Return-Free Risk

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When you think of government bonds and their role in your investment portfolio, you typically think of stability. You invest in the stock market for high returns, but the bond market for stability. Bonds are there to ‘reduce the risk’ of your investment portfolio, and for that many are willing to accept lower returns. This paradigm has failed investors miserably in the last 3 years as interest rates globally have been hiked at record pace.

According to Bloomberg, US 10 Year Treasury Notes have crashed 46% since March 2020. That’s on par with the worst stock market crashes since the Great Depression! In the last century, US treasuries have never delivered more than 2 consecutive years of negative returns, and even then never of the magnitude witnessed since 2020. This truly is an historic market crash. What makes it even more incredible is that no-one outside of the investment industry seems to be talking about it. If it was the stock market or real estate it would be front-page news by now. I say this tongue-in-cheek, but it’s somewhat refreshing for an equity portfolio manager to watch a market crash from the sidelines.

Risk ≠ Return

There is an important lesson to be learned here. It doesn’t matter how high the quality of an asset is, how consistent the cash flows are, or how creditworthy the issuer may be – if the price you pay becomes completely detached from reality, then the asset becomes very risky. What’s worse is that this risk is associated with low returns, even under optimistic conditions. This stands in contradiction to the common (and inaccurate) mantra that risk = return. Higher business risk may typically be associated with higher potential returns, but the higher risk that comes from overpricing an asset is always associated with lower return.

Consider that in 2020, 10 Year Treasuries were yielding just 0.5% p.a. At that yield you’re not thinking about return, you’re all-in for downside protection. Ironic that 3 years later you’ve lost 46% with virtually no interest payments to cushion the blow, while the stock market (which you were fleeing) has climbed ~80%. One of the reasons Treasuries have never done so badly before, even though they’ve been through some extreme rate hiking scenarios, is that interest rates were already high enough in past hiking cycles to offset most of the capital losses. What you lost in capital you gained in interest. Not so when interest rates are close to zero. Can you see how this crash was built into the price?

Implications for the Stock Market

So what does this mean for the stock market? It’s not entirely clear since stocks are affected by many variables besides interest rates. Unlike bonds, future cash flows are not fixed. Higher inflation means higher revenues for companies, but it also means higher expenses, higher financing costs and, at least in theory, lower valuations. I say in theory, because it may also just mean that the relationship between bond yields and stock market earnings yields (the inverse of Price/Earnings Ratio) have finally normalized after more than a decade of being disconnected. We’re used to thinking of stock market valuations in terms of PE ratios and bonds in terms of yields. If I told you the S&P 500 would trade at a PE Ratio of 200x (more than 10 times historic norms), you’d think I was crazy, yet that’s the equivalent of what US Treasuries were doing in 2020. Just because bond yields have normalized from insane levels doesn’t automatically mean that stock market valuations must drop too.

We are beginning to see the effects of more than a decade of extremely loose monetary policy unwind. What has caught so many off-guard is how quickly loose monetary policy has unwound. We saw signs of the inevitable strain in the first quarter of 2023 with the US Regional Banking Crisis. Now we’re seeing it in the longer dated government bond markets across the developed world. Such a drastic change, to something as fundamental as interest rates, cannot take place without the ripple effects being felt throughout the global economy.

For us as equity portfolio managers, we continue to avoid over-indebted and over-valued stocks, which are most sensitive to fallout from higher interest rates. The biggest risks to be avoided in every kind of investment portfolio are always those that come from excessive leverage and extreme overpricing. Investors may have been willing to overlook these risks in zero-interest rate world, but we believe that’s likely to change.

When ‘Tax-Efficient’ isn’t Cost-Efficient…

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‘In this world nothing can be said to be certain, except death and taxes.’ – Benjamin Franklin

One of the biggest differentiators of long-term investment performance is cost-drag. If you’d invested $1m into the S&P 500 twenty years ago at a total cost drag of 1% p.a., your investment would be worth over $5.5m today. The same investment made at a total cost drag of 3% p.a. would be worth just over $3.7m today, a difference of nearly $2m. By saving just 2% p.a. in costs you’ll increase your final investment by 50% over 20 years / 30% over 10 years. While those percentages are consistent regardless of investment performance, the absolute dollar amounts will depend on the realized returns. The following graph demonstrates this visually.

The lesson here is that seemingly insignificant numbers compounded regularly add up to very significant numbers over time, which is why cost-drag is such an important consideration when making investments. An annual platform fee of 0.5%, plus 1% advisory fee and 1.5% for the underlying fund is commonplace and very quickly adds up. Not to mention the possibility of upfront fees, high trading costs, taxes, feeder funds/fund of funds structures, wrappers, trusts, etc… If you wonder where your investment returns are going, look no further than the various layers that separate you from your investments. You may be one of the many investors paying between 3%-5% p.a, when you could just as easily be paying closer to 1% or even less for essentially the same underlying investment. The difference is not insignificant.

Why the Extra Layers?

The question then arises, how do so many investors end up paying so much? The answer is very often ‘tax-efficiency’. Those inverted commas are appropriate tweezers for handling this expression, since many (but certainly not all) of the methods/products which are touted as ‘tax-efficient’ bear resemblance to some other things you’d rather not pick up with your bare hands. To be clear, the intention isn’t to lump good tax advice under a negative label, but rather to warn against a common pitfall when making investments which trips far too many investors up. This pitfall follows a general pattern.

The thinking goes like this: Tax numbers are usually big one-off numbers like ‘40%!’, while fees are small numbers like 0.5% or 1% or 2% (or even 0.5% + 1% + 2%) compounded annually. An inordinate focus is placed upon the scary headline number, often misrepresented/misapplied without considering the important qualifiers. These big numbers are usually only partially mitigated or even worse, only deferred until later, while the small numbers are seen as barely worth mentioning – they’re so small afterall. But do the math properly and you’ll find that in many cases the small numbers far outweigh any supposed mitigation of the big numbers. Taxes, as Benjamin Franklin suggested, are notoriously difficult to ‘mitigate’, whereas fees add up all too easily.

That’s the general principle, now for some practical examples…

SITUS: A Practical Example

If you’re a global investor you’ve probably heard the word SITUS. This is an estate duty levied on foreign investors in the UK/US. The rate is 40%* in both cases, which is very high. The threshold levels are GBP325k and USD60k* respectively (asterisks intended). Those are the big headline numbers that get thrown around in investment circles. The two most common ways of mitigating these taxes are by way of offshore trusts (which are used for other purposes too) and life wrappers. These aren’t inherently bad solutions, unlike some other questionable products being marketed under the banner of ‘tax-efficiency’. But they are all too often being used by investors who have no need for them, needlessly incurring extra layers of fees that will do more damage to their future estates than any taxes will.

Both of these structures work by limiting the estate duty/donations tax to local rates, saving at best 15%-20% for South African investors – not 40%. Further US SITUS works on a sliding scale that starts at $60k and 18% and peaks at $1m and 40%. Note how the focus is always placed on the lowest threshold combined with the highest tax rate? This is misleading – the two don’t go together. The supposed benefits of these structures are often assumed to outweigh the added costs, and in some cases they may, but this isn’t always the case.

Consider an investor with a $500k/R9m global stock portfolio. If this is a well-diversified portfolio, chances are it is invested roughly 50% in the US and 10% in the UK. The UK SITUS threshold is irrelevant in this case. The US SITUS scale would come out at around 20%, compared to the South African rate of 20-25%. (Note: There is a tax treaty between US/SA so you wouldn’t be taxed twice.) There would no tax advantage for this investor, however there would be significant added costs especially if you factor in the half of the portfolio held in jurisdictions where estate duty isn’t levied. In those cases you’d be taxed in South Africa regardless. Even if you made significant growth assumptions over a long period of time, the added costs would in most cases outweigh any potential benefits for a portfolio of this size. There are a lot of cases where it would be better to incur SITUS than to incur the added costs to avoid it. These are straightforward calculations to run.

To be fair, there are other side-benefits to some of these products (favourable CGT rates, no executors), but there are also other disadvantages (loss of flexibility, higher withholding taxes, added complexity) to be considered. All too often we have only the benefits in mind, with little consideration of the added costs/disadvantages – they’re simply assumed to be justified when often that isn’t the case. All the relevant factors should be weighed up through thoughtful analysis on a case-by-case basis and compared to alternatives rather than treated as a one-size-fits-all solution. There is a legitimate place for these products, but it’s usually for much bigger investments than they are often being applied to, and specifically for investments which are US/UK domiciled when SITUS is the main concern being addressed.

What are the Alternatives?

 There are several free/low-cost alternatives to be considered when it comes to SITUS mitigation:

  1. Don’t put assets that aren’t subject to SITUS, or fall below critical thresholds, in a wrapper that is primarily designed to avoid SITUS. You’re needlessly incurring an added layer of costs on those assets when you do this, without the benefit. This includes many unit trusts and ETFs, non-US/UK stocks, etc.
  2. Consider investing via a joint account where possible. This effectively doubles the threshold levels rendering them irrelevant for many investors. The above example of a $500k/R9m portfolio then applies to a $1m/R18m portfolio.
  3. Weigh the use of UCITS ETFs for US/UK exposure above certain levels. These are not subject to SITUS. These can also be used to augment an active portfolio of specific US/UK stocks for larger portfolios.

Saving 1%-2% p.a. in cost drag for essentially the same underlying investment with the same tax benefit is a win-win.

The Tax-Deferral Mirage

Often tax mitigation amounts to nothing more than tax deferral, which is like a mirage promising something in the distance that vanishes when you get there. Consider the following mathematical identity:

Whether you pay tax at the beginning of an investment, somewhere in the middle or at the end makes absolutely no difference to what you end up with unless the tax rates differ. You might have heard someone say that ‘you earn the returns on the larger pretax amount’ but mathematically this makes no difference because the same tax rate applied to a larger terminal amount means you pay more tax at the end and end up at the same place.

Don’t trick yourself into thinking that pushing a tax liability out into the future is somehow beneficial, especially if the means of doing so incurs an added layer of fees along the way. Some retirement products would fall into this category. Even if the tax rates differ, the difference needs to be very significant to outweigh the drag of an added layer of fees, not to mention the loss of flexibility and added complexity that often comes with these solutions.

Avoiding Capital Gains Tax: Another Example

Most investors hate paying capital gains tax (CGT). They would rather hold onto an overpriced asset and risk a poor return than sell it and incur CGT. Or they’d prefer to hold their shares in a unitized structure, where the underlying portfolio trades don’t trigger CGT, effectively rolling the CGT liability up until the units are finally sold. This is an example of CGT tax-deferral that is generally regarded as good tax practice in South Africa, and the cost isn’t necessarily any different. But does this really make sense?

The reality is that the deferral itself adds little value, because the tax rates are the same whether you incur them along the way or pay them at the end. In fact, in South Africa, CGT deferral has generally yielded negative value, because:

  1. You miss out on the R40k annual CGT allowance (R80k if you invest via a joint account), only taking advantage of it once at the end of the investment. The longer the investment duration the bigger the difference.
  2. Wealth taxes in South Africa have been rising, which means that deferred gains have attracted higher tax rates. If this trend continues, deferral will continue to have negative value.

As for holding onto overpriced assets because of resistance to incurring CGT… The fact that the CGT liability doesn’t show on your investment statement doesn’t mean that it isn’t there. If you have two assets with the same carrying value of $100k on your investment statement, but the one has a cost basis of $10k and the other a cost basis of $90k, the latter is actually worth more to you because it carries the lower tax liability.

The lesson: Don’t allow CGT to rule over all other considerations in your investment decision making.

 

In summary, when considering the ‘tax-efficiency’ of your investments, make sure you also consider overall cost-efficiency. Small numbers compounded regularly are often more detrimental than big one-offs. Are the added layers between you and your investments adding value? Always do the math before swallowing the conventional wisdom.

‘Gradually, then suddenly.’

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The biggest story of the 1st quarter was the collapse of Silicon Valley Bank (SVB) and the ensuing regional banking crisis in the US. It took just two days for SVB to collapse after the announcement that they needed to raise capital. Depositors lost confidence in the bank, triggering a run on deposits and cementing SVB’s fate. This followed news that crypto bank Silvergate was closing its doors. Then Signature Bank, roughly half the size of SVB, was also shut down by regulators that weekend. This sent shockwaves through the broader regional banking industry with the shares of banks like First Republic and Western Alliance down 90% and 60% respectively since then. Even the shares of financial services giant Charles Schwab have lost 35% in the wake of SVB’s closure.

So how did this happen? As Ernest Hemingway would say, ‘Gradually, then suddenly.’

‘Gradually…’

The seeds for the present regional banking crisis were already sown in the 2008 financial crisis. To prevent the technical insolvency of the banking industry, regulators changed an accounting rule which allowed banks to carry certain assets at their original book value instead of their prevailing (and much lower) market value. These assets were marked as ‘held-to-maturity’. The idea was that if the banks could hold these assets until they matured several years later, they would ultimately realize their book value, so they needn’t recognize the sizeable losses they were carrying in the meantime. This didn’t do anything to change the underlying reality of what those assets were worth at the time, but it did mean that the banks could satisfy regulatory requirements for capital adequacy without raising fresh capital. This accounting stroke of the pen apparently worked…

Fast forward to 2020 and the COVID/lockdown crisis. The US administration flooded the market with trillions of dollars of stimulus, resulting in a wave of new deposits for the banking institutions. Deposits held with Bank of America (by way of example) jumped from $700bn to $1.2tn between 2020 and 2021 – an increase of 70% in 1 year. What do you do with all this excess cash in a zero interest rate environment? Apparently you invest it in longer-dated ‘held-to-maturity’ securities with interest rates marginally above zero and pocket the difference. This is risky, since any increase in interest rates would decrease the value of those assets, only not on paper since they were marked ‘held-to-maturity’. This is what almost every US bank did with the wave of stimulus-driven deposits that came their way. Almost all of it was invested in longer-dated securities.

‘… then suddenly.’

The unprecedented stimulus, combined with global supply-chain upheaval in 2022, led to resurgent inflation and consequently the fastest interest rate hiking cycle for decades. When interest rates go from 0% to 4% in a year, something must give. The market value of these ‘held-to-maturity’ securities decreased by ~20% in some cases. If these losses were reflected on bank balance sheets, their equity would be severely impaired.

This brings us back to Silicon Valley Bank: Between 2020 and 2021, SVB’s deposit base more than doubled. Virtually all the new deposits were invested in longer-dated ‘held-to-maturity’ securities. In 2022, roughly 45% of their balance sheet was invested in these longer-dated assets (vs 20% in 2020). This is 2x-4x more than most other banks. Add to this that SVB had a very narrow deposit base, focused on the flagging tech startup space, and you have a recipe for collapse. As cash strapped tech startups began to withdraw deposits, SVB was forced to liquidate a portion of their ‘held-to-maturity’ assets at a sizeable loss to meet the withdrawals. This in turn impaired their capital, hence the need to raise new capital, which spooked depositors… and that was the end of SVB.

Finally…

While SVB was in the most precarious situation, there remains an underlying solvency issue with the overall US banking system. If every bank were suddenly forced to realize the losses on their ‘held-to-maturity’ assets, there would be serious implications. While regulators have managed to stem the immediate liquidity crisis (which exposes the underlying solvency issues), it remains to be seen whether time will take care of this problem or not. Either way, US banks have taken a big misstep which cannot simply be waved away because an accounting rule allows them not to reflect it in their financial reports.

In our portfolios we have limited exposure to the US banking sector. We are avoiding exposure to institutions with large ‘held-to-maturity’ exposures, even larger institutions such as Charles Schwab and Bank of America. Finally, when it comes to banks (and insurers) we avoid the smaller regional players since the largest players are usually better regulated and more diversified.

Diversification is No Free Lunch

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“There’s no such thing as a free lunch.” This well-known adage, popularized in economics by Nobel laureate Milton Friedman, communicates the idea that you never get something for nothing. The saying finds its origin in a former practice of American public houses, which would offer a ‘free lunch’ in order to attract clientele. These customers doubtless spent more than enough money on drinks to cover their ‘free lunch’. The saying is typically used in economics to emphasize the reality of opportunity cost. Opportunity cost is what one could have achieved by deploying scarce resources elsewhere.

In portfolio management, the opportunity cost of every dollar invested is the return we could have achieved if we’d invested it somewhere else. This is easy enough to measure after-the-fact (ex-post) – you should’ve just invested everything in the best performer! But before the fact (ex-ante) it is impossible to know which asset will perform the best. Ex-ante opportunity cost is more difficult to measure and must also account for differences in risk. This is why we diversify our investment portfolios. Diversification is a hedge against our ignorance of future outcomes. To the extent that you cannot clearly differentiate between the merits of several investment opportunities, it makes sense to hold all of them rather than just one.

Harry Markowitz, another Nobel laureate, challenged the no-free-lunch rule by saying that diversification is the only free lunch in investing. In essence he was saying that the opportunity cost of alternative investments cannot even be reasonably estimated ex-ante. Therefore the ex-ante opportunity cost of alternative investments is zero. Since the benefit of diversification is the spreading of risk, it would follow that this benefit is to be had at zero cost. If this is true, then indiscriminate diversification is the best investment strategy. But is it true?

Can we Measure Opportunity Cost ex-ante?

 For competing investments, opportunity cost is measured in terms of return potential and risk. Risk and return are ultimately driven by business quality and valuation. Differences in business quality and valuations are readily measurable, if not perfectly then certainly by broad brushstrokes. The problem is that higher quality businesses tend to trade at higher valuations, and vice versa. This means that for most investment alternatives, opportunity cost is difficult to measure. For most of the investment universe, Harry Markowitz was right. But ‘most’ of the investment universe is not ‘all’ of it. There are opportunities where one is able to find high quality businesses trading at low valuations. They just aren’t the norm. To the extent that really compelling investment alternatives do exist, but are scarce, the opportunity cost of diversification is actually enormous!

Picture it this way: The ideal investment portfolio has 3 desirable characteristics:

1) It consists of high quality businesses;

2) The shares of these businesses are well-priced;

3) The portfolio is highly diversified.

If it isn’t possible achieve (1) and (2) simultaneously, you may as well go all-in on (3) since diversification will cost you nothing – i.e. Markowitz. If (1) and (2) can be achieved in many cases, you can have (1), (2) and (3) without much opportunity cost. If (1) and (2) can be achieved scarcely, then you need weigh the opportunity cost of (3), because diversification is actually very expensive – i.e. “There’s no such thing as a free lunch.”

In our experience it is the third scenario that best describes reality, especially in recent years where market valuations have been generally high. This means that the opportunity cost of diversification has been high.

How do the Benefits of Diversification Compare?

 It’s one thing to say that the cost of diversification is high, but cost always has to be weighed against the benefit. So how do the benefits of diversification compare to the costs? Burton Malkiel, a strong proponent of diversification, demonstrated in his book A Random Walk Down Wall Street that by the time a portfolio reaches ~30 holdings (spread across different geographies/industries), virtually all the benefits of diversification (in terms of downside protection) have been achieved, with diminishing benefits for each additional holding. The only further advantage of holding more stocks is in tracking the benchmark index more closely. This isn’t desirable for the active investor.

What we see then is that diversification is actually very expensive with little benefit beyond a 30 stock portfolio. Consider then that most mutual funds hold well in excess of 100 stocks. This is not because they are concerned about downside risk. Rather they don’t want to be too different from the overall market. They are prioritizing their own career risk over their clients’ investment objectives. We addressed this in Dare to be Different. If you’re going to hold 100 stocks you may as well just follow Markowitz’ advice and go all the way. The results won’t differ by much.

How does this apply to us?

At Bellwood, we’ve always understood the danger of indiscriminate diversification and we’ve formulated our process to avoid this. For starters, we’ve emphasized the importance of covering a very broad opportunity set. The best way to ensure a diversified portfolio of well-priced, quality assets is to make sure you aren’t limited to a small opportunity set. A portfolio of 30 stocks chosen from a universe of 5 000 is likely to be vastly superior in terms of quality, price and diversification when compared to a portfolio of 20 stocks chosen from a universe of 500. Our process is geared towards addressing a very broad investment universe.

Further, we’ve worked on a maximum initial position size of 3%, which would result in an initial portfolio of 30-40 stocks. In practice, however, we’ve found that as prices fluctuate certain positions become smaller than 3%, while we’ve tended to trim the positions that have grown in excess of 3%, adding new positions along the way. This has resulted in the portfolio drifting from the initial 30-40 stocks to 40-50 stocks. Because of the scarcity of well-priced, high-quality securities this implies that over time we’ve inadvertently sacrificed a little either on price or quality in favour of greater diversification. This has probably cost us returns at the margin without meaningful benefit.

Going forward we’re going to cap our initial position sizes at 5%, with average position sizes still around 3%. This will result in slightly more concentrated portfolios which consistently remain around our target of 30-40 stocks. We believe this strikes the best balance between return potential and diversification.