Wednesday, 16 January 2013


Why Volatility Matters.


And an Asian Fund yielding 4.8%


Our financial goals determine the asset classes we choose to invest in. In the financial markets, the choice is mainly between cash, bonds and equities. Barclays Capital Equity Gilt Study 2010 compares the returns from equity to the returns from cash and gilts since 1899. Taking this 111 year period, the following table shows that equities outperform cash and gilts, more often than not, for every single 2-year, 3-year etc. period from 1899 to 2010:

The Probability of Equity Outperformance 

Number of Consecutive years
2 years
3 years
4 years
5 years
10 years
18 years
Equity outperforms cash
67% of the time
69%
72%
74%
90%
99%
Equity outperforms gilts
68% of the time
75%
75%
74%
79%
88%


While one reading of this table suggests that the odds favours equity over gilts and cash for any period of time, this has to be tempered by the greater volatility, and so greater risk, of holding equities over a short period of time.

This is illustrated by another chart. While in a single year the returns from equities can vary wildly, much more so than gilts or cash, from periods of 10 years on, equities actually represent a lower risk to the investor than holding cash or gilts and they provide a better return, once results are adjusted for inflation.

Another table from Barcap shows the after-inflation return on five asset classes since 1899 (where available): 

Annualised real investment return, after discounting for inflation: 

Period
2011
Last 10 years
Last 20 years
Last 50 years
Last 112 years
Equity
-7.8%
1.2%
4.8%
5.3%
4.9%
Gilts
15.8%
3.9%
5.9%
3.1%
1.3%
Corporate Bonds
1.6%
1.6%
 na
 na
 na
Index linked
14.4%
4.0%
 na
 na
 na
Cash
-4.1%
0.2%
2.1%
1.6%
0.9%

Cash and gilts are less profitable when held over long (20 years) and very long (50 and 112 years) periods compared to equities, which are remarkably stable, returning around 5% per annum after inflation. The last 10 years has been an abnormal period of low returns for equities, a result of starting the period near the peak of the Dotcom bubble. 

There are some general lessons here for the thoughtful investor: 

1. The risk of heavy losses rises dramatically as the investment period shortens. So trading equities over short periods, even for as long as a year, is very risky and to be avoided. The reason is that in the short term markets are governed by sentiment, which is erratic, rather than fundamentals, which are more stable and predictable. 

2. Equities offer better returns than cash or bonds, with no significantly greater risk, over periods of 10 years or more. So for anyone who can put away their funds for a period of 10 or more years would be wise to consider placing 100% in equities. 

3. As a rule of thumb, bonds are a good alternative to equities for up to 5 years. 

4. Cash is a good short-term investment with minimal volatility, but returns soon fall away. 

Naturally, there are periods (one in ten for cash and one in four for bonds) when other assets outperform equities over ten years. But over 18 years cash only outperforms equities once in a hundred times, while Gilts outperform equities only once in seven times. Go with the odds!

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An Asian Fund yielding 4.8%


There are two ways to tap into growth in Asia and Pacific area. Indirectly on the UK stock market by investing in companies such as Unilever that have a significant market presence in the area or directly via a fund that concentrates on Asia and the Pacific region. Both have their merits. Today I'm looking for an Asia Pacific fund that invests in equities with a good yield. Given the stagnant Japanese economy, I choose to avoid it.  

BNY Mellon  (Newton) Asian Income Fund at 185p to yield 4.8% fits the bill. This fund has a good record of capital gains and dividend payouts and Morningstar awards it a maximum rating of 5 crowns.

Performance over                          1 Year +19.5%                   3 Years +61.2%                 5 Years +85.1%

Quartile ranking compared
to all funds in the sector                      1                                             1                                             1

The managers invest in companies, mainly in Australia, Hong Kong, and Singapore (60% of the total), that yield 30% over the MSCI Asia ex Japan Index and sell them when they no longer meet this goal. This clear and straightforward strategy should ensure a regular increase in dividend income, which fits my overall goal. The yield is paid out of income and not capital gain, an important consideration in any investment. I do not have the expertise to trade in these markets and could not trade as cheaply as a fund, so I am willing to pay their 1.5% annual fee.  

Jason Pidcock has been managing the fund since 2005, and while fund managers will almost always underperform their colleagues and the comparative index at times, over the long haul one is better off with a manager with a good record than one who hasn't. The small exposure to the Chinese stock market and no exposure to the Indian stock market is wise, given the high volatility of both, which are also subject to insider trading and poor governance. As the fund has outperformed the MSCI Asia ex Japan Index by a wide margin and is concentrated on yield, it is in my opinion preferable to an ETF tracker, though it has a higher cost. 

The main drag on performance might well be the huge size, now 3 billion pounds, of the fund. This is the winner's curse. Very successful funds earn a reputation that causes a snowball of new funds that cannot be invested as well as before.


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