‘I Don’t Believe It!’

Victor Meldrew was a fictional character in a long running UK TV series, ‘One Foot in the Grave’.  He is the archetypal elderly pensioner who complains about everything and anything. His catch phrase was ‘I don’t believe it’. Even to this day, such was the success of the series, that being accused of being a Victor Meldrew is a euphemism for being a cantankerous and whinging old man. My wife often mentions this in passing, whilst citing a recent Daily Mail article about the links between levels of cynicism and dementia. Extraordinary. ‘I don’t…’

 

As I approach my 50th birthday I find myself concerned that there are hidden consequences of new technology, and that innovation and competition are not always obviously good or should I just accept the status quo and let it pass me by.

 

In economics competition is universally viewed as healthy especially with respect to breaking up monopolistic policies and certainly there are many obvious clear cut instances of how the often down trodden consumer has benefited from competition. However, little is written of the often negative effects of competition leaving the consumer worse off in terms of quality and choice.

 

Economics 101. How it should work.

 

Firm A provides X service or materials to the consumer. They charge £100. Their costs are £60 and hence their margin is £40. This high profit margin brings another firm B into the marketplace keen to supply X service/materials for £90 despite having the same costs of £60, undercutting firm A and happy to have a £30 profit. Sometime later, firm C discovers new technology means of capital and/or labour which reduces the cost of supplying X to £40 and happy to have the same profit margin as firm B of £30 firm C can now sell X to the market place at just £70.

 

It’s a win, win for the consumer.  They are now getting X for £70 instead of £100.

 

While of course this does happen in the real world rather than just in the economists’ world, the basic presumption that competition benefits the consumer must surely mean that product X remains the same throughout.

 

What is this berk talking about?  The most obvious example of product X changing over time, in the West, must surely be the mass import of consumer goods from the developing world with low cost labour.  A product of globalisation and semi-fixed exchange rate mechanisms but changing products and prices come in all guises.

 

I read recently that 20 years ago, it cost 1/5th of the average UK salary to fly ‘return’ to Johannesburg and today it costs 1/50th.  The explosion in international travel is surely a result of the consumer benefiting from competition entering the old sovereign monopolies and the arrival of the budget no frills airlines.

 

Sullenberger said afterwards ‘One way of looking at this might be that for 42 years, I’ve been making small, regular deposits in this bank of experience, education and training. And on January 15th the balance was sufficient so that I could make a very large withdrawal’.

 

With over 20,000 hours of flying experience, as many as a fighter pilot in the US Air Force, there could arguably be few better people able to deliver that level of service that saved so many lives that day than Captain Sullenberger.

 

Compare that to a recent news article about a budget airline flight inbound to Manchester being diverted because the recently qualified pilot didn’t have the necessary qualifications to land at the fog bound airport.

 

Both sets of passengers had bought plane tickets but the level of service was surely different?

 

The old adage ‘you get what you pay for’ would appear to be a relic from the distant past.  Price used to be the main factor in determining quality. Whether it was a suit from Saville Row or Mr Byrites, a holiday in Canvey Island or Lake Como, or flying Aeroflot or British Airways, there was a clear understanding that if you paid more you got better quality.

 

I don’t know if this was an inherent human belief of value or the fact that in a non-global world, it was much easier to define like for like. Strangely in a global world with instant communications and websites dedicated to comparisons, quality and service have become seemingly more random and haphazard. In the desperate search for profit margins, cheap labour and materials have been sought mainly in developing countries and everyone believes they are in a global competition to provide the same but cheaper product to the discerning consumer. The outcome has not been wholly satisfactory, what maybe looks like the same product is often no more than a poor imitation.

 

It’s easy to spot that offshore call centres in some far flung place do not offer the same level of service that you would often expect at home. You clearly understand that the business in question has done this to cut costs and pretend that the service is the same. Much harder is the purchase of a reasonably priced sofa made in the Far East, cheaper by a good margin than a similar looking item from Scandinavia. It’s only when your child develops burning skin rashes from surface contact that you realise it isn’t the same product, you didn’t get what you paid for. You wanted a good quality ‘non-rash burning’ sofa and weren’t prepared to pay the Scandinavian price. You thought you were buying a similar model for a cheaper price but you certainly wouldn’t have paid the price you did if you knew how inferior the quality would be.

 

Generally most people want an excellent service at a price they perceive to be reasonable.   When service, quality and price become random many events start to occur.  People spend countless hours trying to compare like with like, reading website previous comments, often not realising that these might well be suspect in quality themselves. In a desperate attempt to not be ripped off, they focus more and more on price as it is at least controllable.  The real providers of service at a reasonable price are either forced to compete on price and have to lower their quality accordingly or they vanish into the ‘word-of-mouth’ only club.

 

One notable anecdote recently from the life of Victor M, yours truly:  I was looking to employ a builder for a small domestic project. Having been told by a couple of people of an excellent chap of outstanding quality and exceptionally reasonable value and whose work I viewed at their houses, I contacted said builder to be told, ‘Yes, I can schedule you in no problem, I have 2-3 weeks in September, NEXT YEAR!!!’

 

This is where I believe we have got to in the world of fund management. Hardly a day seems to go past without an article in the financial press about the outrageous fees that have been charged by fund managers or pension providers over the last few decades.  People are writing books and giving speeches about the huge merits in passive investing which really doesn’t address the point at all.

 

The service/product of fund management is no different from any other service.  Most people want an excellent service at a reasonable price.  Unfortunately in general they have not received this. The fees charged by fund managers have eaten into long term returns by too great a margin.  In the absolute return world of hedge funds, the fees have always been higher with an industry wide norm of 2% management fee and 20% performance fee. You can easily add 1% for administrative fees including audit, legal and regulatory not to mention transaction fees.

 

A gross return of 15% might well translate into a net return to the investor of just 9%!!  Also with a high water mark in place, any drop in the NAV would increase the fees relative to the return. Arguably the hedge fund strategy is harder to define and compare against any benchmark and hence any hedge fund return can only be viewed against cash.

 

Much less opaque is the typical mutual fund long only equity fund strategy where there has been talk of fund managers being sued for charging for active investment management but in reality only attempting to hug the index and as you see doing a pretty poor job of that.

 

A brief look at the following 4 charts will give you an idea about how the UK fund management industry has not really lived up to its side of the service bargain.

 

First of all, a 5 year comparison with the TOTAL return FTSE 100 index  (including dividends) shows a general index hugging but some real outperformers in theory.  Chart 2 is a 10 year comparison. This will be the one that Neil Woodford, of former Invesco fame, will be showing as his fund launches.

 

 

 

 

 

Chart 3 will not figure too prominently in fund managers’ presentations, Invesco apart.  Fund managers are rarely constrained to invest only in FTSE 100 stocks and often any real outperformance to the FTSE 100 index comes from investing in FTSE 250 companies. The 50/50 benchmark comparison is shown below which would be more appropiate.

 

 

 

Chart 4 is the one that no one wants their clients to see despite the 5 year history being the most widely quoted total return numbers currently for obvious reasons. In the last 5 years, very few funds have come close to beating the standard 50/50 benchmark. Invesco’s stellar 10 year performance reveals a very defensive approach at all times and hence needs regular crises to outperform in the long run.

 

 

 

 

The passive investing mantra crowd is having a field day with this chart and who can argue. Fees are always top of the list when any primary analysis is done and this has become so mainstream that everyone understands now that Index trackers in Exchange Traded Product forms are a viable alternative.  However in a very short time I will predict that the cost of a UK fund relative to ETF will be comparable and then what will the pundits have to write about.

 

There are only really two other possible reasons for failing to beat the index or hugging it:

1)      Size of Assets under management

2)      Fear of losing that AUM with any underperformance to the index even over a very short time line

 

The table below shows the average quarterly returns relative to the index including dividends for the stocks in the FTSE 100 by position. So the top 10 in the first column means the average of the 10 best performing stocks in that quarter relative to the index. Numbers 11-20 are the second best performing stocks and so on. I’ve looked at a lot of data in my time but these are truly amazing numbers. The first 3 columns are almost too crazy to be believably.  If we just focus on the 4th column, in short if you can chose a selection of say 10 stocks from the 31-50 best performing stocks in the FTSE 100 and rebalance only quarterly, you will perform approximately 15% a year BETTER than the index!!!

 

 

If it’s that easy then why aren’t more fund managers achieving that type of outperformance you might ask?  It goes back to 1) and 2).  The number of equity holdings in a portfolio that is seen as optimal from any academic analysis is 20-35 holdings. Enough for diversification but also focussed enough to target outperformance.  Unfortunately when your fund AUM is in the several/tens of billions, it is not possible to hold such a small basket without becoming the market (i.e. owning too high a proportion of the outstanding shares) in those stocks.  Hence as the fund grows, more stocks are needed and the bigger you get, all of a sudden, hey presto you own 350 stocks and you look like the index and any rebalancing is measured in weeks rather than hours.  Regulatory issues, market forces, ego, you name it, the whole industry is an AUM game rather than performance.  There are fund managers out there who shun the limelight, have control of their own destiny and purely want to make their clients the best return and nothing else. They are managing £300-800mm, they are beating the index by 12% a year, their fund is closed to new investors and they are every bit as elusive as my builder.  Chances are you won’t have heard of them, your pension won’t be in them and even if you do find them, you can’t access them in because they are closed to new investors.

 

With all this in mind, Hinde Capital’s new product SG Hinde Dynamic Equity ETN (HALF) has tried to solve for these issues.

 

 

 

Our aim in creating this product was to provide a strategy that provided investors with some stable returns through both dividend yield and capital accumulation without exposure to a severe damaging portfolio loss in a crisis.

 

We wanted to create a product that was highly accessible, had intra-day liquidity and focussed on achieving absolute returns in a more prudent risk-adjusted manner using a dynamic strategy than the actively managed funds that in reality merely hug the index and badly at that.

 

The salient points of the strategy:

1. It’s about systematically buying high quality FTSE350 stocks at the low ‘undervalued’ point in their cycle (relative to their own cycle and that of the index)

 

2. It’s about dividend capture – it’s not just about yield, our method looks for relatively high yielding stocks that are close to paying out a high proportion of their annual yield – thus we capture dividend cash flow more efficiently and effectively for investors

 

3. Essentially we aim to compress the typical investment cycle returns to accelerate the compounding effect of dividend capture, dividend reinvestment and capital gain. With traditional value strategies this cycle usually takes much longer to play out

 

4. The strategy creates attractive risk-adjusted returns, providing downside protection (the 50% hedge) whilst not limiting the upside because we own a diverse set of companies that can revalue quickly in any quarter based on dividend and capital appreciation, and then be rebalanced or swapped on an equally weighted basis into the next ‘cheap’ stocks based on the systematic output of the Hinde Dividend Value Matrix (proprietary stock-rating scoring system)

 

5. The simulated test has returned 255% over 11 years with half the drawdown of the composite FTSE100/250 total return index and over a third less volatility of returns

 

The key element here is that we do not limit the potential upside performance of the strategy because our long portfolio is picked to outperform the indices over the medium and long term.

 

Nonetheless the 50% beta hedge will provide more downside protection in markets such as 2003 and 2008.

 

To emphasis this point, the long only version of this strategy in the chart above shows the combination of our stock selection and dynamic rebalancing to capture dividend and capital returns would have provided a net return of 458.20% on our simulated back-test from Jan 2003 to end of Dec 2013

 

The 50% hedge version of this on simulated past performance provided a near 255% total net return at an annualised rate of 12.21% with less volatility and drawdowns than the FTSE 100 and FTSE 250 total returns over the same period.

 

This strategy is available on the London Stock Exchange – epic code HALF: SG Hinde UK Dynamic Equity ETN (50% Hedge).  To learn more please click here for more information and if you have any enquiries contact us. All information is provided at www.hindecapital.com.

 

You may well say ‘I don’t believe it!’ The main board of Hinde Capital portfolio managers have been investing successfully in markets across all asset classes for longer than 20 years and in my case 30 years. We are a mixture of quantitative analysts, traders and investment managers who know from experience the potential pitfalls in differing market conditions, because we have witnessed them first hand. Long-term success in investing only comes out of experiencing failure. We have thankfully had more successes than failures but it is these invaluable investing lessons that have helped us formulate this strategy. It has taken almost two years of testing but in truth this is a culmination of our lifetimes’ experience. We believe this will serve investors well in the world of NIRP.

 

 

THIS COMMUNICATION IS FOR PROFESSIONAL CLIENTS AND SOPHISTICATED RETAIL CLIENTS IN THE UK

 

This communication issued in the U.K. by Hinde Capital who is authorised and regulated in the UK by the Financial Conduct Authority. FCA number 471754.   The SG Hinde UK Dynamic Equity ETN (50% Hedge) (the ETN) is directed at professional clients and sophisticated retail clients in the UK, who have a good understanding of the underlying markt and characteristics of the ETN.   It is important that you appreciate at the outset that you could lose all of your invested capital when investing in these products. You should be satisfied that they are suitable for you in the light of your circumstances and financial position. If in any doubt, please consult an appropriately qualified financial advisor. We recommend that retail investors seek independent professional advice prior to investing.   You should not deal in these products unless you understand their nature and the extent of their exposure to risk. The value of the product can go down as well as up and can be subject to volatility due to a range of factors which include price changes in the underlying instrument and interest rates.   Final Terms are published for this security detailing its specific characteristics and its pay-off at Maturity, and the product features given in the Final Terms are prescribed by the approved Base Prospectus. Both documents can be found at www.sglistedproducts.co.uk

 

This ETN is a security that is listed on the London Stock Exchange and is issued by SG Issuer via an Issuing Programme which is approved by the UK Listing Authority. SG Issuer is a 100% subsidiary of Societe Generale.   As the Issuer of the ETN, if SG Issuer and Societe Generale were to default or become insolvent, the ETN will terminate immediately. The amount that you receive back on your investment will depend on i) the market value of your investment at that time and on ii) the value of the Collateral Assets at the time of default. You may receive back less than your initial investment. This ETN is not covered by the provisions of the Financial Services Compensation Scheme (“FSCS”), nor any similar compensation scheme.   Societe Generale is the only market-maker for SG ETNs and Trackers and therefore the only liquidity provider. On-exchange liquidity may be limited as a result of a suspension in the underlying market represented by the index tracked by the product; a failure in the LSE, Societe Generale systems; or an abnormal trading situation or event.

 

 

 

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