Last years review is here,
https://www.lemonfool.co.uk/viewtopic.php?f=56&t=17266
The format of the first half of this review will be similar to last year. In the second half I will focus more on what I have done in the last two months or so (for obvious reasons), and also I will be giving much more thought than normal to what is going to happen in the next 12 - 24 months.
Current situation
After hitting my FIRE moment in late 2013 (If memory serves, I think that stands for, "F*** it, I'll retire early) I am still living mainly off investment income, with a smattering of book royalties, part time lecturing, and the occasional consultancy fee. I am a year older (mid forties), my kids are a year older and my wife is also a year older but I am obliged to say she doesn't look it. My third book came out in October, and I will be celebrating the tenth birthday of my fixed term mortgage next year (this may become relevant later).
Performance and income sustainability
Overall our household balance sheet is down 9.0% since last year. Broadly speaking that is the net result of:
Dividend income (net of tax): 3.3%
Other income (net of tax): 0.8%
Household spending: -3.2%
Mark to market: -10.0%
(Household spending includes mortgage interest, but not repayment since the latter has no net effect on overall wealth). No increase in house value is included in net worth; I still value my house at acquisition cost plus cash improvements.
This is the first time my net worth has fallen since.... well since 2008-9. On the upside, since I retired our household balance sheet still has an average annualised growth of exactly 4% a year, and this crash has put me back to around late 2016. And right now, looking around the country, we are still in an extraordinarily lucky position.
Anyone who is relying entirely, or mostly, on dividend income needs to think about their 'margin of safety'. You can already see from the figures above that household spending was covered by dividends after tax, if we ignore mortgage repayments. Here is my preferred way of presenting this, the 'waterfall'. From top to bottom spending goes from 'permanent' costs to costs that will eventually vanish; and on the income side from 'guaranteed' dividend income down to other passive income (royalties), then finally various kinds of employment income.
If 100 is income from all sources then:
Household expenditure excluding mortgages: 62.6
........ with mortgage interest: 73.7
........ with mortgage interest & repayment: 84.2
Income from dividends outside of tax shelters, net of tax: 41.2
Income from all dividends: 81.2
Income from all dividends, plus book royalties (net of tax) - eg passive income: 87.2
Income from all dividends, royalties, self and part time employment (net of tax): 100.0
It is likely that this picture will look very different in a years time, but more of that later.
The difference between income inside and outside tax shelters is down to cashflow. Because my dividends outside of tax shelters do not cover expenditure, and because I want to avoid withdrawing from ISAs and SIPPs, I need to generate extra cash. This cash requirement will increase over time as more of my assets become tax sheltered, eg in my 2018 review I earned 55% of income from non tax sheltered dividends and now this is just over 40%.
Ideally this will come from other income, and factoring this in I earn 60.4% of my income outside of tax shelters; still a shortfall. Futures trading also generates cash, and this year it generated a lot (more on this later). However from time to time I will have to sell assets outside tax shelters to realise enough cash. As long as this does not incur CGT I am fine with this. Some cash is also required to fund these tax shelters to the maximum level allowable, and sales here are just "bed and ISA/SIPP" transactions.
Portfolio overview
My investment portfolio can be deconstructed in various ways. For this post I will use the following categories; the figures shown are the contribution of each category to my total investment performance (so these are not XIRR figures):
a) UK equities -3.9%
b) ETFs -11.6%
c) Long only investments (consisting of a plus b) -15.5%
d) Systematic futures trading +7.0%
e) Equity hedge +2.3%
Total net: -6.2%
An explanation of d and e; my futures trading account is funded with a lump of equity (both buy and hold, and ETF) and some cash. To avoid equity returns “polluting” that account I hold a hedge against the equity exposure (also in futures). This makes the returns of that account a combination of two hedge fund strategies - “managed futures” and “equity neutral”.
It's pretty obvious why a short equity hedge has made money in the current environment. The futures trading should also be uncorrelated to equities, though perhaps not the 'disaster insurance' of a negatively correlated strategy. Indeed, the figures above hide the fact that I made all money in futures in the first 10 months of the period, and was then flat in the COVID period from mid February onwards. Whereas the long only stuff was up nicely and then collapsed in the last few weeks. So although it looks like there has been a nice diversifying effect from the futures, this is stretching the truth somewhat.
UK equities
This is effectively a 'trading' portfolio, using a mechanical system described here https://www.lemonfool.co.uk/viewtopic.php?f=7&t=684&p=6221#p6221 plus enforced sector diversification. Crucially there is a 30% stop loss in place on all these positions.
At the start of the year the picture looked like this:
ICP 20.98% (Inter Capital Group)
VSVS 10.79% (Vesivius)
BKG 10.59% (Berkley Group)
CEY 8.91% (Centamin)
STOB 8.76% (Stobart)
GOOG 8.69% (Go ahead)
PTEC 8.66% (Playtech)
LGEN 8.47% (Legal and General)
HSBA 7.21% (HSBC)
BP 6.94% (BP)
At the end of the year, it looks like this
HMSO 100% Hammerson
What has happened here, I hear you cry? Well after doing some more research I decided to make a further tweak to my system, where I wouldn't replace stocks that had hit their stop loss if there was clear downward momentum at the index level. And indeed, that is exactly what happened.
Just for fun I decided to calculate the effect of this extra tweak, and it actually ended up losing money, but not very much (~2.5% of the starting portfolio value). The index is now trending upwards, so I am rebuilding this portfolio. More on this later.
Not shown above, but held at various times of the year were Hays HAYS, Kingfisher KGF, Elementis ELM, and Man Group EMG (my former employers).
Almost all my positions showed a total return loss during the year, ranging from -68% for Stobart (though I have been selling this position gradually for a few years, and am way ahead) to BKG and ICP which were basically flat (-1% and +1% respectively).
The bottom line for this subportfolio was an XIRR of -23.1% vs a benchmark (FTSE 100 ETF) of -24.3%. A small beat, but on a slightly longer view my UK stockpicking performance has been pretty respectable:
2016 - 2017 XIRR 29.2%, benchmark 22.7%
2017 - 2018 XIRR 18.3%, benchmark 2.2%
2018 - 2019 XIRR -2.3%, benchmark 7.6%
2019 - 2020 XIRR -23.1%, benchmark -24.3%
Divis made up about 4.6% of the XIRR, not a surprise given my filter likes buying high yielders with sustainable dividends.
ETFs and funds
All my non UK and non equity exposure is in ETFs, with a smattering of investment trusts. As usual trading was done for tax optimisation, to generate funds for SIPP and ISA Investment, and to get the right risk exposure (discussed later). I don't look at the performance of my ETF portfolio seperately, only in conjuction with UK shares.
Long only
The news here wasn't much better. Adding up the performance of both my stocks and ETFs, I get to an XIRR of -17.5% versus a benchmark of -10.5% (a Vanguard lifestyle fund where the bond:equity allocation is chosen to be as close as possible to my overall strategic risk allocation). That is pretty unpleasant, and there are a few reasons for it. Firstly, I have a relatively high equity allocation in my long only portfolio, which is a bit lower once I take into account my equity short and the risk allocated to my futures trading. I should probably use a seperate benchmark for my long only portfolio, versus my entire portfolio, but life is too short. Adding on my equity short hedge performance would bring my XIRR up to 15% (and would of course make my performance in earlier years mostly worse).
Secondly, my equity allocation was higher than my strategic allocation before the crisis hit, due to favourable trends (the signal I use to adjust my equity allocation). Finally, my bond allocation at the start of the year was overweight in riskier bonds (EM and higher yielding corporates). Basically I was a 'yield hunter' unwilling to buy safe low yielding developed country government bonds, but of course in a crisis riskier bonds behave more like equities.
As an interesting footnote my systematic futures portfolio was quite happy to buy low yielding government bond futures, as these still had 'positive carry' despite their low yields.
Here's the (rather mixed) track record for my long only portfolio:
2016 - 2017 XIRR 22.3%, benchmark 17.7%
2017 - 2018 XIRR 1.3%, benchmark 1.3%
2018 - 2019 XIRR 4.0%, benchmark 7.2%
2019 - 2020 XIRR -17.5%, benchmark -10.5%
Systematic futures and equity hedge
I've already noted that my hedge made money as one would expect (although it actually made a small loss when offset against the stocks it was supposed to be hedging, but as usual I don't show this figure as it would be double counting). On pure futures trading I made 39.4% of the notional risk capital allocated (my preferred measure; it would be a much higher figure as a percentage of cash allocated or used for margin). For those who know and care about these things my target annualised standard deviation of returns is 25%, so this is a 'Sharpe Ratio' of over 1.0. It's a good year, no matter how you slice it.
Here is the track record versus two industry benchmarks which I've adjusted for the different levels of risk compared to my own portfolio. The first benchmark is an industry average (the SG CTA index, if you care. CTA stands for Commodity Trading Advisor. It's a shorthand for the type of strategy I run, using futures to capture trends in asset prices). The second is a representative fund run by my former employers. They are much better than the industry as a whole,
There is slightly more track record here, since I started methodically tracking the performance of this portfolio once I began trading it in April 2014.
2014 - 2015 XIRR 58.2% benchmark N/A, 65.8%
2015 - 2016 XIRR 23.2% benchmark -6.7% -9.4%
2016 - 2017 XIRR -14.0% benchmark -21.9% -5.3%
2017 - 2018 XIRR -3.7% benchmark -3.8% 9.7%
2018 - 2019 XIRR 5.2% benchmark 0.7% 5.9%
2019 - 2020 XIRR 39.4% benchmark 8.0% 23.4%
I've certainly been better than the industry average, and unusually I've also managed this year to beat my former employers (who have something like 75 front office staff working on their fund). It isn't a meaingful result, but it's enough to make you chuckle slightly.
Total investment return
I already gave away the total return figure in the headline, but for completeness here it is again: an XIRR of -6.6% vs a benchmark of -10.5%.
To put that into some context, here are the figures for the last few years since I started doing this exercise:
2016 - 2017 XIRR 18.2%, benchmark 19.3%
2017 - 2018 XIRR 0.6%, benchmark 1.3%
2018 - 2019 XIRR 4.4%, benchmark 7.2%
2019 - 2020 XIRR -6.6%, benchmark -10.5%
You can see there is a pattern of small underperformance each year, which was finally broken this year (though realistically, I'm still behind).
Still a fun exercise is to compare this to the likely performance I would have had with a 100% UK equity portfolio, which is what I held in 2008 and which I guess is still pretty common. A FTSE 100 tracker would have lost 24.3, and I lost 6.6%. Where does the outperformance come from?
- - A FTSE 100 tracker would have lost 24.3%
- My UK stockpicking 'skills' bought that down to 23.1%
- A geographically diversified equity ETF lwould have lost about 16%
- Adding global bonds to the mix gets you to -10.5%
- My lack of skill in global asset allocation knocked me down to -17.5%
- My equity hedge reduced that loss to -15%
- Allocating to an industry average CTA fund would have reduced the loss to about -12%
- My 'skill' in futures trading reduced the loss further to -6.6%
Or to put it in order of importance:
- - Geographic diversification across stocks added ~8%
- Diversification across asset classes added ~4% (with bonds) or ~7% (with a CTA allocation)
- 'Skill' and hedges added around 3%
Diversification really is the thing to do! OK, it's not easy for everyone to run a mini CTA from home. But everyone can buy a diversified ETF portfolio.
Risk
My risk allocation has been a moving feast this year! Here it is as of April 5th, and I will discuss the changes and future direction in the next COVID-19 specific part of the post.
Cash allocation
|Asset |Start of year|Current|
|Bonds | 22.7% | 28.8% |
|Equity | 65.1% | 45.8% |
|Other | 2.7% | 0.2% |
|Cash | 9.5% | 25.2% |
"Cash" excludes money held in bank accounts which will cover ~6 months of living expenses that I do not deem part of my investment portfolio.
Risk allocation
|Asset |Strategic|Start of year|Current|
|Bonds | 22% | 12.0% | 17.4% |
|Equity | 50% | 60.7% | 50.2% |
|Futures | 25% | 24.7% | 32.2% |
|Other | 3% | 2.5% | 0.3% |
Yes, I have a lot of cash. This is also why my futures risk has gone up as a percentage; I have a smaller proportion of my investment portfolio in non-cash at-risk assets, but my futures risk in money terms is almost identical to last year. In real terms I've essentially de-risked the long only part of my portfolio, with a re-allocation from equities to bonds.
More on this subject in a moment.
Regional exposures (rows add up to 100%)
| | Asia | EM | Euro | UK | US |
|Bonds | 0% | 19% | 14% | 17% | 49% |
|Equity| 17% | 32% | 8% | 23% | 19% |
The global pandemic sized elephant in the room
This would normally be the end of the post, with some trite quote from Charles Dickens or Peter Mandelson. However this has not been a normal year, and the next couple of years probably won't be eithier.
It certainly seemed reasonably normal when in mid February I went on a skiing trip in Northern Italy. There were guys at the airport testing temperatures when we arrived in Milan, but nothing when we returned to the UK a week later. Some of my Chinese students came in wearing face masks, but then this hadn't been uncommon during the SARs epidemic (which killed ~800 people globally, or roughly the number that are dying every single day just in the UK from COVID19). Since then the world has completely changed, at least temporarily, and from a hard nosed economic point of view global markets have fallen by about a third, and have since rallied so they are now down 'only' 20%.
So what I have been up to? My futures trading is fully systematic, and as I've already alluded to it didn't do very much. Having made a lot of money in 2019, and then another 9.7% in January, it was flat in February, March, and (so far) April. My UK stock portfolio has also been discussed; my stocks started hitting stops on February 27th and were not replaced in accordance with my tweaked trading rule. The earlier the stops were hit the better those trades look; all the trades I did before 7th March are in the black. Those done afterwards are mostly in the red since the stocks have since rebounded, and as I've already said this resulted in a small loss net-net amounting to about 0.4% of my total net worth.
That left me with the job of trying to manage my overall risk allocation by trading ETFs, something I do entirely manually although I am guided by the same principles that I use elsewhere. In particular I allocate to asset classes based on trends and risks; an asset class in a downtrend needs to be reduced, as does an asset class whose risk has increased. It is obvious then that I was overweight equities. The market had helped here, by reducing the value of the equities versus bonds in my portfolio (thanks market!). Still I decided I needed to do more.
On February 28th I sold US and European equity ETFs amounting to 4.5% of my investment portfolio and bought US treasury bonds. For this crisis portfolio my bond allocation was not going to be in 'dash for trash' high yielding government bonds; I needed the real diversification of gilt edged securities. The equities I was selling was with one eye on optimising capital gains tax, and with the other eye on keeping a reasonable geographic diversification.
A couple of weeks later on the 13th March I recycled some of the proceeds from selling UK shares into US treasury bill ETFs, a value amounting to about 6.6% of my portfolio. My concern here was something else; I didn't want to exceed the deposit insurance limits which I was well over in several brokerage accounts. US treasury bills are 'cash like' but do not count towards these limits. With the same thing in mind I opened a government backed NS&I account to look after a chunk of cash sufficient to cover a years living expenses (more on this later). At this stage things looked pretty grim; I even took several hundred quid out of the bank in paper money in case the ATMs stopped working (a real fear in 2008). Ironically no shop will take paper money now, and instead it's sitting in an envelope inside our safe.
Between the 16th March and 19th March I sold more equity ETFs, amounting to about 15% of my total investment portfolio, and again recycled these into a mixture of US government bonds and treasuries.
On the 20th March I called the bottom https://twitter.com/investingidiocy/status/1240650064923709440
And I started to gradually shift my exposure back towards equities https://twitter.com/investingidiocy/status/1241009290246270976.
But I'm a conservative systematic trader, so I didn't go 'all in', sadly as it looks like I was very close to spot on (just one trading day early). The other thing I didn't want to do is buy individual equities just yet, until there was at least some updating of analyst forecasts to reflect the new normal, even if those updates are still sticking wet fingers into the air. So instead I bought the quasi-tracker IUKD as a placeholder for my UK stock exposure (which as a happy by product of this crisis, I was going to be able to consolidate in a single tax-sheltered brokerage account), as well as European equity ETFs which were on particularly attractive yields. Total purchases of around 4% of my portfolio value were relatively modest.
I continued to buy through the 25th, 26th and 27th March, first using cash and then rotating out of US government bond and T-bill holdings. Total purchases amounted to some 21% of my portfolio value.
With the crisis situation I decided to start monitoring my risk in real time and occasionally posted it on twitter. This gives a numerical picture of the story above:
| | April 2019 | 12th March| 17th March| 20th March| 5th April |
|Bonds | 23% | 26% | 53% | 54% | 29% |
|Equity| 65% | 44% | 26% | 27% | 46% |
|Cash | 12% | 30% | 21% | 19% | 25% |
Overall all my trading activity since 27th February has made ... well enough that my XIRR would have been -8.1% rather than -6.6% (and that includes a small loss from UK equity trading). But it has been a lot of trading. I turned over more than 100% of my portfolio in just over a month. And the figures updated to today probably aren't as good, as the market has continued to rebound.
What next?
Now at least some of the dust has settled, it's worth having a long hard look at where my portfolio currently stands and to judge if it's correct, and what my plan will be for the current tax year. It's very easy to make a bullish or a bearish case for the stock market right now, and I won't bore you with these as I am sure you have heard it all.
If there are bargains to be found, it's probably mostly amongst individual stocks; large sell offs producing large dispersions variations in price, not all of which are justified. Here I limit myself to holding stocks in the UK to avoid any hassles with tax, and because of the availability of filters that suit my choice of metrics. My UK equity portfolio is just 11% of my total portfolio, compared to 18% a year ago, and almost all of that is in ETFs so there is plenty of space here.
So after month end, once some data was available, I decided to start rebuilding my UK equity portfolio. Only the first of these purchases, Hammerson, is included in the year end figures above. It dropped by a quarter in value the day after I bought it, but now shows a modest profit.
Now a large number of stocks are passing my filter, but I am wary of going 'all in' and trying to bottom fish whilst risk levels are still elevated and trends are showing a mixed picture (decidedly up in the short term, still down in the long term).
My rule about sector diversification is more important than ever here; a huge number of housebuilders look great value, but they are probably more exposed than average to the bear case and so you would not want to exclusively own this sector.I decided to invest a proportion of my target portfolio every week in the stock that shows the best value, initially limiting myself to one stock per sector, with an eye to eventually holding about 20 - 25 stocks. I will miss out on some bargains by averaging in like this, but will hopefully pick up a some stocks that are currently overvalued, and will obviously benefit if the current rally turns out to be a false dawn.
At the moment I am using cash for this, but at some point I will sell the 'placeholder' IUKD ETFs and also do a modest reallocation from bonds. It will take about 6 months to fully re-invest this sub-portfolio.
Outside of the UK, my first thoughts involve investing at least some of my remaining unproductive cash. Some of my year end cash was earmarked for ISA funding and has now been transferred.
A chunk of my cash sits in my futures trading account and is required for margin payments. One positive side effect of the crash is that I've reduced the size of my equity holdings in this account (and the hedge against them); something I couldn't do before without incurring CGT. The account is now a 'purer' futures account, with very little p&l coming from the equity + hedge component. This does mean there is more cash in this account than before, although this doesn't reduce my overall risk. Some of this is now invested in 'cash like' treasury bill ETFs, but I am limited to how much I can do of this since the broker currently limits the ability to borrow against these if I need more futures margin. I will have to be more proactive about managing this, if I have larger futures positions I may need to sell down the ETF holding and vice versa. For now my positions are quite small and I can put quite a bit more into 'cash like' ETFs.
Some money can also be retrieved from the NS&I account, but I will need to think more carefully than before about having a sufficient cash buffer to cover living expenses. The reason is covered in the final section of the post, though it's probably not a surprise.
All this investment will be directed into equity ETFs, with a close eye on diversification. In particular, I'm pretty seriously underweight European equity so it's likely that will be amongst my first investments. I intend to
After all that activity it's likely my risk allocation will look something like this:
Cash allocation
|Asset |Start of year|Current| Target |
|Bonds | 22.7% | 28.8% | 33.7% |
|Equity | 65.1% | 45.8% | 57.6% |
|Other | 2.7% | 0.2% | 0.2% |
|Cash | 9.5% | 25.2% | 8.5% |
Risk allocation
|Asset |Strategic|Start of year|Current| Target |
|Bonds | 22% | 12.0% | 17.4% | 17.5% |
|Equity | 50% | 60.7% | 50.2% | 54.4% |
|Futures | 25% | 24.7% | 32.2% | 28.1% |
|Other | 3% | 2.5% | 0.3% | 0.2% |
This does not seem a particularly bad allocation considering the huge amount of uncertainty that is still around at the moment. I can see myself increasing my equity allocation further if the positive trend continues.
Safety first / A total return mindset
In previous years I've been pretty sanguine about my income; I did no detailed cash flow planning, watching dribs and drabs of money and dividends appear, with some judicious trading to optimise CGT and ensure the cash buffer remained at a reasonable size. My margin of safety was sufficiently generous that I could be relaxed about an ordinary setback; royalties drying up, part time employment going awry, consultancy income, or even a modest cut in dividends.
But this is a very different time. It's likely that dividends will be much lower over the next 12 months, with many companies cutting them completely. Conservatively, an expectation of zero dividends seems in order. I fully expect to lose my part time lecturing gig when my contract finishes in a few months time, as UK university funding is likely to be badly hit. It would also be prudent to factor in zero income from consultancy, though book sales seem to be fine so far. I doubt I will be able to draw on government support for self employed people, but I will wait and see. I have to keep reminding myself how lucky we are compared to the vast majority of people.
The obvious thing I need to do is to hold a higher cash buffer. Factoring in the above, I worked out how much cash I'd need to get through the next 12 months. I will leave this amout in my NS&I account.
There is a more subtle point, which is that I should perhaps be thinking about my income in total return terms; in other words factoring in the mark to market increase as 'income', at least whilst dividends are diminished. On one level this is all pyschology, but it's still difficult not to assume that living off dividends is safer than touching capital. This is one reason why I don't allocate all my capital to my futures trading account, which in expectation and in reality, would have done much better than my entire portfolio.
I go some way towards this: I mentally treat my futures trading account as providing 'one off' income rather than capital gains, since it produces cash when capital gains are made. A way of thinking that might make sense is that I got a 'one off' income boost of around 160% of annual income from my futures trading which I can use to cover my expenses whilst dividend levels are depressed. This is all accounting funny business, but it helps.
Summary
It has been an interesting year and a pretty rocky few weeks, but I'm pleased with how I've navigated it. As someone who lives off their investments, capital preservation is more important than making big swings with the bat and knocking the ball out of the ground. I don't know what is going to happen next, and I don't profess to, and my portfolio reflects that.