Where are my investments kept?
One of the most important considerations in choosing what you do with your money is where it is kept. Gone are the days of keeping cash under your bed and gold coins and jewellery stashed in safes at home, thus in a digital world it is likely your money sits electronically with a custodian. We can work with our clients’ custodians and brokers to manage their money and investments held at their custodian or we can arrange for custody on the Multrees platform. These accounts are called separately managed accounts (SMAs). Based on our experience with different banks and custodians we have a list of preferred custodians with whom we work and thus we may suggest clients change their custodian due to either concerns about their current custody set up and safety of assets, or due to the fact that the fees they are paying are too high relative to other firms or the broker’s execution capabilities are poor. Our clients value our independence in this regard.
I’m new to investing please tell me The Basics of Investing
Most of our clients are sophisticated investors, have experienced investing for many years, and are familiar with the basics. Some, however, are new to investing so this section aims to educate the less experienced investor. No need to read further if you understand most of what is on our website.
Money as we generally know it, is a means of exchange for goods or services and the reason for investing it (or keeping it safe somewhere like under your bed or in a bank or investment account) is so that you (or next the generation) can use it in the future to purchase goods or services. The choices of what you do with your money are important because with whom you keep it, and into what you invest it can dramatically impact the existence of it (i.e. disappears) or value of it (i.e. declines in value) in the future.
Something you have probably heard of many times and experienced is inflation – rising prices. Inflation is something which central banks around the world manage, ideally in a modest way with pre-defined inflation targets. The reason for this is that the opposite (deflation) can cause all sorts of problems like increasing the real value of debt and can cause a decline in economic activity. This is simply because people will delay purchases of goods or services if they believe the price of those will be lower in the future – i.e. deflating.
A simple way of explaining an increase in the real value of debt because of deflation is to consider the following; if you buy a house today for £100,000 and you take out a mortgage (debt) for £100,000 to pay for the house (ratio of 1 to 1) if the price of assets deflated (dropped) by 10% and your house was one of these assets your house would now be worth £90,000. The mortgage, all else equal, would still be £100,000 and thus the ratio of your debt to asset would be £100,000 mortgage debt divided by £90,000 house which is 1.11 (11% more than the ratio of 1. Thus, the real value of debt has risen because of deflation.
Declining economic activity can cause recessions and job losses, which in turn causes discontent and unrest and lower standards of living and this could unseat incumbent governments or cause a host of other economic problems which we won’t go into here. Thus, let’s agree central banks target inflation (modestly rising prices). The importance of this paragraph must not be ignored because if there is inflation (which is a goal of governments and central banks) you must save and invest your money with the goal of beating inflation (or at least matching it) over the long term. If not, in real terms, you lose money. More on this here, if of interest to you.
What does “in real terms” actually mean? It’s quite simple actually, if you have a 100 Dollars, Pounds, Euros (or any currency) of savings today and you put it under your bed for safekeeping, or lock it in a vault for safekeeping or put it on deposit at 0% at a bank for safekeeping i.e. you earn zero interest on it, if there is inflation of say 5% per annum (most developed countries target around 2% per annum) it means that the same basket of goods which you could have bought with your 100 a year ago, will now cost 105 and there will not be enough to buy the full basket of goods; i.e. the same basket costs 105 due to the annual inflation of 5%.
Thus, you can see that in order to maintain the same level of spending power you need to at least match inflation. Doing this is simple, but not easy at the same time, as it requires you invest into some asset or security which will return or give you back at least 105 in 1 year. This requires you to take some level of investment risk.
What are some of your choices and their Return and Risk Consideration?
1. Cash under your mattress
– 0% return thus doesn’t beat inflation.
– You feel more in control of your money and it’s tangible and available.
– It could get stolen.
– Benefit is you’re not subject to a bank default.
2. Cash in a bank vault
– Less than 0% return as you probably have to pay storage costs too. Thus, you definitely don’t beat inflation.
3. Cash in bank deposit
– You may earn some interest, but generally less than the inflation rate so you don’t generate a positive real return. In real terms you lose money over time.
– Additionally, you are subject to bank credit risk and could lose your money if the bank doesn’t return it. In the US a list of examples can be found here. In the UK the Northern Rock story is still fresh in the minds of many.
4. Invest in developed country government bonds (this is a loan that you give to a government when the government raises money in order to fund its budget)
– Depending on the maturity of the bonds you buy, and the way inflation pans out in the future (coupled with interest rate changes), you may generate a return below or above inflation.
– Your default risk is lower than with a bank (generally speaking) because if a major developed country defaulted on their obligation it could spell disaster for the country’s ability to raise capital and investment into the country.
5. Invest in company i.e. corporate bonds (this is a loan that you give to a company in order for them to fund their business)
– Generally, you earn more from company bonds than from developed country bonds because the perceived risk of a company is higher than of a developed country.
– You can often match inflation or slightly beat it over time if the interest rate environment doesn’t change too dramatically or the perceived risk of the company in question doesn’t rise too much.
– You are subject to default risk but for large conglomerates this is lower.
6. Invest in Emerging Market Country or High Yielding Company Bonds (this is a loan you give to an emerging market country or riskier company)
– Provided you are very well diversified, and don’t lose a large portion of the investment in one single bond, you generally beat inflation and thus earn a positive real return.
– Generally, you earn a higher return than for any of the above examples but that is because you take on more risk. The government or company could not pay you back (i.e. default) and you lose all (or large portions of) your capital.
– The greater the perceived or actual risk of the country or company the higher the yield to maturity you will earn on your investment in (loan to) the government or company.
7. Invest in the equity of a company. This could be:
– Publicly traded equity (generally listed on an exchange)
– Private Equity (unlisted)
– Equity is the most risky part of a company’s capital structure. If you give a company a loan you rank higher in the event of liquidation and insolvency and any recovered money from the sale of residual assets would be paid to debt holders first, but equity holders are not entitled to anything. If there is not enough left over you lose all of your money.
– You do not necessarily earn income from your investment. There is no interest paid. Companies may pay dividends to you, but they are not obligated to.
– Because equity is the riskiest part of a company’s capital structure you can generally demand a higher return. Historically equities as a whole have returned the most but not without severe periods of loss in between.
– Over the long term (>10 years in our view) equities outperform any other asset class and do beat inflation. The simple reason why equities are a good hedge against inflation is because companies can adjust their selling prices to reflect changes in the price of their inputs (labour, raw materials, fixed costs etc) thus mitigating the inflationary pressures they face.
– We do not recommend owning equity unless your time frame exceeds (at least) 5 years.
8. Commodities (derivatives of a commodity or the physical commodity)
– When you buy a commodity as an investment you don’t earn interest or dividends from the commodity. You buy it in the hope that the price will be higher than when you bought it. This is somewhat speculative as you do not have an income producing productive asset or an agreement (as you implicitly do with a bond or bank deposit) on which you earn an interest rate.
– Commodity prices rise and fall due to supply and demand.
– We think owning commodities directly is too risky an investment due to the challenge of consistently predicting which ones will rise. The cost of holding commodities (finance and storage) is also a drag on your investment performance especially when you earn no income.
– Our view is that indirect commodity exposure by owning the equity of commodity related companies is better.
9. Real Estate – This is generally a very good asset class to own in order to beat inflation and it also generates a yield.
– Owning direct specific real estate assets can expose you to concentration risk (to the asset or tenant).
– It is also a less “liquid” asset class meaning your funds may not be readily available quickly in the event you wish to sell your investment.
– Listed property exposure can easily be obtained through listed investment vehicles called Real Estate Investment Trusts (REITs).
– Where investors generally go wrong with real estate is they borrow too much money to buy the property and when there is tenancy default they can’t service their debt. REITS have leverage rules to restrict the amount of borrowing but they are still risky equity investments as they have leverage. REITS have the additional risk of being exposed to the vagaries of the equity market and so have a relationship (correlation) to how equities perform.
What is the difference between base currency and exposure currency?
Base (or reporting) currency is the currency used to keep score (accounting) and exposure currency is the currency to which you’re exposed by movements relative to other currencies. For example, you may keep score in GBP but if you invest into an exchange traded fund investing into United States stocks (for example the S&P500) you would have exposure to USD although the performance overall might be measured in GBP.
What base currency should I choose?
One should adopt an approach to choosing a base currency (and primary investment currency) linked to future liabilities and expenses so that the impact of large currency moves doesn’t cause a loss of spending power in your spending currency due to currency fluctuations. This thinking comes from the investment strategy widely embraced in the pensions world called Asset Liability Matching (ALM). i.e. you should match your assets and the income they generate to your future liabilities and expenses in terms of returns and cash flows.
The reality, and the practicality of the situation is that our clients often do not know which currency their primary currency for future liabilities and expenses will be because they are global citizens spending in multiple currencies, or they are unable (obviously) to predict where their heirs will live and spend.
We thus think it is important to have global currency exposure with the bulk of one’s exposure in a basket of developed currencies, not necessarily just one currency. We also suggest keeping exposure to emerging market (riskier) currencies to a low percentage of total invested assets. We suggest this not so much because of the potential underperformance of these currencies, particularly in environments when investors are nervous or panicking but because one can never be sure if a currency in a risky jurisdiction will continue to exist. One example of this would be the Zimbabwe Dollar which got demonetised in 2015. Other examples of currency crisis which caused massive wealth destruction for investors include the 1994 economic crisis in Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002).
What is currency hedging and should I hedge?
Many clients with whom we work will often be told they need to hedge their non-base currency exposures back to the base currency. If they know for certain that they will spend all that money in that particular currency in the future (or imminently due to an upcoming purchase) then they should hedge back to their base currency. If not, which is most often the case, we think currency hedging is a futile and expensive exercise for several reasons.
1. Currency hedging costs money and you pay this to the executing broker year after year and over time the impact of this cost drags on return.
2. When hedging the non-base currency exposure of equities, you are in effect assuming that the companies you own in the country or region, which are not in the country or region of your base currency, generate all their profits in that particular currency. This is completely false. If you are a British investor with a GBP base currency and you own an S&P 500 Index ETF you would be wrong to say all your exposure is to the USD. Let’s list some companies in the S&P500 which we know for sure have global, not only USD earnings… McDonald’s, Amazon, Google, American Express, eBay, Estee Lauder, General Electric, Johnson & Johnson, Microsoft, Nike… and the list goes on. Therefore, do you think it makes logical sense to hedge the USD exposure you think you have, back to GBP?
3. Further to the point above, many of the large multinational companies you’d indirectly own in your portfolio will have in-house treasury teams potentially hedging their revenue streams or costs in other currencies. i.e. the companies themselves could choose to keep or not keep certain currency exposures in their business. By doing a portfolio hedge you could indirectly be increasing or further reducing exposure to a currency exposure already dealt with or not dealt with by the company. The pass through of revenue and expenses in other currencies to a company’s earnings would be reflected in the changing share price linked to those earnings.
4. Currencies generally mean revert (in layman’s terms – move back to their long-term trend) due to the fact that economic theories like Purchasing Price Parity (PPP) and Inflation Rate Parity often hold true over long periods of time. Our investors’ time horizon is long-term and thus retaining the underlying currency exposure of the assets into which they invest is something we recommend.
5. It is true that there is increased volatility at a portfolio level due to the fact that non-base currency exposures can cause greater swings up and down in a portfolio when measured in a particular currency, but this does not concern us as the long-term goal is to generate positive real returns (i.e. above inflation) as measured in any currency.
6. We and many academics would argue, you should be diversified by region and asset class to achieve optimal risk adjusted portfolio returns. In the same vein currency diversification is also a powerful tool to preserving long term wealth to pass to future heirs. Nobody knows which currency will perform the best in the next 10, 20 or 50 years. In a world where geo-politics, economics and trade in goods and services is always changing, we argue, as part of keeping diversity at the core of the investment approach, it should encompass currency diversification.
What are the tax consequences for my portfolio?
We do not provide tax advice, but we are tax aware and reasonably knowledgeable about tax. We work closely with our clients’ tax advisors regarding the tax considerations and requirements for their portfolio.
In summary, however, the tax consequence of clients’ investments will depend firstly on the tax residence of the client (which may be a company, trust or individual). It will also depend on whether distributing or accumulating (roll-up) ETFs are purchased. Income in the form of dividends from a distributing ETF will likely be taxed at normal income tax rates for the entity or person. Sales of ETFs, which realise a capital gain or loss, would likely be subject to Capital Gains Tax (if applicable in the tax jurisdiction). Many clients choose SMA mandates which only invest in accumulation share classes to avoid the dividend distributions from the ETFs. The income then rolls up into the Net Asset Value of the ETF.
Other clients have concerns about Death or Estate Duty taxes and thus avoid ETFs issued in certain jurisdictions. These are all discussions we have with clients upfront, most often with their tax advisors.
Why do clients want to work with OMBA as opposed to their current Wealth or Asset Manager?
– Our clients appreciate our Business Values first and foremost.
– They like our robust investment process.
– They love that we are transparent and honest.
– We manage their expectations and explain risk clearly.
– We are ETF specialists and provide an excellent solution for people who like the use of ETFs but don’t have the time or expertise to navigate the 1000’s of choices one has.
– We are independent with respect to which ETF provider to use and are not tied to any firm.
– We are long term investors not traders and punters. We build globally diversified low cost investment portfolios for clients.
– Our clients understand our simple and low fee with no conflicts between our investment process and the revenue we earn.
– We forge close relationships with our clients and maintain ongoing dialogue relating to their investment needs. i.e. not just providing an upfront solution without subsequent interactions.
What choices do I have regarding an OMBA Separately Managed Account?
We run four risk profiles in the investor’s choice of base currency USD, GBP or EUR:
1) Conservative Risk
2) Moderate Risk
3) Higher Risk
4) 100% Equity
For each of the above we run Accumulation or Distribution class ETF portfolios.
Note: 100% Equity is the Highest Risk portfolio – read more on equity market drawdowns.
Do you give advice?
Yes we do! Contact us if you qualify to be a client and we’d be very happy to assist you in navigating the global investment landscape.
Which ETF providers do you use?
We are independent and not tied to any one provider. We consider the whole universe of ETF providers. We weigh up many factors before considering which ones to use including: credibility of issuer, liquidity of the ETF, is it physically backed by shares or bonds as opposed to derivatives, cost, tax status for the client among many other factors.
What are “Smart beta”Etfs?
These are ETFs which use different (described as “smart”) construction rules compared to traditional ETFs which will often have constructions rules trying to bring the ETF in line with traditional indices, which are often Market Capitalisation weighted. They will take into account factors like size, value, volatility and recent performance to then over and under-weight stocks which make up a traditional index. The Smart Beta ETFs develop rules which they must adhere to in order to try and outperform the traditional ETFs. Because the rules they create using these factors are supposed to be special and “smart” these ETFs are generally more expensive. Sometimes these ETFs cost as much as an Active Manager.
Some people in the investment industry would argue that Smart Beta is in fact Alpha and that this Alpha is being charged for because the Smart Beta ETF’s cost more. It is because ETFs are so in vogue now that many of these “Active”, “Smart”, “Factor based” strategies are being used in the ETF world. The reality is that many of these same “Smart Strategies” are used by Active managers a lot the time.
Do OMBA use smart beta etfs?
Sometimes. We do think there is merit in considering the universe of Smart Beta ETFs as some “smart” strategies can perform better in certain market environments or over long periods of time. We do, however, make sure that the additional costs of these more expensive ETFs are outweighed by higher returns when compared with traditional ETFs. For the academically inclined we liked this paper.
I have read that ETFs are in a bubble and this bubble could burst – is this true?
No. Firstly, and it depends on the exact date and research report you read, as of 2017 less than 40% of funds invested in the USA were in passive investments implying more than 60% were actively managed. In Europe the percentage in passive is less than 30% implying more than 70% in active. So how then is it that an equity bubble will be caused by ETFs? If investors panic, most will be invested in active managers (as the above implies), and thus these managers will experience as much of a correction in price, as ETFs. Many investors own both passive ETFs and actively managed investments and if they de-risk in a panic they’ll likely de-risk from both passive and active managers.
Secondly, another important point to note is that good Active Managers have had to start making investments into companies which are smaller (mid and small cap), in more remote regions and which are often (or thus) less liquid. Additionally, good honest “active” managers have (rightly so) also had to start building more concentrated portfolios of stocks to try and beat their benchmarks and not be accused of “Benchmark Hugging” or “Closet Tracking”. This also justifies their fee and helps them try and differentiate themselves. We think in a major market correction, as these active managers have to unwind their positions to create liquidity for their redeeming investors, the fall in price of these less liquid stocks and the sale of concentrated positions by mutual funds will cause as much of, if not more of a correction than in the large, liquid ETF universe into which we invest. We’d far rather own a stake in the 500 largest companies in the USA (S&P500) or the 600 largest companies in Europe (Stoxx 600 Europe) than 20, 30 or 100 less liquid ones picked by an active manager dabbling in the “niche” illiquid space.
Additionally, there are over 5,500 ETFs these days and as mentioned above some have “Smart” strategies, some have funky and esoteric strategies and many have been developed to cater to a hot, sexy current theme which sells (Livestock, Lithium, Marijuana, Water, Waste Management, Biotech). These niche ETFs are in fact also investing into often a different universe than the well-known traditional ETFs and so when researchers track data of flows into ETFs they also include the flows into these niche strategies. We would argue that these niche strategies (or an investor that picks a niche strategy for her or his portfolio) is in fact making an active decision and thus could be called an active manager. The equity market participants thus include active manager stock pickers and active manager theme pickers but both own stocks. More general ETF pickers are also active to a large extent (like us) as one still needs to decide which region, country, sector or theme to own. So, the bubble, if any, is because of everyone, and it’s not limited to only large well-known ETFs.