OpenMoney Q4 Investment Commentary - Breaking The Habit

The OpenMoney team

February 11, 2021

“Prediction is very difficult, especially if it's about the future!”

Niels Bohr

Human beings love to make predictions. Just look at the extraordinary growth of the gambling industry. Twenty-four hours a day, you can place a bet on anything from the number of throw-ins in a football match to the colour of the Queen’s hat at Ascot.

But there’s a problem - and a reason why online betting is one of the most profitable sectors in the economy. It’s that most of us aren’t very good at it.

Ask Professor Philip Tetlock at the University of Pennsylvania. In the mid-1980s, he began one of the longest and most detailed studies ever carried out into the accuracy of predictions made by experts across a number of fields, including politics, the economy and finance.

Fooled by Randomness  

In 2005, he concluded that the forecasts he analysed were statistically indistinguishable from random guesses. “It is impossible,” he wrote, “to find any domain in which humans clearly out performed crude extrapolation algorithms, less still sophisticated statistical ones.”[1]

Of course, the fact that we can’t predict the future doesn’t stop us believing that we can. This tendency was observed by psychologist Ellen Langer[2]in a series of experiments during the 1970s. In one, she asked a group of students at Yale to watch someone toss a coin 30 times and call the toss as either heads or tails.

Langer then asked the students how well they thought they might do if the exercise were repeated. Students who had experienced a pattern of success had a higher opinion of their coin-toss forecasting skill and felt that they would shine again.

That’s right: they were fooled into believing that they had the power to predict entirely random outcomes based solely on their past immediate success.

Langer dubbed this tendency “the illusion of control”; and you only need to browse through the financial pages of national newspapers at this time of year to see that the phenomenon is alive and well in the world of investing.

Lessons of 2020

You might have thought that last year, of all years, would have taught us to be wary of making financial forecasts.Twelve months ago, few financial forecasters were predicting that a then obscure virus in a remote corner of China would morph into a pandemic that would ravage the global economy.

Neither did forecasters expect that Brent crude prices would plunge to their lowest levels in more than 20 years atone point below $US16 a barrel as governments put their economies in hibernation, sending oil demand into a deep freeze.

Source: US Energy Information Administration (2020)[3]

But this is the problem with forecasting. You start with a set of macro-economic assumptions about economic growth, interest rates, currencies, commodity prices and household demand, then overlay a bunch of micro-economic assumptions about industry supply and competition. Finally, if you’re a stock picker, you analyse company fundamentals like cash flow and debt-equity ratios and market position.

None of this can ever take account of the possibility, however remote, of unpredictable events like wars or political crises, natural disasters or pandemics.

And even if these events were predictable, guessing what impact they might have on the markets is another huge challenge. Who would have thought, for instance, when global markets plummeted in March 2020, that most of them would recover and reach new heights as quickly as they did?

Source: FE Fundinfo (2020)

A Better Way To Invest

So, if the future is unknown, even by the best forecasters, and if even the most meticulous financial plan can be undone by bad luck, what can we do?

Well, it starts with acknowledging what we don’t know. There’s nothing wrong with having opinions. But realistically, do we have any unique insights that can genuinely give us an edge?

Do we know what the future has in store for the economy? Are we more informed than the world’s top virologists on how long it will take to bring the pandemic under control? Can we predict how the recently signed Brexit deal will impact the UK economy in the long term?

Investment managers would love to have the power of clairvoyance, as well as other psychic powers, fortunately we are humble enough to accept that we cannot predict the future and thus must answer “no” to all the questions posed above. That's why we don’t try to pick asset classes, sectors or funds that we “believe” will outperform their peers.

Instead we focus on the things that we can control. We use decades of research that shows the most successful investment strategy over the longer term is to have a low cost, globally diversified portfolio. At OpenMoney we use a global market weighted strategy which means that we allocate more of your investment towards countries with bigger economies, which is why the US has the largest exposure.

Brexit – We Got There In The End

It only took four and a half years, cost two Prime Ministers’ their jobs and polarised the nation to an extent that the police were preparing for Brexit riots, but after 47 years the UK has finally left the European Union, surprisingly with a trade deal. The fine print of the 2,000-page document is still being closely examine and despite the UK and EU both proclaiming they “won” in the negotiations, the consensus amongst political observers is that both sides made concessions.

The conclusion of the Brexit saga is indeed good news, in such that it removes the one thing markets truly dislike: uncertainty. We didn’t try to predict whether a deal would be made or what would be included in any such deal, however, we were of the opinion that common sense would prevail as both the UK and EU had more to lose economically by not reaching an agreement. As to be expected, markets reacted positively to the news, with both the domestically focussed FTSE 350 and the EURO STOXX 50 closing 1.58% and 0.91% higher respectively, the day after the deal was stuck[4].

Source: FE Fundinfo (2020)

Although encouraging, since the result of the Brexit referendum in mid-2016 the UK equity market has consistently lagged broad European and World equity markets. Will the deal cause the UK to close this gap over the coming months or years? We make no prediction. However, the chart above does reinforce the importance of taking a global perspective to investing and not maintaining a UK home bias, however counterintuitive and uncomfortable this may be.

Asset Class Returns

After cases of the virus seemed to fall over the summer, infection rates began to rise in Europe and the US. In response, many governments in Europe introduced new strict lockdowns during November and December. The US, hesitant to introduce a national lockdown, instead allowed individual states to manage their own response to deal with the virus.

Despite this, for the third consecutive quarter of 2020, equity markets continued to rally, far outperforming fixed income; global equity increased by 8.31% while global fixed income suffered losses of -2.81%[5].

Source: FE Fundinfo (2021)[6]

Emerging market equities also showed strong growth of 12.37%[7]. China, having successfully contained the virus was able to reopen factories closed earlier in the year, to meet the increased demand for pandemic related goods: electronics and medical equipment. The increase in demand for Chinese goods resulted in a total trade surplus of $75.42bn in November, the largest since records began in 1990.[8] 

Notably, this increase in Chinese exports resulted in a worsening trade surplus with the US, increasing by 52% to $37.4bn in November.[9] Despite the “phase one” trade deal being signed between the two countries in January 2020, seen by many as being the first step towards ending the US-China trade war, China has consistently failed to meet its obligations to increase US imports.

Source: The Peterson Institute for International Economics (2020)

China may have believed a change in the Whitehouse would improve the situation, however, President elect Joe Biden has made it clear that he is in no rush to change US trade policy towards China by reducing the tariffs introduced by the Trump administration back in 2016, despite numerous studies finding the trade war has cost US jobs[10] and reduced GDP[11]. It looks as if both sides will need to return to the negotiating table over the coming months.

The fourth quarter did give hope to embattled value stock investors. Value investing involves identifying stocks that are trading at a price below which the business performance of the company would justify, in the belief that in the long term the market will recognise this mispricing and their value will increase. Essentially, buy low, sell high. For a number of years value stocks have underperformed their growth stock rivals; those assets which are expected to outperform the overall market in terms of revenue and earnings growth.

The pandemic exacerbated the performance differential. When the pandemic hit earlier in the year, and lockdowns closed down economies across the globe, equity markets crashed. Governments and central banks acted quickly, introducing various strategies to safeguard businesses and jobs. This caused a sharp recovery in equity markets.

Source: FE Fundinfo (2021)

However, this recovery was not equal across investing strategies, with value stocks trailing their growth stock counterparts. The explanation for this is in part due to the cyclical nature of many value stocks: energy, transport, retail, for example. These sectors were hit particularly hard by lockdowns, while many growth stocks actually benefited from lockdown, particularly the technology sector. How many of us flocked to Amazon, Netflix and Zoom?

Over the last quarter of 2020 there was a noticeable shift in the relative performance of growth and value stocks. Since the beginning of October, the MSCI World IMI Value index was up 10.03% whereas the MSCI World IMI Growth Index climbed 5.76%. There is insufficient data to make a definitive statement as to whether this is the start of prolonged shift in the growth versus value investment strategy relationship, but it is an encouraging start.

Source: FE Fundinfo (2021)

Indeed, the beginning of the shift in early November coincided with two events which caused a shift in investors’ expectations of a return to economic growth. Firstly, President elect Biden won the US election, during his campaign he made it clear he intends to invest heavily in areas such as energy and infrastructure.[12] Secondly, Pfizer’s[13] announcement of the first viable vaccine gave hope that life will eventually return to normal. Both of these events will have a greater impact on traditional cyclical sectors of the economy.

With President Trump signing a $900bn[14] stimulus package at the end of December, together with additional vaccinations being approved, this has the potential to assist a continued value rally but is this a permanent switch from growth to value? Time will tell.

Portfolio Performance[15]

Open Money Cumulative Gross Performance

Equity markets continued to recover from the market shock earlier in the year. Compared to the end of last quarter, whereby Portfolio 2 and Portfolio 3 were both in negative territory over the preceding 1-year time period, returning  1.8% and -4.1% respectively, now all portfolios are in positive territory over all time periods.

Portfolio 3 returns continues to lag the other portfolios over the 3-year period, although return has increased from 9.7% to 12.1%. This is due to the fact that Portfolio 3, being the most heavily equity weighted portfolio suffered the greatest decline in value during the market shock early in 2020. However, over the 5-year period, Portfolio 3 has delivered the highest return to investors of 55.5%.

Source: Betafolio (2021)
Source: Betafolio (2021)
Source: Betafolio (2021)

Data sourced 10/02/2021. OpenMoney portfolios have been running since April 2017, therefore returns before this date are simulated based on the performance of OpenMoney's underlying investments. Past performance is not an indicator of future returns.

Closing Words

Where to start? Well, I think we can all agree, 2020 is a year to forget, maybe we should turn our calendars back from 2021 to 2020 and try again? A year ago, as we drafted the last quarterly review for 2019 the team discussed the news coming out of China of a new virus, we balked at the idea that a pandemic was on the way and expected it to disappear in the same way as SARS or Swine flu. We are not good at predictions!

The year was a rollercoaster for investors, experiencing a full market cycle in a matter of months; the fastest 30% drawdown in the history of global equities in the first quarter, followed by the largest 50-day advance in market history in the second. However, it was not only the continued economic uncertainty that served to challenge investors, the government’s response to the pandemic has been unprecedented; straining our emotional, mental and physical health.

With the approval of both the Oxford-AstraZeneca and Pfizer vaccines in the final weeks of 2020 it looks as though we are approaching the endgame. The next step, inoculating 66.8m[16] people is a huge logistical challenge and even if the NHS managed to inoculate the 2 million people a week, recommended in a recent study[17] to prevent a third wave, normality is still many months away.

Despite the ongoing pandemic and the associated anxiety and stress it continues to cause, rest assured, your investment portfolio has been designed using decades of research in order that it can successfully weather such market shocks.

References

[1] Tetlock, P. E. (2005). Expert Political Judgment: How Good Is It? How Can We Know? Princeton University Press.

[2] Langer, E. J. (1975). The illusion of control. Journal of Personality and Social Psychology, 32(2), 311-328.

[3] Daily prices 01/01/2020 to 31/12/2020.

[4] Closing value 24/12/2020 versus 29/12/2020.

[5] Global Equity: FTSE Global All Cap, Global Bonds: Bloomberg Barclays Global Aggregate,01/10/2020 to 31/12/2020.

[6] Global Bonds: Bloomberg Barclays Global Aggregate, UK Gov Bond: Bloomberg Barclays Global Aggregate UK Government Float Adjusted, UK Equities: FTSE All Share,Global Property: FTSE EPRA Nareit Global, Emerging Markets Equity: MSCI Emerging Markets, EU Equities (ex-UK): MSCI Europe ex UK, Japanese Equities: MSCI Japan, US Equities: MSCI USA, Global Value Equities: MSCI World Small Value, Global Equities: FTSE Global All Cap, UK Inflation (RPI): UK Retail Price Index.

[7] Emerging Markets: MSCI Emerging Markets 01/10/2020 to 31/12/2020.

[8] Bloomberg. (2020, December 7). China’s Exports Surge in Year-End Rush as Pandemic Fuels Demand. Retrieved from Bloomberg: https://www.bloomberg.com/news/articles/2020-12-07/china-s-exports-rise-most-since-2018-as-year-end-demand-surges

[9] Barron's. (2020, December 7). China Exports Surge By Forecast-beating 21.1% In November. Retrieved from Barron's: https://www.barrons.com/news/china-exports-surge-by-forecast-beating-21-1-in-november-01607315402

[10] Moodys Analytics. (2019). Trade War Chicken: The Tariffs and the Damage Done. Retrieved from https://www.moodysanalytics.com/-/media/article/2019/trade-war-chicken.pdf

[11] Bloomberg. (2019, December 18). Trump’s China Buying Spree Unlikely to Cover Trade War’s Costs. Retrieved from Bloomberg: https://www.bloomberg.com/news/articles/2019-12-18/trump-s-china-buying-spree-unlikely-to-cover-trade-war-s-costs

[12] Biden Harris (2020).

[13] Pfizer(2020).

[14] The Washington Post (2020).

[15] All data is up to last price - 31 December 2020. Past performance is no guarantee of future return. Data sourced from Morningstar API. Careful consideration has been taken to ensure that the information is correct but it neither warrants,represents nor guarantees the contents of the information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Percentages may not total 100 due to rounding. Performance Periods: 1 Year: 31/12/2019-31/12/2020; - 3 Year: 31/12/2017 – 31/12/2020, 5 Year:31/12/2015-31/12/2020.

[16] ONS. (2020). Population Estimates. Retrieved from Office for National Statistics: https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/populationestimates

[17] London School of Hygiene and Tropical Medicine. (2020). Estimated transmissibility and severity. Retrieved from https://cmmid.github.io/topics/covid19/reports/uk-novel-variant/2020_12_23_Transmissibility_and_severity_of_VOC_202012_01_in_England.pdf

The Peterson Institute for International Economics. (2020, December 23). US-China phase one tracker: China’s purchases of US goods. Retrieved from The Peterson Institute for International Economics: https://www.piie.com/research/piie-charts/us-china-phase-one-tracker-chinas-purchases-us-goods