Why Did We Decide to Make a Change?

This table shows the original Wallet portfolio. It consisted of government and inflation-protected bonds, global equities, a small proportion of gold, and cash.

The first thing that probably catches your eye is the high weight of cash. Originally, we wanted to use cash to acquire an investment certificate tied to investment loans which would pay out a fixed return to its holders. The funds raised from this would be used to provide loans to dynamic clients seeking to invest with leverage. We will discuss more about the delayed launch of this service at the end of the blog.

Due to central bank policy, until recently, interest could not be earned on cash. Because of negative rates, cash invested in the money market would be gradually losing value.

However, the situation has changed. The European Central Bank (ECB) has rapidly increased interest rates and its deposit rate is currently at 4% (as of 8th November 2023). Thanks to ETFs that replicate the central bank rate, investors can now earn interest on their cash reserves as well.

Therefore, the first goal of the Wallet change is to invest the cash component and achieve money-market interest on it.

The second objective of the portfolio change will be to adjust its risk to the investment horizon. To understand this adjustment, I will first briefly explain how risk works when investing in bonds. These instruments play a dominant role in the Wallet, just like in any conservative portfolio.

Each bond has a specific maturity, which can range from a few months to decades. During this period, the bonds pay their holders regular fixed interest payments. At maturity, the bond pays off the principal and ceases to exist.

Because bonds have fixed payments and you know their price when buying them, you can already estimate how much you could earn when entering the investment. Simply put, you compare the promised fixed payments to the bond's price (the initial deposit) to see how much more you'll get back (i.e. how much you'll appreciate your deposit by). The resulting percentage is quoted on an annual basis and is called the yield to maturity.

In some cases, the full promised return may not be paid (e.g. when the issuer declares bankruptcy). However, if you invest in a broadly diversified portfolio of bonds from governments of rich countries and high-quality companies, bankruptcies usually affect only a minimum of payments.

Thus, if you hold these bonds to maturity, the resulting investment return is highly likely to be similar to the yield to maturity at the time of purchasing them.

Before maturity, however, the price of the bonds will fluctuate. Interest rates are one of the main factors that determine changes in bond prices. Bond prices move in the opposite direction to interest rates. If the central bank raises rates, the value of the portfolio will go down. If interest rates fall, the value of the portfolio will rise. That's why we say that when you invest in bonds, you are exposed to interest rate risk.

The key question is how much your portfolio will fall or rise in response to a change in interest rates. We can measure the sensitivity of bonds to changes in interest rates using what is known as duration. It's basically the number of years it takes a bond to pay back the amount invested by its holder (i.e. how long it takes to get your money back).

The longer the duration, the more sensitive the value of the bond is to changes in interest rates. Thus, you can reduce portfolio fluctuations by investing in a portfolio with a shorter average duration. The main factors affecting the duration's magnitude are the maturity and interest rate of the bond or bond portfolio.

Let me illustrate this difference graphically. The blue line shows the development of an index focusing on euro-area government bonds with a maturity of 1-3 years. The orange line represents an index of euro-area government bonds with a maturity of 5-7 years. As the latter index contains bonds with longer maturities, it will also have a higher average duration. You can see that this index experiences more aggressive monthly fluctuations and tends to decline more deeply when the interest rates rise.

Source: Bloomberg. Bonds with a maturity of 1-3 years are represented by the FTSE Eurozone Government Broad IG 1-3Y Index. Bonds with a maturity of 5-7 years are represented by the FTSE Eurozone Government Broad IG 5-7Y Index. Past performance is no guarantee of future returns.

The problem with the original Wallet was that its bond component had a high duration, which made it more sensitive to interest rate increases.

Thus, the second objective of the Wallet modification was to reduce its duration to a level of 1 to 2.5 years to make its value resilient to rate changes and consistent with the Wallet's recommended investment horizon.

What Will the Change Look Like?

Two asset classes will be dropped from the portfolio: gold and equities, which originally held a combined 12% of the portfolio. The role of gold was to reduce the portfolio's volatility, but it does not earn a predictable return. Therefore, it will be replaced by money-market ETFs, which replicate short-term interest in the economy with near-zero fluctuations.

We have also excluded stocks to increase the product's safety. In our eyes, the slight increase in long-term return potential due to equities was not enough to justify the resulting tripling in volatility (i.e., the risk of fluctuation's in the portfolio's value).

The new Wallet consists of a bond and a money-market component. The former gets 60% of the portfolio, the latter 40%. The Intelligent Wallet is thus a combination of the bond and money markets. Specifically, it contains the following funds:

Source: Monthly factsheets of the ETFs as of 14.06.2024.

40% of the portfolio consists of a fund focused on government bonds of the largest euro-area economies with maturities of 1-3 years. The bonds must be issued in euro and have a high credit rating (investment grade, i.e. bonds with a very low chance of default). For example, bonds of the governments of France, Italy, Germany, Spain, Austria, or the Netherlands are represented.

20% of the portfolio is represented by a fund containing bonds of companies from all over the world issued in euros with a maturity of 1-5 years. They must also be investment grade, i.e. the debt of the highest quality companies in the world.

A 39.4% stake has been taken by a fund that aims to replicate the short-term €STR (the price at which banks lend out excess reserves overnight). The public cannot invest directly at this interest rate, so the ETF replicates it using so-called swaps. Its current annual return is 3.97% (as of 31.10.2023) with zero price reactivity to interest rate changes (its duration is therefore zero).

This composition represents the current tactical allocation. In the event of rapid changes in market conditions (especially sharp changes in interest rates), the investment strategy allows us to adjust it to the new situation. In such a case, we will be able to add a small equity component to the Wallet (up to 20%), change the ratio of the money-market component to the bond one, or adjust bond maturities (however, the total average duration of the portfolio’s bond and money-market components can never exceed 2.5 years).

It is certainly not our intention to make such changes frequently; rather, they are intended to protect investors from changes in market conditions that would make the current set-up objectively unfavourable (e.g., if interest rates were to fall back to zero or into the negative territory). We will inform you in advance of any changes to the Wallet portfolio.

You can read the full text of the new investment strategy at this link.

This table compares the important features of the bond and the money-market components of the new and the original Wallet. It shows the current annual yield to maturity (gross and after fees) and the sensitivity to interest rate changes (duration).

You can see that the sensitivity to interest rates in the new Wallet has fallen to a third of its original value, while the current yield has risen by 1.3 percentage points. This proves we have witnessed the return of the era of bond and money-market investing in the recent years. After more than a decade, even safer short-term bonds provide a decent appreciation at low volatility.

How Will the New Wallet React to Changes in Interest Rates?

We wanted to confirm the resilience to interest rate changes by looking at specific market scenarios. When you know the duration of each fund in the portfolio, you can estimate how it would perform in the event of different interest rate changes. In fact, duration tells you how much the price of a bond will change in response to a 1 percentage point change in rates.

That is why we created modelled investments in the new Wallet in which we assumed both a gradual increase and a gradual decrease in the ECB deposit rate by 2 and 4 percentage points over the next 2 years. The term "interest" in the columns of the table therefore refers to the central bank's deposit rate (currently 4%). In the calculation, we assume that bond yields will also change in line with changes in this rate. The results in the table are net of the Finax fee of 0.5% per annum.

You can see that although an increase in interest rates would reduce your expected return, their effect would not outweigh the current high yield to maturity. Expected annual return remained in the range of 2-3% for both 2 and 4 percentage point interest rate increases (both of which represent unusually large movements).

In the event of a fall in the deposit rate to 2%, the expected net return even rises to almost 4% due to the resulting rise in bond prices.

Even in the event of a cut in rates to zero (which is highly unlikely given the current elevated inflation), the expected return falls only slightly. Note, however, that the yield in the table covers the investment for the next two years, during which time rates would gradually fall to zero (i.e. they would still be positive for most of the investment horizon). If you were to enter the new Wallet at already zero rates, it would likely offer a minimal return.

Therefore, we plan to adjust the composition of the Wallet if interest rates fall back to zero at some point in the future (you can read more about this in the section on investment certificates and margin below) to protect it from zero or negative yields.

Of course, these figures should be taken with a grain of salt, they are only estimated results. The final yield may be affected by a number of factors that the model cannot take into account (e.g. investor sentiment, slower adjustment of bond yields to changes in ECB rates, etc.). The resulting yield may, therefore, differ from these estimates.

Why Are We Making the Change Now?

You may ask why we did not come up with this composition when launching the original Wallet, given that it provides such a decent yield with lower interest rate sensitivity. Unfortunately, at the time of the creation of the original Wallet, the central bank kept interest rates in the negative territory. The money market and short-term bonds were earning negative returns at the time, and the value of such a portfolio would have been declining.

The only way to create a portfolio with a positive return was to invest in bonds with longer durations (which tend to have higher yields in exchange for greater interest rate sensitivity) or with greater credit risk. Since we did not want to expose clients to bankruptcy risks, we stuck with longer-term debt of the highest-quality governments and companies.

Unfortunately, near-zero inflation turned into a double-digit one within a couple of months, and central banks launched the steepest interest rate hikes in history. Because of this, bonds experienced their longest correction in history, and the Wallet paid the price. Sadly, that is also a part of investing. We are sometimes surprised by events that the world has never seen before.

Even the new Wallet is not immune to changes in interest rates. The unprecedented developments of the past years would have put it in a decline as well. But this portfolio is much better prepared for potential interest rate rises. The chart below shows the cumulative return of the new and the original portfolio since the launch of the Intelligent Wallet.

You can see that even the historically steepest rise in interest rates did not manage to cause a significant damage to the new Wallet. Thanks to the higher yield to maturity, it has been steadily recovering over the past year while the original Wallet has been stagnant. And you can also see that the new Wallet's trend line is much more stable. On a monthly basis, its value doesn't experience such sharp swings.

Please note: The cumulative return of the New Wallet is calculated based on the NAVs of the underlying ETFs as published on the issuers' websites. The New Wallet portfolio corresponds to the optimal/initial product composition. A portfolio management fee of 0.5% p.a. including VAT is charged once a month in the modelled development. Past performance is not a guarantee of future returns.

However, there is no need to become overly fixated on the past when investing. The biggest opportunities have often been hidden in markets that have previously been hit by a crisis. During the 2008 crisis, many people got burned by stocks, which subsequently enjoyed a decade of record growth.

The bond market now also offers an attractive opportunity. Many types of bonds are offering the highest yield in decades. The New Wallet makes this return potential available to common investors.

Please note: Investing always involves risk associated with the development of financial markets. For details on the risks connected to investing, please see this blog.

How Will the Change Be Executed?

The strategy will change across the board, for both new clients and those who already have an open Wallet. The change will take effect from Tuesday 5.12.2023 (our regular investment day).

We will sell the positions in the Wallet accounts of existing clients on Thursday 30.11.2023. New ETFs will be purchased on the following investment day (Tuesday, 5.12.2023) according to the changed Wallet composition.

In accordance with legislative client notification requirements, no deposits will be made into the Wallet from 15.11.2023 until 5.12.2023, when all funds in the Wallets will be invested according to the new strategy (the last purchase in accordance with the original strategy will take place on 14.11.2023).

Investing on Margin and Certificate are Still in the Plan

At the inception of the original Wallet, we communicated our intention to replace the cash component of the Wallet with a fixed-rate investment certificate linked to loans that Finax would provide to its long-term investors in dynamic portfolios. Long-term investors would thus be able to multiply their returns thanks to leverage, and savers in the Wallet would receive a more stable return even in times of low interest rates.

The current change to the Wallet does not mean that we are cancelling plans to launch investment loans and the creation of an investment certificate. We have fulfilled most of the technical and regulatory requirements, being prepared to launch the project.

However, we have decided to postpone the launch of these products, as we do not consider the current time (particularly given the level of interest rates and the stock market developments) to be a safe time to launch credit investments.

Although this was not an easy decision, we feel responsible for our clients' assets and want to continue promoting responsible investing, where you don't take too much risk (in the form of high interest rates that your investment would have to overcome to avoid losing money) in a pursuit of shortcuts. Therefore, we currently consider money-market ETFs to be an adequate substitute for a certificate in the Wallet.

However, when interest rates fall, it will be a much more appropriate time to launch investment loans and a certificate. The need for a fixed-rate certificate in the Wallet will be greatest at that time, as both money-market and bond ETFs will begin to offer lower yields. At the same time, leveraged investing would make the most sense at that time, as it would not be as costly, and low interest rates would also likely stimulate growth in equity markets.

At this point, however, we'd like your opinion as well. If you think that margin investing makes sense even at current rates (4-5%) and you would be likely to take out a loan even in the current environment, please get in touch with us at client@finax.eu or by calling +421 2 2100 9985. If there is still a high level of interest in leveraged investing, we may reconsider our decision.

We believe you will be pleased with the changes towards greater security and better returns. Thanks to the high interest rates today, you don't have to take too much risk if you want to appreciate your savings for a shorter period of time. Bonds and the money market have not offered such returns for more than 10 years, so it's a shame not to take advantage of them. The new Wallet opens the door to these markets for you. It's the perfect destination for the savings you'll need in 1 to 3 years.

Thank you for your trust in Intelligent Investing and all the ideas and comments about portfolios you share with us.