If you have to ask, you can't afford it
When shopping on Bond Street it can be a bit embarrassing to ask the price. When investing it should be the first question but some investors seem to have forgotten that.
It is a truism that the dominant determinant of the success of any investment is the price you pay for it. Yet in recent years financial markets have been flooded with money from investors who do not care what the price is. Their motivation is support (or manipulation, depending on your point of view), “liability matching” or replication.
This being financial services, we of course have a catchy name for these investors. They are “Price Insensitive Buyers”. This can be rational. For example, there have always been a lot of them in the currency market. Many investors, and a lot of global companies, hedge assorted currency exposures at the time they incur the potential liability, not based on the price.
Since 2008, central banks around the world have been Price Insensitive Buyers of assets, particularly bonds. Their motivation is a combination of wanting to keep the level of interest rates low and to encourage other investors to do something different with their money than lending it to governments and receiving a de minimis return. They execute based on the calendar, buying a certain amount of bonds in a certain amount of time. There is no mention of the price (or yield) that they will buy at. The central banks of the US, UK, Japan, China and the euro area have bought $20 trillion, one third of the global bond market, this way.
Other investors in the bond market, such as pension funds, can also be price insensitive. They will have a target for bond purchases based on the exposure they need to match some level of their liabilities. If the price changes after they have decided on the strategy, they simply buy more (or less) of the asset. They too will pay any price.
In recent years a lot of private and institutional investors have been buying exchange traded funds (ETF’s) or mutual funds that track bond indices. These indices include a lot of corporate bonds. Globally total assets in passive bond funds are estimated to be around $1 trillion. Although that represents a fraction of central bank holdings, the passive component of the bond fund universe is growing rapidly.
These portfolios make no effort to distinguish the attraction of individual bonds. A corporate bond passive fund is merely tracking indices where the largest weightings are in the companies that have issued the most debt. This too creates a distortion—it allows companies who issue a lot of debt to borrow more cheaply than they might be able to do without the money flowing into passive funds. It also means these investors are not asking what the price is; they just want to have exposure to “the market” whatever the price.
Up until recently there were fewer price insensitive buyers in the equity market. Some central banks (Japan and Switzerland for example), have bought equities but most have not. UK pension funds have been selling equities, not buying them.
But in the equity market the influence of passive funds owned by individuals and institutions is much greater than in the bond market. The chart below shows the proportion of the US equity market that is owned by passive funds. It is on the way to 40%.
Does this matter? Well, yes it does because passive funds simply buy equities based on the size of the company in the underlying index. So here in the UK, for example, the largest five equities in the market are HSBC, British American Tobacco, Royal Dutch Shell, BP and Diageo. A passive fund will have 26% of its assets in those companies. Every pound that is invested in a passive fund merely supports the share prices of the largest companies in the index without asking whether the share price of those companies is justified.
An active manager could choose to have 26% of their portfolio in those stocks but the process by which the active manager will make the decision is rather different. First and foremost, the active manager will ask what is the price of each potential holding in the portfolio and is that price justified? To do that a process is followed involving at least three factors. First, the valuation of each security will be known. Second, a judgement is made on where we are in the economic cycle and whether the business the company is involved in will prosper in that environment. Third, a judgement is made on the technical factors surrounding the stock (such as whether there is any euphoria or capitulation evident in how the stock has been trading) to determine whether this is a good time to buy the security.
This is not easy to do but it is essential to do it to have long-term investment success. Those that do not do the work to find out whether the current price is justified are likely to be disappointed in the results over the long-term. For passive investors that will likely show up in a period where the overall index is dominated by companies that begin to do less well, for whatever reason. When that happens, active managers should do better for their clients than those that simply own an index in decline.
At Waverton our portfolios are composed of a high conviction and diversified list of 30-40 holdings that are a reflection of our best investment ideas. This enables an investment approach that is both pragmatic and flexible, providing the greatest opportunity to identify and invest in companies that we believe will deliver superior capital growth, while allowing us to avoid those parts of the market with a higher risk of capital losses. We commend this investment approach to you. But don’t have a process on Bond Street. Not knowing the price of the biggest and shiniest thing makes gift giving much more fun.
By William Dinning
Head of Investment Strategy & Communication
The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
Changes in rates of exchange may have an adverse effect on the value, price or income of an investment.
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