Jacko the Gorilla and Investment Portfolio Benchmarking . . .

And an Investment Grade Bond Yielding 7.5%

 

In January 2000 Jacko the gorilla, who lives in Amsterdam's zoo, picked ten bananas from the seventy-five he was offered. Each banana was marked with the name of one of the 75 largest companies, by stock market capitalization, on the Amsterdam Stock Exchange. Every month Jacko picks out one of ten bananas corresponding to his portfolio and that stock is sold. Then he chooses one banana from another pile of 65 bananas, corresponding to shares he does not hold, and that is his buy. Jacko's portfolio outperformed the Amsterdam Exchange Index (AEX) every year in the 11 years between 2000 and 2010. If he had been a fund manager, Jacko would have had a stellar reputation. Then in 2011 his portfolio bombed. He underperformed the AEX by more than 32%. Was this the end of Jacko's good judgement? Well, in 2012 Jacko is back to his good old ways and he outperformed the AEX.  In the 13 years he has been choosing bananas, Jacko's portfolio has increased by 32%, which compares to a loss  of 54% for the AEX (both exclude  income).

    As Jacko's investments are reported daily, neither Jacko nor his human interface have had the opportunity of cheating. Unlike an investor, Jacko pays no trading commissions. With a portfolio turnover of 120% per annum, these would have been substantial. But as the Index itself has no trading commissions, Jacko's performance does compare to it on a like-for-like basis. Or does it? Jacko's portfolio is chosen from the 75 largest stocks while the AEX index is based only on the 25 largest stocks traded in Amsterdam. The other stocks are quoted on 2 different indices, the AMX - mid-cap and the AScX - small cap shares, representing the 26 to 50 largest stocks and the 51 to 75 largest stocks traded in Amsterdam.

   Even if these indices were included, they would misrepresent Jackos's choice of stocks, as the indices themselves have changed radically over the 13 years that Jacko has been trading. 

Number of constituent companies in the index in both 2000 and 2013:

Amsterdam large cap    AEX                       13 of 25 constituents

Amsterdam mid-cap      AMX                        3 of 25 constituents

Amsterdam small-cap   AScX                        0 of 25 constituents

In the case of the small caps AScX, the oldest constituent of the index today only dates back to March 2005.

   The same distortion occurs with our own indices. The FTSE 100 has gained 147 constituents and lost 147 constituents during the last 13 years. With this level of volatility, why compare our own portfolio to an index, unless we are happy to leave our money in an index-linked fund? Did I feel any the better because the FTSE 100's fall of 45% between May 2008 and March 2009 exceeded my portfolio's stomach-wrenching fall? Or did I feel any less relieved by the prodigious recovery in the value of my portfolio in the following 12 months because the FTSE 100's bounce of 62% exceeded my own?

   Benchmarking a portfolio is good practice: without a benchmark we are like a rudderless dinghy bobbing along at sea, with no idea and no control over where we will eventually land. Fund managers require a generally accepted yardstick in the public domain, and they rely on indices, but that doesn't mean this is the right yardstick for an individual. In fact it is fiendishly complicated to account for one's investment history, taking into account all the vagaries of life, that  can be compared to an index such as the FTSE 100.

   Financially speaking, individual investors have messy lives. We spend large sums on weddings, houses, divorces, our children's education and our own businesses. We save as best we can, we receive bonuses and inheritances and by downsizing our homes we release capital to invest. We invest when we can and disinvest when we have to; at bottom our objectives have nothing to do with the vagaries of the FTSE 100.

   Benchmarking should reflect our goals. For a young professional, who wants to buy a first home, the most appropriate benchmark might be to accumulate X thousand pounds within Y years as a deposit.  This he must achieve through savings and capital gains. For the self-employed homeowner, who wants to secure his retirement, the benchmark might be a Self Invested Pension Plan that, with current annuity rates, will provide an income of at least X pounds a year from the age of 65. And for someone nearing retirement, who wants his income to keep pace with inflation, the most relevant benchmark will be based on the income generated by his investments and not the asset value of his portfolio. Our benchmarks change as our lives and circumstances change. And by being specifically related to our financial objectives our personal benchmarks point us to the financial assets that best suit our needs.

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An investment grade bond yielding 7.5% p.a. 

The Co-operative Bank's 13% Perpetual Subordinated Bond (symbol CPBC) is yielding, at the present offer price of 173p, 7.5% into perpetuity, and the Co-op is rated A3 (investment grade) by Moody's for long term obligations. Does this make CPBC a good buy? With 3.5% War Loan yielding 3.8%, the 370 basis point premium over Gilts is attractive in the present low interest and low inflation environment. Indeed, if the present rate of inflation of 2.7% were to continue forever the 4.8% real return from CPBC would match the long-term historical real return from equities, but without equity's volatility. And, unlike most Permanent Interest Bearing Notes (PIBS), there is no provision for resetting the coupon at specific dates or for calling the issue early.  As the Investors Chronicle noted 22 August 2012, "Principality Building Society did this in 2011 with its 5.375 per cent Pib, which had a reset rate of just 1.05 points over Libor, slashing the running yield from around 8 per cent to just 2.67 per cent."  
   No doubt the recent failures of the Bradford and Bingley and Dunfermline building societies and the 'rebasing', i.e cutting the coupon from other building society obligations has helped to supress the price of CPBC.

    As the coupon is paid gross of the tax credit, the best place to buy CPBC is in an ISA or SIPP wrapper. The main risks are: 

• There is no protection in the coupon against rising inflation.

• As a perpetual bond never reaches maturity, the capital value of the bond could fall quite drastically if inflation and interest rates rose.

• CPBC is subordinated to all other debt, so that in the event that the Coop went into administration, the bond would become worthless. In this sense, it resembles common stock in a publicly quoted bank.

    CPBC is the only investment grade perpetual bond of any size (110 million pounds), with no recall or reset feature that I have been able to find with such an attractive yield in sterling.