Raconteur

Future of Investing 2019

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F U T U R E O F I N V E S T I N G 2 Democratisation of the corporate bond market for private investors Until now the corporate and high-yield bond market has been the preserve of major investment funds, but this is set to change as the digitalisation of the market creates more affordable access UK PENSION FUND ASSET ALLOCATION 2018 1 32% 53% 14% 1% Equity Other Cash Bonds WHAT ASSET CL ASSES CAN PRIVATE INVESTORS ACCESS DIRECTLY? Commercial feature Asset classes Access Who Equities Yes Everyone Government bonds Limited Financial elite Corporate bond market 2 Yes Everyone Forex Yes Everyone Commodities Yes Everyone Equity crowdfunding/venture capital Yes Everyone Property Yes Everyone P2P lending and mini-bonds Yes Everyone CFDs Yes Everyone Cryptocurrencies Yes Everyone Other alternatives Yes Everyone magine a dystopian future when access to the stock market has been restricted to institutions and the ultra-wealthy. Private investors, newly disenfran- chised, have woken up to the scary reality that a small number of elite finance professionals now control the stock market. In this imaginary world, perhaps some investors would simply keep their cash in the bank. But many would surely be furious at the removal of these basic democratic freedoms. This scenario may seem far-fetched, but when most private investors look at corporate bonds this is what they see: an appealing asset class, restricted by a powerful elite. The institutional, club nature of the corporate bond market, limited online trading venues and min- imum purchase sizes typically above £100,000 a unit immediately shut out almost all private investors. There has been an increasing clamour for this to change. In an environment of persistently low interest rates and growing inflation, investors want better returns and greater reliability than the often volatile equity, commodity and currency markets. It remains to be seen if European bond markets will become as devel- oped as their US counterparts, where an estimated 19 per cent of corporate bonds are held by retail investors 1 . A recent European Commission study 2 insists the market be enhanced, noting its importance to investors reducing equity exposure. Bonds already form a large portion of UK pension asset allocation 3 , so why is this different for individuals? In the UK, several projects have attempted to free the bond environ- ment from its shackles. Most notable is the creation of the London ORB, a market open to private investors, but only containing a limited selection of corporate bonds at any one time, with typically lower yields, high cash prices, long maturity dates and ever-smaller corporates using it to issue. The closed-off nature of corpo- rate bonds is particularly conspicuous when we consider that between 2006 and 2018 they have outperformed the largest 100 London-listed equities. Barclays calculates that sterling invest- ment-grade fixed income returned 5.2 per cent annually in the period, com- pared to the FTSE 100 at 4.5 per cent 4 . This is not to mention the superior per- formance of high-yield paper, which returned 6.9 per cent, according to Bank of America Merrill Lynch 5 . In addition, with more than £3.1 trillion of bonds outstanding in the UK, the Bank for International Settlements notes the UK corporate bond market is larger than the London-listed share market 6 . According to McKinsey, the value of cor- porate bonds outstanding worldwide has nearly tripled in the decade since the 2008 financial crisis 7 . Many compa- nies issue both equities and bonds in a bid to optimise their capital structures. The barricaded nature of the bond market means that private investors have not been able to select from such instruments for truly diversified port- folios. While private individuals have been able to invest in company debt through small business peer-to-peer and mini-bond lending, this has been beset by numerous failures and con- cerns of default. Corporate bonds, by contrast, are encouraged by the long-running pur- chase programmes of central gov- ernments and by the reassuring fact that each issuance receives a rating from the main agencies, Moody's, S&P and Fitch, and offers valuable trans- parency given the openness of cor- porate reporting and associated press coverage. Crucially, recent technological inno- vations have greatly opened up the potential for access to the bond mar- kets. The concept of fractionalisa- tion, or splitting into smaller sizes, has been employed for stocks with high prices and this is now being applied to corporate bonds, which means much smaller purchasing sizes and online trading. "It's time for bond markets to enter the digital age and open up to investors," says Rezaah Ahmad, chief executive of WiseAlpha, which offers exposure to corporate and high-yield bonds to anyone with as little as £100 per invest- ment. "In our opinion, the corporate bond asset class is the best mainstream risk adjusted asset class, and we believe greater access and choice should be available to all private investors." Typically, until recently, even funds wanting to invest in the mainstream fixed income markets would have to call a trading desk at an investment bank, with little price transparency. "Even though bonds are a multi-tril- lion-pound market, they are as anti- quated as the stock markets were 50 years ago," says Mr Ahmad. "Amazingly, this method of trading still accounts for 80 per cent of bond volume in the US and is higher in Europe." WiseAlpha has sought to open the market by fractionalising the bonds of FTSE 250-size companies, dividing them into affordable tranches and allowing individuals to gain exposure to bonds issued by household names ranging from Virgin Media and Thames Water to the RAC, Tesco, John Lewis and many others. People can choose the com- panies of most interest to them or use WiseAlpha's robo-manager service to help diversify their portfolio. "Our mission is to transform and rebuild the corporate bond market," says Mr Ahmad. "We have started a big change and we expect policymakers and regulators to further aid the lib- eralisation of the market, as they look to support greater consumer financial welfare, and to introduce healthier fixed income choices, more electronic trading initiatives, greater transpar- ency in corporate financial reporting and fewer systemic risks." Private investors are looking to estab- lish more diverse portfolios and the opening of the bond markets will trans- form their options. The level of return on offer, given the risk profile, is hard to ignore. To find out more about the corporate bond asset class please visit wisealpha.com We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. As with all investing your capital is at risk. Please remember bonds are investments, not deposit-protected savings products. This financial promotion has been com- missioned by WiseAlpha Technologies Limited, which is authorised and regulated by the Financial Conduct Authority (No 751087). "Private investors" is used in this article to refer to individual investors. 1 Deloitte, The Corporate Bond Report 2018 2 European Commission, Analysis of European Corporate Bond Markets 3 Willis Towers Watson, Global Pension Assets Study 2019 4 Barclays Sterling Investment Grade Index LC61TRGU FTSE 100 Total Return Index TUK XG 5 Bank of America Merrill Lynch Sterling High Yield Index HL00 6 £2.24-billion FTSE All-Share market cap (Bloomberg 2018). £2.6-trillion financial and £511-billion corporate bond market (BIS) 7 McKinsey, Rising Corporate Debt I It's time for bond markets to enter the digital age and open up to all investors 1 Willis Towers Watson, Global Pension Assets Study 2019 2 Please note a small selection of retail corporate bonds do exist on the London ORB for UK investors Commercial feature The true cost of cognitive errors Understanding ingrained behavioural biases can help investors improve decision-making and identify irrationalities, but it is not an exact science ost investors think they know what they are doing. They do not. A startling picture is emerging of the true cost of human error in investing. Nobel-winning academics such as Daniel Kahneman and Richard Thaler have shown that humans are driven by many deeply ingrained behavioural biases, such as fear, greed and overconfidence, in their invest - ing decisions. This has led a small army of investment statisticians to try and calculate how much these biases cost individuals. Research firm Morningstar claims biases cost the average investor 1 per cent a year in returns. Vanguard Asset Management claims the figure is 1.5 per cent. Researchers at Dalbar put it at 3.5 per cent, while finan - cial economist Professor Brad Barber and colleagues say errors cost investors a hefty 4 per cent annually. Advisor y education f irm Edvoa has created a tool showing how these per- centages affect investments over time. It shows that for a £100,000 investment over 25 years, the biases would cost an investor £85,000 based on a 1 per cent annua l cost of errors or £191,000 based on 2 per cent. Vanguard looked at the effect on individ- uals making a £250 monthly investment. For them, a 1.5 per cent cost would lose them £24,000 over 20 years, but that would grow to a painful £274,000 over 50 years. Behavioural biases can be difficult, or even impossible, to override. Craig Burgess, managing director of EBI Portfolios, recom- mends reading Dr Kahneman's Thinking Fast and Slow to see why. "These biases evolved over thousands of years," says Mr Burgess. "We are pat- tern-seeking primates, which is useful for hunting prey, but terrible for complex tasks such as investing. So, we are now regularly prone to hundreds of biases, too deeply ingrained to overcome without removing the human from the process. Reading the book is not enough. "A simple example is the investment industry's arbitrary obsession with three and five-year performance data. That short - er-term view can sway investors." But Ken French, a pioneering academic in this field, showed you need 22 years of data to prove that a manager has enough skill to beat the market consistently. Mr Burgess says removing the human makes it relatively easy to solve these prob- Tim Cooper M B E H A V I O U R lems using a systematic approach based on principles proven by academic evidence. These principles include diversification across asset classes, funds, sectors, geog- raphies and investment styles. Another principle is investing for the long term and ignoring short-term volatility. A third is minimising costs as these can dent returns significantly over time. So-called passive investments are there- fore important as they are cheaper because they track an index automatically without much intervention from a fund manager and they remove the risk of a human man- ager making errors. Also so-called smart beta funds automat- ically access certain factors that evidence suggests will outperform the market. These factors include investing in smaller com- panies, "value" or cheaper companies and highly profitable ones. However, so-called active managers dis- pute these ideas and point to other evidence showing that a skilled manager with con- viction can beat the market consistently. James Norton, senior investment plan- ner at Vanguard Asset Management, says errors are mostly sub-conscious so inves- tors are not aware of them. This can lead to dangerously risky behaviour. "If you pick a fund that does well, you may think it's down to your skill, even if it's not," he says. "That may encourage you to take more risks next time. The opposite is true in a falling market. For example, if you sold out of shares at the lowest point of the credit crunch in 2008, you would have missed the next ten years of growth [more than 60 per cent]." Other people suffer from a different bias called loss aversion, which means they feel the pain of a loss twice as intensely as the pleasure of a gain. "That leads many to avoid investing com - pletely, despite evidence that you will be better off if you stay invested in shares for as long as possible," says Mr Norton. To avoid biases, he suggests asking for feedback from a colleague, friend or adviser, planning investment strategies and stick- ing to them, and rebalancing automatically to stay within your desired asset allocation and risk range. It is also important to start derisking, by moving from shares into bonds or cash, well before you need the money. Mr Norton also suggests limiting port- folio reviews to once a year, for example. This means you will only tend to see posi- tive movements and fewer of the painful short-term drops that could spark an irra- tional reaction. Advisers and investment professionals can help investors do all these things, he says. Behavioural biases do not just affect individuals as herd mentality often leads stock markets to behave irrationally, creat- ing short-term disconnects between share prices and fundamental data on corporate performance. The result is bubbles, such as the dot com boom, and crashes as seen dur- ing the credit crunch. Some argue that disciplined investors can exploit these biases by buying cheap stocks in a falling market, when the herd is fearful, and selling when the herd is greedy and overbuying. Blake Crawford, portfolio manager at J.P. Morgan Asset Management's interna- tional behavioural finance team, says: "If investors can improve the decision-mak- ing process and identify irrationalities when they happen, they can spot mispriced securities." He suggests setting up rules or frame- works that apply consistently to investment decisions and reduce the role of emotions. A downside is that this approach "can be painful for short periods, particularly when markets are behaving irrationally, but long term this is the only sustainable way of investing", says Mr Crawford. Another solution can lie with policymak- ers. Mr Crawford highlights an evolution of behavioural finance called nudge theory, proposed by Dr Thaler. This suggests policies that nudge people towards rational decisions. Pensions auto-enrolment is the perfect example as it pushes employees to invest in the market, via a pension, for the long- est time possible. As a result, millions of people are avoiding an irrational decision to shun investing for the long term, says Mr Crawford. We are pattern-seeking primates, which is useful for hunting prey, but terrible for complex tasks such as investing HOW INVES TORS RESP OND TO VOL ATILIT Y Changes that investors made to their portfolios in direct response to market volatility Schroders 2019 Moved some of their portfolio into cash Moved some of their portfolio into lower- risk investments Moved some of their portfolio into high-risk investments Beginner/ rudimentar y investors Intermediate investors Expert/advanced investors Phil Ashley / Getty Images 17% 26% 52% 29% 40% 38% 14% 20% 24%

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