Will MiFID II Fuel the Next Correction?
Skerritts View – January 2018
The short answer to this question is probably, no, not exactly. It is unlikely to cause it. However, we strongly suspect that it will have exactly the opposite effect on retail investors to the protectionary ideal against which it has been introduced. We suspect that, because of one aspect in particular of the new MIFID II regulations that have been brought in since January 3rd, retail investors will most likely be worse off as a result. Why is this?
One of the new requirements is to report to investors at least quarterly from now on, rather than six monthly as before. We find that those who are interested in their investments will use the online facilities widely available to check as often as they like on how their investments are faring. If they are not the “check-a-day” type, they tend to find that a half-yearly report is more than adequate. Often, in our experience, clients would prefer just one statement a year, so the compulsory four times a year will be more of an annoyance if anything.
The new rule that we think is seriously flawed however, is the one that says that investment firms providing the service of portfolio management need to inform clients by the end of the business day if the value of their portfolio has depreciated by more than 10 per cent from the beginning of the last reporting period. It also requires disclosure at each subsequent fall of a multiple of 10 per cent.
Now, what have we always been told about investing for growth? It’s for the medium to longer term, surely? Wasn’t there a bit of disquiet recently about the move towards short-termism that was being seen as a negative trait in modern investors? We’re often told that it is foolish to try to time markets and that the most common mistake that retail investors make is to buy high and sell low. This is PRECISELY the likely outcome of the new directives.
Looking back at how the FTSE 100, S&P 500 and the DAX have performed since 1st January 2008, if the new rules had been in place back then, we would have written to clients invested in these indices on a combined 31 occasions because there had been a drop of 10% in values (15 times for the DAX, 9 times for the FTSE 100 and 7 times for the S&P). It would be a strong-willed investor indeed who could decline the opportunity to sell with this many notifications. Once sold, it would be highly unlikely that they would re-enter the market quickly, and very likely that if they re-entered at all, it would be at the wrong time on the back of a recovery (buying high).
It is no coincidence that since 2008, every correction has seen a “V-shaped” recovery (i.e. a quick one) because this new era of low interest rates and low bond yields causes cash to seek a meaningful return in the equity markets. It’s impossible to calculate how much investors could have missed out on by selling at the wrong time during the liquidity-driven long-term bull market that has been in place over the past decade, but a simple buy and hold strategy would have produced a return of 73% (FTSE 100), 92% (DAX) and 200% (S&P 500) respectively despite the regular 10%+ drawdowns in that time [Source FE Analytics].
Quite how the new rules encourage longer term thinking escapes us.
Most risk models will tell you that equities are more risky than bonds, and that a low risk portfolio should consist of far more of the latter over the former. Is this still the right way to be looking at risk? With bond yields still stubbornly and historically range bound below (typically) 2%, the risk is far more skewed to losing capital than making it.
Indeed, as the table below shows, the drawdown in the European bond market since July 2016 has been far greater than that in the equity market, a phenomenon that has been seen in the UK and US markets too, if not as severe. Can “low risk” investors cope with drawdowns like this? We’re not advocating that lower risk clients invest 100% in the stock market but it is indicative of how the old rules perhaps don’t work so well in this new era of extended low interest rates.
2018 has got off to a flying start, but can it last? We were not the only ones to forecast more doom and gloom than actually manifested itself throughout any of last calendar year, but does it mean that we are merely closer to the great correction that has been feared thus far? Inevitably every day that does not see a correction means that the next one is a day closer, because that is the nature of markets, but barring a black swan event, we are hopeful that markets can continue to grind higher, at least for the first half of the year.
Storm clouds begin to brew as we approach 2019 however. One signal that we are watching for is the US Treasury yield. Should it reach 3% it suggests a couple of things. First, the equity market is likely to have risen still further, with valuations becoming more stretched as any potential bad news in the economy (and its subsequent effect in future profits) is ignored. Second, at 3% yield, bonds begin to look more attractive once more (assuming inflation has not taken hold) and begin to take on the characteristics of a safe haven asset once more. If money rotates into bonds, the subsequent sell-off in equities could be particularly violent, triggering a series of letters to investors informing them of the drop in their portfolios’ values. The trapdoor could then open.
We strongly believe that the best place to be invested is in a fund that can “go anywhere” in terms of assets and geography as this will offer the better damage limitation should things turn ugly, yet allow investors to enjoy the party while it’s in full swing. We have said before that the biggest bubble of all appears to be in complacency. People have forgotten what a sharp correction feels like. Let’s hope that when the next one comes, the 10% rule won’t make the hangover even worse than it would have been.
These are our views, as always, and don’t constitute advice in any way.
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Established in 1990, Skerritt Consultants Limited is regulated by the FCA – number 163291 and is a MIFID firm
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