Irregular Roundup, 5th August 2024

We begin today’s Irregular Roundup with structured products.

Structured products

Joachim Klement is not a fan of structured products and would like the industry to stop selling them.

• Joachim is from Germany. – these products are popular on the continent but have never caught on in the UK or US, where stocks (and spread bets/options for leverage) dominate.

They are illiquid products where the only market maker is the bank that issued these products in the first place and where a ton of fees are hidden in the pricing of the derivatives that make up the products. The most common ones are:

• convertible bond structures (essentially a long call option plus a money market investment),
• a reverse convertible (a short put plus a money market investment) and
• barrier reverse convertibles (fancy version of reverse convertibles with exotic options to provide additional downside protection).

They are sold for tax-efficiency or downside protection but as usually not worth buying.

A recent study looked at the impact of structured products (SPs) on a regular 60/40 portfolio.

Volatility does indeed drop for small allocations to structured products of 20% or less. The reduction in volatility tends to be in the order of 0.1-0.2%. or about 1-2.5% of the total volatility of the original 60/40 portfolio. That is paid for by a reduction in returns in the order of 0.3-0.7%.

This is not a good deal and leads to lower Sharpe ratios.

Advocates for structured products sometimes say that Sharpe-ratios and volatility don’t matter because structured products are designed to reduce downside risk not upside opportunity. 

So perhaps the Sterling ratio is a better measure.

• This divides return by the average drawdown (plus 10%).

Sadly, adding SPs pushes down the Sterling ratio, too.

Structured products aren’t even good at doing what they are supposed to do, namely reduce downside risks with limited reduction in upside opportunity.

But the issuing banks make money from selling them, so they won’t stop.

US debt

For Ruffer, Gemma Cairns-Smith said that the US debt level was too high.

We fear the cost of servicing debt is on track to become excessive. The US government is currently spending almost a fifth of all tax revenues to pay the interest on their borrowings.

That’s already more than the entire defence budget today. Even more worryingly, the government is forecasting that interest costs will rise to 35% of total revenues by 2054. These projections are based on rosy assumptions: GDP growth ofabove 1.8%, ten year yields below 4%, and inflation of 2%.

The most likely way for governments to deal with this is financial repression.

• Keeping inflation higher than interest rates will reduce the real value of government debt over time.

This is the cornerstone of our structural view; we are in a new economic regime where 2% inflation is the floor rather than the ceiling. This would be a challenging environment for asset prices – 2022 was a lesson in this.

So inflation protection becomes important.

For the Ruffer portfolio, such protection comes in the form of UK and US
inflation-linked bonds alongside gold and other precious metals, and
commodity exposure.

Index-linked bonds did badly in the recent bout of inflation, but they should do well if interest rate expectations fall and inflation expectations rise.

National Wealth Fund

In The Spectator, Ross Clark was unimpressed by Rachel Reeves’s ‘National Wealth Fund’

• It leaves me cold, too.

A real sovereign wealth fund is like a pension pot – you save from an annual surplus and invest for the long term.

• Norway’s use of their oil and gas money comes to mind.

Norway now has £1.3 trillion squirrelled away, equivalent to £240,000 for every citizen.

The Labour version is more like PFI – a mix of public and private funds that will be forced to invest in unproven projects from a targeted sector (in this case green stuff).

The Norwegian fund has its 18 trillion kroner spread over 9000 companies in more than 70 countries. Reeves is looking to concentrate on one asset class, and an extremely dodgy one at that: early stage green technology. She wants to invest in green steel,  in hydrogen production from electrolysis of water and in carbon capture and storage.

These will all come in useful if the new government sticks to the ludicrously ambitious Net Zero targets.

• But they have to work first, and at the moment they don’t.

And the fund is tiny.

Reeves’ fund will be started with a modest £7.3 billion squeezed out of the public budget, in a context of a government that is heavily overdrawn on its current account. From a personal point of view I would look to pay off my credit card balance before I started having a flutter on the stock market.

Rather than the National Wealth Fund, they should have called it the Blue Sky Jam Tomorrow This Time Next Year We’ll All Be Millionaires fund.

Disappearing millionaires

In the FT, Emma Agyemang reported that the UK stands to lose more millionaires than any other country over the next four years.

An analysis of global wealth trends by UBS projected that the number of dollar millionaires in the country would fall 17 per cent from 3.062mn in 2023 to 2.542mn in 2028. The Netherlands was also forecast to lose 4 per cent of its millionaires.

52 of the 56 countries UBS looked at were set to have more millionaires.

This is the second report to suggest an exodus:

Henley & Partners last month said the UK would experience a net loss of 9,500 millionaires in 2024 — second only to China worldwide — and more than double the 4,200 millionaires who left the country in 2023. More millionaires had been leaving the UK than arriving over the past decade, with the UK suffering a net loss of 16,500 millionaires between 2017 and 2023.

The mobile wealthy have historically been attracted to the UK. UBS Economist Paul Donovan said:

The UK has the third-highest number of dollar millionaires after the US and China and . . . for a country the size of the UK or even the economy the size of the UK, that’s a quite remarkable statistic.

But things have changed:

• Sanctions have got rid of Russians
• The UAE and Singapore have become more attractive
• Brexit and the non-come regime changes have made the UK less attractive
• Protectionism, and contracting supply chains mean entrepreneurs want to closer to their businesses

HNW attitudes

In a similar vein, Wealth Club’s “British Wealth Rrepot” found that 55% of high-net-worth individuals (HNWs) think that the UK isn’t supportive of wealth creation.

• WC surveyed 744 of their clients to compile the report, which aims to measure investor sentiment.

Other findings include:

1. 42% think the UK isn’t a good place to set up a business
2. 31% are more inclined to leave the UK (compared to last year)
3. 81% think the UK is in worse shape economically than five years ago
4. 60% expect taxes to rise and 83% think they will personally pay more tax
5. 71% think that taxes are already too high
6. IHT was the most popular tax to cut, with 42% choosing it
7. Only 32% felt that the was a good place to invest, with 47% preferring the US

For WC, Nicholas Hyett said:

The UK has an image problem [with] wealthy investors. These people are important to the UK. The top 100,000 earners pick up a quarter of the total income tax and capital gains tax bill despite accounting for just 0.3% of UK taxpayers.  Changing this group’s perception of the UK should be a key goal for an incoming government. 

Landlord returns

For FT Adviser, Tom Dunstan reported that average landlord returns have fallen by 45% over the last four years.

• That’s a fall of £4K in profits, largely because of rising interest rates.

The average two-year BTL mortgage now stands at 4.73%.

• The average rental property was worth £230K and would have returned £9.3K pa in 2020 (a 4% yield, assuming assuming a 75% LTV).

The average property is now worth £281K but returns just £5.1K pa (a 1.8% yield).

BTL lending dropped 56% in 2023 (from £41.4 bn to £18.3 bn).

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The research was carried out by Finder, which appears to be a financial comparison site. For Finder, Liz Edwards said:

The buy-to-let market has been stagnating over the past couple of years as rising interest rates have made it less profitable for landlords. We are now seeing the worrying effects this is having on an already competitive market, leaving renters with fewer options and pushing prices higher and higher. 

Record high UK rent inflation of 9.2 per cent was seen in March this year. This new government needs to tackle the rental crisis.

Good luck with that. I doubt Labour will make things easier for landlords, which means that the supply of rental properties will shrink, and/or rents will rise.

German tax breaks

Following on from last week’s news that Portugal plans to offer tax breaks to immigrants of working age, now we hear that the Germans have the same idea.

• The new budget from the coalition government gives new skilled migrants 30% off their taxes in year one (plus 20% in year two and 10% in year three).

The Netherlands already has a similar system but spread over three periods of twenty rather than twelve months.

Everybody wants skilled workers it seems.

• I can’t imagine how it would feel to work alongside someone who is getting a 30% tax break for the same effort, but there won’t be many people who find this kind of thing motivating.

Quick Links

I have just one for you this week:

1. Alpha Architect looked at The Value of WallStreetBets.

Until next time.