FAQs

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.

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.

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).

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.

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.