BMS gained 3.2% in Q4 (based on an account size of roughly €500K, transaction costs can vary somewhat depending on the size of the account). BMS outperformed the benchmark by 1.25% in Q4. BMS gained 7.8% in 2021, outperforming the benchmark by 3.92%.

Those numbers include all charges, which is not the case for our peers. They show you returns before taking account of all charges. For comparative purposes; if we reported our returns before accounting for all charges, our returns look significantly higher than our reported numbers, after taking account of all costs and charges. Wouldn’t it be great if there were no costs and charges? In the real world there are costs and charges. We don’t report our numbers in that way because it is not real and while it is not illegal yet to do so, it is clearly mis-leading. We highlight this in bold print because this truth widens the outperformance of BMS in real terms.

Portfolio Breakdown

Total Equities: 37.5%

• MSCI EAFE ETF: 21.8%
• S&P 500 Low Volatility ETF: 12.4%
• MSCI Pacific Ex- Japan ETF: 3.3%

Total Bonds: 54.2%

• US Treasury Inflation Protected Bond (TIPS) ETF: 32.3%
• Invesco Ultra-Short duration Bond ETF: 21.9%

Currency Hedge: 6.8% capital deployed/ 34% Hedge

Cash: 1.5%

Equities

In this asset class, our model favours The MSCI EAFE (an index that captures large and mid-cap representation across 21 developed markets around the world excluding the US and Canada), The Low Volatility S&P 500 and the MSCI Pacific ex-Japan (an index that captures large and mid-cap representation across 4 of 5 developed markets in the Asia Pacific region, excluding Japan). There hasn’t been a lot of differentiation in risk adjusted returns (after taking account of currency effects) across the globe, so the model still has a wider net cast.  The model continues to carry relatively low exposure to riskier assets.

Gold

The model still has no position in Gold at this time. Among safe havens Gold is the most important diversifier because it has no long term correlation to Equities or Bonds but currently Gold is out of favour for the model because risk-adjusted returns have been worse there than the safe havens which the strategy currently holds – the Invesco Ultra-Short duration Bond ETF and the US Treasury Inflation Protected Bond (TIPS) ETF.

I am very bullish on Gold over the long term, hence our position there in multi-asset portfolios, but remember BMS is a quantitative, systematic strategy. It will adapt into Gold and potentially other safe havens as well, when risk adjusted returns warrant doing so.

It has been the right call to own US Inflation protected bonds (TIPS) over Gold this last year but it is important to realize that Gold tends to track real interest rates quite well over the long term. Real interest rates are the difference between the nominal interest rate and the rate of inflation. The image below shows the price of Gold in yellow and 10 year real interest rates (inverted) in blue.

At some point we expect Gold to either play catchup with US Inflation Protected Bonds (TIPS) and we would expect the model to pick up on the momentum shift by bringing Gold back into the portfolio.

Bonds

German Government Bonds in 10Yr+ duration gained 2.09% in Q4 and finished the year down 4.85%. The 10 Year US Treasury in euro-denominated terms, gained 5.37% in Q4 and finished the year up 3.2% on the year (the stronger Dollar has masked weakness for European holders). US & European Inflation Protected Bonds have done much better than their traditional counterparts in Q4 and on the year.  US Inflation Protected Bonds gained 4.37% in Q4 and gained 14.3% on the year in euro-denominated terms (again the stronger dollar helped). European Inflation Protected Bonds gained 1.65% in Q4 and 6.23% on the year. Risk- Adjusted returns have been better in inflation protected Bonds, which is why they are our largest Bond position.

Our second Bond position and least risky position in the portfolio outside of cash is the Invesco Ultra-Short duration Bond ETF, which holds bonds with an avg duration of 1 year and yielding only 0.54% annually, which is not much but it is better than sitting on deposit. It helps me to maintain the risk profile of the product.

Currency Hedge

Before we talk about the currency hedge I want to remind you why it is sometimes necessary. Keep in mind I am not a tax professional. US ETFs are Capital Gains Taxed (CGT) in Ireland at 33% and tax losses can be offset against those gains. European ETFs are taxed on a gross roll up basis. The income and gains are taxed on exit and cannot be offset against prior losses. Individuals are taxed at 41%, while companies pay 25%. There is a deemed exit every 8 years. Many of our clients prefer CGT tax treatment. In order to avail of CGT tax treatment, we have to use US ETFs, which means we have to take Dollar denominated investment positions. This means that we carry a currency risk. When the Euro is falling in value vs the Dollar it is a benefit, but when the Euro is rising in value vs the Dollar, it has a negative impact on returns. This is why it is sometimes necessary to hedge currency risk.

We currently carry a partial currency hedge to our Dollar denominated positions. We continue to carry a 34% hedge to EURUSD upside. We had a full hedge in the summer of 2020 which was timely and since early autumn 2020, have run a smaller hedge. We’re currently comfortable with more exposure to USD upside, but if that changes we will seek permission to increase the currency hedge.

Risk

Risk has been running lower recently than what would be perceived as normal over a longer period of time. Currently risk is more like a 3.65 than a 4. I believe the main reason is that the model is systematic and over time it adapts and weights the portfolio according to risk. Because 2020 was such a volatile period it caused the model to dampen risk more than was needed (in hindsight). Because realized risk was much lower in 2021 in comparison, I would expect the model to adapt to that throughout the passage of time, so it is certainly possible that the model will at some point in the near future increase weightings in riskier assets relative to safe haven assets.

Conclusion

I’m very happy with the way the model has managed risk in 2021, but I do have concerns about having roughly 29% of the capital tied up in between a currency hedge and a bond product with a risk profile of 1. That obviously makes it more difficult to generate positive returns. That said we judge ourselves vs our benchmarks and on that basis this product has outperformed by nearly 4%. I expect the model to continue to outperform the benchmark over the long term and on a lower cost basis.

Kind Regards,

David Flynn

Chief Investment Strategist and Director

dflynn@baggot.ie