Transparency – a blessing and a curse

One of the overriding principles of the MiFID II regulation is to provide greater transparency. This came through a plethora of measures – ranging from trade and transaction reporting to allow for better transparency when trading, to enhance cost disclosures to make it easier to understand the costs paid when investing in a fund or portfolio.

Another measure introduced is the rule known colloquially as the ‘10% drawdown rule’. This stipulates that a discretionary manager must inform an investor if their portfolio has fallen by more than 10% since the start of the quarter (based on the reporting cycle of the manager) within one business day of the drawdown occurring. The manager must then report any further portfolio drawdowns in multiples of 10% during the same quarter (i.e. 20%, 30% and so on). The aim behind this rule is to provide greater transparency to an investor on how their portfolio is performing.

This rule has been in place since the start of 2018, and was widely triggered into action at the end of 2018 when global equity markets fell by up to 15% during the fourth quarter; this mainly affected higher-risk portfolios with high-equity content, especially given bonds rallied over that quarter.

However, the global sell-off this quarter invoked by fears around the coronavirus have been larger, with global equities experiencing a drawdown of over 20%, with an even bigger fall for UK equities down by more than 30%. This means portfolios traditionally classified as ‘balanced’ – typically consisting of around 60% equities and 40% bonds – have been captured by the 10% rule, and as such a much greater number of investors have been notified of a 10% loss, triggering an often difficult conversation.

We are big advocates of greater transparency, and in general we champion any rule that encourages this. However, the flip side is that it can invoke fear into investors, encouraging them to sell down at precisely the wrong time. As an example, the below graph shows the growth of a £10,000 portfolio for an investor in the S&P 500 index from 2000 to 2018; it then shows the (lower) growth they would have experienced if they missed out on the best days of the market. The biggest rallies usually come after the biggest falls, and therefore it can be a hindrance to long-term returns to liquidate holdings when the portfolio value has already fallen.

Source: Bloomberg. All analysis is before fees.

A 10% loss over a 12-month period is fairly rare, especially for a ‘balanced’ portfolio. As part of our literature, we show the typical range of returns for our portfolios. A stress scenario for our MPS 3 (balanced) portfolio is precisely 10%, representing a once-in-20-years occurrence.

Source: AJ Bell Calculations, Morningstar

As the output is based on statistical forecasts, the actual outcome and performance could differ from the scenarios outlined. Please refer to the important information on page 2 within the AJ Bell MPS FAQs document.

However, intra-year a 10% drawdown is breached more frequently. Our portfolios were launched in August 2016 in a period of low volatility; as such, they are perhaps not representative of ‘typical’ markets. Therefore we look instead at different blends of UK equities (represented by the FTSE All-Share Total Return index) and UK Government bonds (represented by the FTSE Conventional Gilts Total Return index). Our analysis is before fees.

Since the start of 2000, we have analysed 81 full or partial calendar quarters through to Friday 13 March 2020.

A portfolio invested fully in UK equities would have seen a 10% drawdown under the MiFID II rules in 16 of these quarters or, put another way, the rule would have been invoked on average every 1.3 years.

As expected, a portfolio blending equities and bonds (60% equities and 40% bonds) would have experienced fewer drawdowns, however there have still been five separate quarters when a drawdown of 10% or greater has occurred (a one-in-four-years event). Although still not a regular occurrence, this is a much more frequent event than an annual drawdown of 10%, and so the notifications will occur more often than it may first appear.

For many clients, this will be the first time they have received a drawdown notification, however our key message is don’t panic. No doubt the falls seen over the last couple of weeks have been large and dramatic, and it is tough seeing the value of portfolios fall dramatically – retirement may suddenly look a little bit further away. However, the biggest friend for an investor is time.

We are not medical experts, and therefore are not in the business of trying to predict the short-term consequences of the virus. Indeed, the effects may run from months into years. However, our investment time horizon is five years and beyond. When we model our returns, we use forecasts covering the next 10 years. At this stage, nothing has caused us to waver from these long-run forecasts.

Alongside missing out on any bounce, another consideration when making changes is any trading costs and time out of the market. Trading is not free. Alongside bid/ask spreads and transaction costs, if trading open-ended funds there is the possibility of being out of the market for a period of time if the valuation points differ. With equity markets moving up to 10% a day at the moment, there is a risk of making a trade and ending up in cash at precisely the wrong time. These explicit and implicit costs could be material, especially in volatile markets, racking up to 3% plus in less liquid asset classes.

Our cost-conscious approach coupled alongside our long-term horizon is the reason we have haven’t made any knee-jerk reactions, however rest assured we have certainly kicked the tyres to get to that conclusion.

Our portfolios

Rather than simply reacting, our approach has always been a proactive one.

The intrigue of financial markets is no one knows precisely how they will react to situations and when. We have some recent examples of this. After the Brexit referendum in June 2016, the markets rallied strongly, an unexpected reaction as people failed to factor in the effect of weaker pound. Similarly, the election of Trump was initially seen as a shock, but again the market rallied on the back of tax reforms.

The point here is that the art of building a robust multi-asset portfolio is to not put all your eggs in one basket.

Our portfolios are outcome-orientated, targeting different levels of risk or return. As such, each portfolio will be exposed to market moves to differing degrees – unlike a strategic or absolute return fund, we would never sell down all our assets into cash.

However, within each asset class we focus on ensuring we have different levers to deal with different types of shock. Alongside the typical segmentations such as region for equities and credit quality and currency for bonds, we also cut our assets in different ways.

For example, within our equity holdings in our MPS 3 portfolio, we have dedicated holdings to three different sectors: Technology, Consumer Staples and Healthcare. Our Technology holding has fallen in line with the market. However, given the defensive nature of the Consumer Staples sector, its link with bond prices, and the demand for healthcare supplies during this crisis, this sector has performed (relatively) much better, offering some downside protection. Within our bond holdings, we spread across different maturity profiles and include an allocation to emerging market debt. Our longer-dated US treasuries have helped, whereas EM debt has hindered.

We cannot predict the type of shock we will next see in the market, and how it will affect different asset classes precisely, however our proactive approach to ensuring greater diversification aims to provide relative protection on the downside compared to a fully passive portfolio – though we will still suffer falls in absolute terms.

A forward-looking, long-term approach

We understand it is a testing time for markets – indeed, 12 March saw the largest single equity market drops since 1987 – and it is almost impossible to not feel some anxiety. However, we want to reassure you that our processes ensures portfolios are well diversified for shocks, and although they have suffered in the short term, they are still in line with our long-term expectations. A 10% (or even 20%) drop seems large, but it is normal over the course of fairly recent history, and has always seen a recovery in the medium term.

After global markets crashed in 2008, it took less than two years for them to recover all of the losses.

Head of Passive Portfolios AJ Bell Investments

Matt is responsible for the day-to-day running of the AJ Bell Funds, working with our investment team to further grow the range of investment options. He joined us with over six years’ experience in financial services, having previously worked at a leading provider of wealth management services as a Senior Fund Manager and Head of Fixed Income Research, with specific responsibility for managing a discretionary fixed income fund. He also formed part of a four-person fund management team that ran the company’s multi-asset funds. Matt graduated from the University of York with a first class Masters degree in Mathematics, and is a CFA Charter holder.

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