns above inflation.  The latter is the real (excuse the pun) risk to long-term investors.  Avoiding equity market risk and putting money on deposit is actually the risky strategy.  Over the past 10-years, those holding cash have lost around 1/5, or 20%, or £20 in every £100 of purchasing power[3], however you want to describe it.  That is risky.  Managing risk in our lives is summed up well by Professor Dame Glynis Breakwell who wrote a book titled The Psychology of Risk[4].

‘Risk surrounds and envelops us.  Without understanding it, we risk everything and without capitalising on it, we gain nothing.’

Go on, get the vaccine, take that long haul flight (once you can) back to the azure waters, brave the sharks and stick with your equities.  The risks will be worth it.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

 [1]    https://www.bbc.co.uk/news/explainers-56665396

[2]    UK Health and Safety Executive (HSE) https://www.hse.gov.uk/

[3]    Bank of England – 1 month Treasury bills

[4]    This is not for the faint-hearted – it is an academic tome.  If you are interested in how to use and understand statistics in a statistics-laden world, an enjoyable and accessible read is Tim Harford’s new book ‘How To Make The World Add Up’

Leverage, often referred to in investing as a ‘double-edged sword’, is another word for borrowing money to own more of an asset. Much like a mortgage on a house, it enables individuals to own a higher value of an asset they would otherwise be unable to own, but it does run the risk that the value falls such that one ends up owing more than one owns (coined ‘negative equity’ in the housing world). This is never a good place to be.

Our systematic approach is ‘long only’ (as opposed to taking an element of short positions, which requires borrowing) and unlevered. This means that the investments are owned without inherent borrowing within the funds themselves. Of course, we do believe debt is a powerful tool that corporate finance departments and governments can use to raise capital to fund future growth and we recognise the importance of borrowing in capital markets, but we don’t generally believe that this is a risk worth taking at the fund or portfolio-level. Markets can be scary enough at times like Q1 2020, without magnifying the downside further through leverage.

The potential upside of highly leveraged strategies is magnified returns which can leave investors drooling. The downside could be 100%, or more. As you might have spotted in the press, the family office Archegos Capital Management has been made all too aware of this[1] with the recent unwinding of their leveraged bets which has left some banks, which provided the capital to Archegos, nursing heavy multi-billion pound losses[2].

The reader will be well-aware that borrowing is commonplace in the housing market, with interest rates now at historically low levels. For example, 2-year fixed-rate mortgages are now at around 1.6%[3]. Some will remember times in the 1970s and early 1990s when rates were 10 times this. Although mortgage rates are cheap, few are able to borrow ‘on margin’ on such favourable terms and for most the potential downside of such an approach outweighs the potential benefit.

Although curtailed slightly of late, the rise of retail investors over the past 12 months has been significant and has come with cheaper access to leverage through the trading of financial derivatives. With one of the common questions asked by those ‘YOLO-ing their stimmies’ (i.e. investing their US stimulus cheques) into such investments being “what is the stock market?”[4] one is led to believe these investors are not pursing a ‘risk-comes-first’ approach. Unfortunately, many will learn a painful and costly lesson.

Our default approach is to invest in unlevered long-only strategies. Our risk-focused approach to portfolio construction means that our Investment Committee regularly reviews the risk exposures of your portfolio and seeks to mitigate or avoid those that are unwanted or typically go unrewarded. In general, leverage is one of those.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

 [1] Economist, April 3^rd 2021. “Margin call of the wild: Archegos, a family office, brings Nomura and Credit Suisse big losses”. Also, for a good insight into the backstory: https://www.bloomberg.com/news/features/2021-04-08/how-bill-hwang-of-archegos-capital-lost-20-billion-in-two-days

[2] Succinctly summed up in this meme

[3] Average at 75% LTV. UK Parliament: House of Commons Library, 10^th March 2021. “Household Debt: Key Economic Indicators”

[4] Ft.com, 9^th March 2021. “Rise of the retail army: the amateur traders transforming markets”