The idea of being a long-term buy-and-hold investor is attractive – it doesn’t require making many decisions, and decisions are often stressful, especially those about your financial future.
But the unfortunate truth is that markets change with time. If they didn’t, we’d all still own railroads and steel companies.
We must therefore make difficult decisions when markets change, because not making them can be more stressful.
Trigger unhappy
A former boss of mine used to say: ‘Markets move in a way that causes the most pain to investors.’
This happens when all the potential buyers have bought, leaving everyone on the same side. At this point, even a small shift can trigger a move in the opposite direction, causing maximum pain.
For example, owning wind turbine companies seemed an obvious and easy investment as the world transitioned to green energy, especially at the end of 2020, with the share price of leaders like Vestas and Orsted up more than 250% over the prior three years.
But at that point, it was too obvious, and the ESG focus meant everyone was already on the same side. All you needed was a combination of high valuations and a trigger appearing out of nowhere (in this case, cost inflation) to cause the pain of share prices falling more than 50%.
The problem is that, right now, everyone is on the same side when it comes to US large-cap quality growth.
Painful brands
Just as it was easy to buy companies exposed to wind energy in early 2021, it’s been easy to buy quality companies with recognisable brands, such as Apple, Nike and Pepsi. And when bonds were yielding almost nothing and consumer brand companies paid dividends, no price was seemingly too high.
This is especially true in a market that has risen double digits in 11 of the past 15 years (let’s pretend it’s December) and only had one double-digit down year, in 2022, which artificial intelligence helped us forget three months later.
Both passive and active funds exposed to those factors performed very well. This performance attracted new investor flows, propelling the prices of their holdings even higher, further driving returns and driving flows. Rinse repeat. That is, until triggers like higher inflation and higher interest rates appeared, disrupting the cycle and causing maximum pain in 2022.
Unstable staples
Do you remember when leading fund managers told us that buying strong consumer brand companies with pricing power was a sure way to protect portfolios from inflation?
Well, the MSCI World Consumer Staples index, packed with companies like Procter & Gamble, Nestlé and Pepsi, has only compounded at 5.6% a year over the past three years as high valuations, lower volumes and now a new trigger – those amazing obesity drugs – all combined to cause pain to holders.
By comparison, the MSCI World Banks index has compounded at nearly 14% over that same period. Back then, everyone was deriding banks as terrible businesses but a combination of low valuations and the trigger of rising net interest margins caused pain for those not exposed.
‘Luxury goods had pricing power and China was opening up’ was the theory. But in practice, everyone was on the same side, meaning the trigger of disappointing results caused pain, with LVMH’s and Estée Lauder’s share prices falling 26% and 50% respectively from their 2023 highs.
One by one, such themes are being challenged in this new environment of ‘higher for longer’.
For now, the so-called magnificent seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla) remain outliers, with the S&P 500 Total Return index up 18% so far this year in contrast to the Equal Weighted ETF on the same index, which is up only 1%.
Don’t phone home
How much longer can this continue? Perhaps the slowing demand for £1,000 handbags is a harbinger of a slowing demand for £1,000 iPhones?
What, then, should investors do?
Investing with a top fund-of-funds manager or using a respected MPS would be a great start.
If you want to go it alone, ensure the funds you own have different investment styles and/or geographic allocations so that you’re not on the same side as the rest of the investment world.
One trick is to look at their correlation; having a portfolio of four funds or exchange-traded funds that are 95% correlated to each other is not diversified. This may also enhance returns – both the Japanese Topix and the Stoxx Index 600 are ahead of the S&P 500 over the past year. And they don’t have the magnificent seven.
Analyse fund fact sheets or use Morningstar data to see the valuation metrics and geographic and sector allocations of the funds you hold.
If the portfolio’s PE ratio is above 20, and the allocations and holdings are all US-centric with high exposure to large-cap names, be aware that you’re on the same side as most of the investment world.
Passive regressive
Before you rush to diversify into passive value funds, also know that an S&P 500 Value ETF has Microsoft, Meta and Amazon as its three largest holdings.
How?
Because, simplistically, passive index compilers have to allocate companies somewhere, so they put the fastest growers in the Growth bucket and the slowest ones in the Value bucket.
Unfortunately for passive investors, slow growers do not automatically mean Value. Indeed, large, over-owned, expensive companies with no growth are the least desirable of all investments.
For those wanting to reduce risk, the market’s 2023 rally makes it an ideal time to diversify into some of the styles that aren’t on the same side as the market – active value, ex US, mid- and small-cap companies. These strategies have lower valuations, which should mean higher future returns.
The decision to diversify is not about returns, though. It’s about reducing risk and exposure to potential pain.
And decisions like these are less stressful.