THE TORTOISE AND THE HARE | APRIL 2012 | MASECO PRIVATE WEALTH 1

the tortoise and the hareISSUE 14 | APRIL 2012

An existential moment for

the euro

One of the distinctive features of the post-2008 financial world is the recur-rent tensions in euro-area sovereign debt markets, in clear contrast with developments in other industrial countries.

One of the distinctive features of the post-2008 financial world is the recurrent tensions in euro-area sovereign debt markets, in clear contrast with developments in other industrial countries. In the United States and the UK, for example, long-term government bond yields have trended consistently down since mid-2008, in some cases reaching unprecedented lows late last year. On the opposite side of the spectrum, an increasing number of euro-area countries are experiencing funding difficulties amidst rising sovereign spreads versus Germany, when compared to the US and the UK.

The most dramatic case is, of course, Greece, which has effectively defaulted on much of its debt. But, more importantly, sovereign tensions spread last year to bigger countries such as Italy and Spain which, together, represent as large a share of the euro-area as Germany. Sovereign tensions in the euro-area can no longer be dismissed as isolated to marginal countries. If allowed to continue, those tensions would create (and are indeed creating) an existential threat to the euro. We are witnessing a defining moment for the future of Europe and, as always in such an instance, there are major risks and opportunities for investors attached to it.

In a nutshell, the sovereign tensions in the euro-area’s periphery reflect a renewed awareness – which was absent in the pre-2007 world – of the existence of credit

risks in countries that no longer control their monetary policy. Thus, even if prior to 2007 the US and the UK developed macro-economic and financial imbalances as large as (and sometimes larger than) those of the euro-area’s periphery, the possibility of resorting to the printing press reduces enormously the risk of default (although, in exchange, it raises the risk of inflation and the country’s exchange rate in the long term). The virtual absence of credit spreads among euro-area sovereign bonds in the first decade of the euro period was an abnormality. The key questions as the euro has entered into its second decade are: i) Have spreads now widened too far, and thus

represent an attractive medium-term investment proposition?

ii) Or will the euro break up creating major losses for investors in the entire periphery (and elsewhere)?

The plight of the periphery

Fundamentally, peripheral countries need to tackle two interrelated macro-economic problems: a high level of (public and/or private) debt and the accumulated loss of external competitiveness. Correcting them requires, respectively, a prolonged period of deleveraging and of low wage and price inflation. The former is necessary to reduce debt to more sustainable levels; the latter is

THE TORTOISE AND THE HARE | APRIL 2012 | MASECO PRIVATE WEALTH 2

needed to shift productive resources from satisfying domestic demand towards exports. The problem is that, without a sufficiently accommodative monetary policy, both adjustments interfere with each other: Low inflation makes deleveraging more difficult and potentially self-destructive, because it may lead the economy into a tailspin. This is the state that Greece is in, Portugal may be entering into, and where Italy, Spain and Ireland might find themselves in the not too distant future. A further complication arises from the absence of a major impulse from external demand, which would soften the domestic adjustment in those countries. If Germany and other core countries were to experience a strong domestic demand-led recovery, then the periphery would at least enjoy a rapid increase in its exports, limiting the negative effect of the contraction of domestic spending. After all, the reverse happened in the pre-2007 world, when domestic booms in the periphery (and a generally strong global economy) helped Germany tackle successfully its own problem of external competitiveness created after the exchange rate appreciation of the early 1990s. Unfortunately, there are no signs, nor near-term, prospects of a strong economic recovery in Germany. German consumers remain as savings-prone as ever.

A bit of political perspective

The euro was from the beginning a political project. Its fathers conceived monetary union (EMU) in the early 1990s as a first step towards the final goal of political integration, which was deemed unfeasible at that time. They knew that a single currency without sufficient fiscal (and, hence, political) integration would run into internal contradictions – although, of course, they did not have perfect foresight to anticipate what shape these contradictions would exactly take (now, we know!). The plan was: “Once the internal inconsistencies show up, we’ll grab that opportunity to take a step towards political integration. After all, the European project always progresses in response to crises”. Indeed, EMU was itself a response to the growing problems encountered in managing different monetary policies in a world of free capital movements in a closely integrated trade area.

Today’s policymakers do not seem to have the grand vision of the early fathers of the European project. At first, they underestimated the depth of the current crisis, treating Greece as an isolated case with an “ad hoc” rescue program which is inescapably failing. Later, they tried to “ring-fence” Greece, Ireland and Portugal with rescue mechanisms that are not big enough to tackle similar funding difficulties in Italy and Spain.

Recently, however, there are some signs that, faced with a stubborn reality, European policymakers may finally be grasping that this is a “make or break” moment for the euro and the entire European integration project. Witness the bolder actions by the ECB (providing massive

liquidity injections to save the banks and, indirectly, help government funding) and by governments (setting up a larger and more flexible rescue mechanism and starting to discuss, albeit informally for now, further significant steps towards fiscal integration).

At the end of the day, unless there is a rapid revival of economic growth in the periphery, the future of the euro lies in the increasing financial support (or the credible promise of it) by Germany and other core countries. Today, that support still looks half hearted, and the risk that domestic politics interfere in the future with a deeper German involvement in supporting the periphery remains high.

The ECB liquidity actions and the strengthening of the rescue mechanisms have contained the sovereign crisis but not redressed it entirely. In the past two years, investors in core countries have repatriated hundreds of billions of euros from the periphery. The challenge is to convince these investors to return to the periphery, and they will do so only when they see either economic growth returning or, while they wait for that to happen, a decisive commitment to help them by the European authorities (starting with Germany) and perhaps the IMF.

Risk and returns

There is thus a lot at stake in the Euro area and, in particular, in Italy and Spain. The consensus scenario is that the Euro area will experience a prolonged period of sluggish growth but that the euro will survive (with Greece perhaps out) and that there will be future gradual steps towards fiscal and political integration. In the meantime, the ECB will be more constructive in the face of Italian and Spanish difficulties, because they are large enough to drag the entire area down with them.

But there are more extreme, not unrealistic scenarios. In the first one, European policymakers bite convincingly the bullet by transferring rapidly more fiscal sovereignty to a central European fiscal authority and eventually issuing common Eurobonds. In this case, Italian and Spanish spreads are very attractive, and the euro’s exchange rate would likely benefit. After all, as European policymakers repeat time and again, the Euro area, taken as a whole, can boast of a much more balanced macro-economic and financial position than the United States and the UK.

In the opposite scenario, domestic political considerations in Germany or other core countries impede the deepening of EMU or the adjustment in the periphery reaches social limits. The entire periphery would precipitate into a series of defaults, probably leading to a break-up of the euro. In this event, peripheral assets plunge massively (via massive haircuts and/or large exchange rate depreciations) but also core assets would suffer (because of the end of the trade advantage inside the Euro area and of a one-time negative wealth shock).

Economics: An existential moment cont.

THE TORTOISE AND THE HARE | APRIL 2012 | MASECO PRIVATE WEALTH 3

Insight: How to be the world’s worst investor

Let’s try and put some numbers on this wealth destruction: an annual study in the US compares the returns that the US equity market has delivered over the previous 20-year period, against the returns that the average investor has made by investing in US equity funds. The result: for the period to the end of 2008, the market delivered a return of 5.3% after inflation on average per year (that is the compound rate of return). Did the average investor receive a comparable return? No. In fact, the average investor managed to lose 1% a year after inflation.

If we transfer those return numbers into dollars and cents, we can gauge the true level of wealth forgone by many millions of Americans. Imagine yourself in their shoes – you invested $1 million in the market in 1988 in a fund that sought to deliver the return of the market

as closely as possible (these are known as index tracker or passive funds). You forget about it until the end of 2008. Your return, after fund costs (of say 0.3% per year) and inflation was 5% per year. Your $1 million was now worth $2.7 million in purchasing power terms. On the other hand if you had made the same mistakes as the average American investor, you would have turned your $1 million into $800,0001. That is an enormous opportunity cost of almost $2 million.

In Europe, the numbers reveal a similar pattern. A recent study2 revealed that the average investor in UK funds received a return of around 4% below the market per annum.

Figure 1: Throwing money away1

Avoiding key mistakes

The encouraging truth is that being aware of the mistakes that many investors make and avoiding the traps that are set allows you to take some simple steps to capture as much of the upside that is on offer from the markets – and that is rightly owed to you for the risks you take with your money. These words are emphasised as you may need to protect your interests from an investment industry whose interests may not always be sufficiently aligned with your own. So what are the $2 million mistakes?

It is perhaps alarming to realise that a huge amount of wealth is destroyed by investors, as they fall into the traps set, either by human nature, or inadvertently by those working in the investment and advisory industry itself. The harsh fact is that the wealth that is needlessly forgone will have a significant impact on their lifestyles and the opportunities that wealth brings to them, their families and their communities.

$1m

StartingAssets

Purc

hasi

ng P

ower

Out

com

e

Purchasing Power E�ect20 years to 2008

Buy-and-Hold

ReturnChasing

(average investor)

Cost of Emotions(~ $2m)

$2m

$3m

1 Dalbar Quantitative Analysis of Investment Behaviour, 2009

2 Schneider, L. (2007), Diploma thesis: Are UK fund investors achieving fund rates of return? Submitted in July 2007, Fachhochschule Kufstein, Tirol, Austria.

Source: Dalbar, 2009

THE TORTOISE AND THE HARE | APRIL 2012 | MASECO PRIVATE WEALTH 4

Insight: How to be the world’s worst investor cont.

Mistake 1: Being human

Unfortunately, we have been bowled a googly (cricket term: a ball bowled as if to break one way that actually breaks in the opposite way – the cricketing equivalent of a curve ball) by evolution that makes us susceptible to making poor investment decisions. While the human mind is an incredible thing, it has evolved a number of biases that, while useful as survival tools for everyday life, are the very basis for the wealth destruction that is so often evident.

A deep seated sub-conscious battle is constantly played out in investors’ minds, pitting greed and the desire for reward against the fear of uncertainty, loss and social isolation. Its manifestation is irrational and emotionally-driven investment decision-making. Emotions and innate biases (such as over-confidence, inertia, seeing patterns and trends where none exist, the desire to avoid regret, and going with the herd) can make an investor susceptible to poor decision-making. The whip-saw effect Humans have survived by applying what they have just experienced and extrapolating that into the future – successful hunting grounds this year are likely to be good next – but this makes us all susceptible to making bad investment decisions. Mix in a bit of subconscious greed and the result is the temptation to chase ‘winners’, both in terms of markets – such as gold and emerging market equities – for no other reason than they are going up (or because the case is backed by a seemingly plausible story), or in terms of brightly shining ‘star’ managers and funds.

The trend is not your friendThe problem is that the past is not a good guide to the future, as every piece of investment literature rightly states.

Yet every Sunday paper you pick up will have a money section full of tables and commentary on the best funds and managers, usually based on the past one to

three years. Investors are prone to extrapolate these returns into the future. Mix in a propensity for failing to take account of the role that luck plays in short-term fund performance (lucky coin flippers will inevitably exist in these rankings, given that there are thousands of funds in existence) and it is easy to see how you can get seduced into believing that the short-term, market-beating performance will inevitably continue long into the future – it rarely does3. Up like a rocket – down like a stickThe problem is that markets inevitably go down as well as up, and managers sometimes run out of luck. The reversal causes concern, discomfort, fear and finally panic selling. The result is a buy-high, sell-low strategy – a recipe for destroying that $2 million of potential wealth.

Looking at the CGM Focus Fund we can see an extreme example of these human weaknesses in action: in 2007 this commodity-based fund returned 80% and, as a result, in 2008 investors poured a staggering $2.6 billion into the fund. Commodity markets reversed and the fund fell by almost 50% and investors withdrew around $750 million. Buy high – sell low!

Mistake 2: Not understanding the game

Through no fault of their own, many investors have not stopped to think about the game in which they are participating. Imagine that two investors own the whole market. The first picks and owns all the companies that did better than the market. By definition, the other investor must own all the stocks that failed to beat the market. One investor’s gains must be funded by another’s losses – trading in the markets is a zero-sum game (before costs).

That would not matter if skilled investors, who either must have better information than others or use the same information better, could turn this information asymmetry into profitable market-beating returns. You could buy their funds.

Doubt

Caution

Con�dence

Enthusiasm

Greed

Indi�erence

Concern

Fear

Panic

BUY

WEALTHDESTRUCTION

SELL

Figure 2: The cycle of wealth destruction

3 Bogle, John, C., (2007), The Little Book of Common Sense Investing, John Wiley & Sons, NY: NY.

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The evidence would seem to suggest that you should not try to beat the market, but simply try to capture as much of the return that capitalism can deliver in reward for owning companies (equities) or lending capital (bonds), by looking at low-cost asset class (passive) funds.

Mistake 3: Ignoring the maths

That leads us to the question of maths. One of the reasons why some active managers may fail to achieve their market-beating objectives is that they need to overcome the costs of investing. This includes their own fees for managing the fund and other expenses that are set against the fund’s performance. This ‘on-the-road’ cost of investing is known as the Total Expense Ratio (TER). On top of these costs are the costs of buying and selling securities held by the fund (turnover).

Let’s start with some simple adding

Active vs. index funds p.a.Average active UK equity fund TER4: 0.9%. Plus the estimated turnover cost5 of: 1.0% Gives a total active cost of: 1.9%Less the total index fund cost6: 0.3%Cost difference: 1.6%

That does not sound too bad if the markets have gone up by 30% in one year. However, in the context of long-term return history, equities have delivered a return after inflation of around 5% p.a. over the past 111 years7.

Now for some simple percentages1.9% is almost 40% of the 5% that equities have returned over the long term after inflation. In other words, the investment industry participants have helped themselves to a large part of your wealth. Yet you have taken all the risk and it is your money and future at stake.

Now for some multiplicationImagine that two identical funds exist and that they own all the shares in the UK equity market. The only difference is that Fund A has a cost structure of 1.9% p.a. and Fund B has a cost structure of 0.3%8 p.a.. Let’s assume that the UK equity market delivers 5% p.a. over the next 30 years and you invest £100,000 in each.

Your investment in Fund A rises to about £250,000 – not bad until you look at Fund B which delivered you a little under £400,000 – a difference of £150,000.

The power of the mathematics of compounding (calculating interest-on-interest) combined with time is immense; small differences get magnified into large final outcomes. Costs really do matter in investing – the lower the better.

And finally some probabilitiesThe question you need to ask is: what is the probability that a manager will deliver skill-based, market-beating returns over the long term? The empirical evidence indicates that we are probably looking at around 2-3%3. Remember that the manager has been selected based on past performance. The next question is: what, then, are the chances that you or an adviser can pick a skilled manager today, who will deliver over the next 30 years? Answer: probably minimal. As Jack Bogle, one of the pioneers of index investing states, “Don’t look for the needle, buy the haystack!”

At the end of this maths 101, it is probably easy to see the lesson that emerges – costs really do matter in the investment game. Again to quote Jack Bogle, “In investing you get what you DON’T pay for!”

Good investing is not rocket science

At its simplest, investing is quite straight-forward. You only have two things you can do with your money: buy part ownership in companies (equities), with the reward of dividends and hopefully share price rises; or lend your money to a government or a company, with the expectation of receiving interest and your money back.

It is not a get rich quick fix, but a slow controlled preservation of the purchasing power you have accumulated, and hopefully achieving some growth too by taking, managing and living with specifically chosen and understood risks, accessed in a low-cost and effective manner.

A well-thought-through and evidence-based approach to investing should deliver better outcomes over time. Perhaps, and most importantly, we all need to hold our nerve when markets are either overly exuberant or in the depths of despair and avoid the whip-saw of emotions and human biases.

If we can achieve that for our clients, we will have earned our annual relationship fee several times over.

Summary

• Investorsneedlesslydestroywealth.• Emotions and human biases make us prone to

poor investment decisions.• Weignoreinvestingcostsatourperil.• Sensible portfolio structures, robust process and

hand holding by an adviser could help to mitigate these risks.

4 The average UK All Companies actively managed fund has a total expense ratio (TER), which comprises the Annual Management Charge (AMC) and other fixed costs that can be offset against fund performance, of around 1.6% (Lipper 2009). Within that there is around 0.5% trail commission passed to commission-based advisers each year. Another 0.3% represents payments to fund platforms to cover the cost of holding the assets for the client. To make a fair apples-to-apples comparison, these costs have been omitted from the ‘all-in’ calculation.

5 Other costs that are a drag on performance, relate to the decisions to sell and buy shares. The average turnover is around 100% of the portfolio a year (SCM Private 2010), which is based on estimated round trip costs (Albion estimate 2010) to sell and buy a share in the UK of around 1% (0.5% of which is stamp duty). This implies that the average active fund incurs around 1% of trading costs a year.

6 Investors can access the UK equity market these days for around 0.2%. Index funds tracking the broad market have very low turnover and associated costs, estimated at 0.1% a year.

7 Barclays Equity Gilt Study (2010)

Insight: How to be the world’s worst investor cont.

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MASECO Update

Welcome to the new-style Tortoise and the Hare. A number of our clients have spoken to us about their preference for a smaller but more frequent publication, so we have responded by increasing the frequency of our regular newsletter. We will now be sending it out on a monthly basis and carry fewer articles, but believe that the quality of the articles remains at the same high level that you are used to. As ever, we would welcome any comments you have. You can reach us on MASECOCommunications@MASECOpw.com.

The first quarter of 2012 has been busy again and we are delighted to welcome new team members who further strengthen our services to our clients.

In London, we have recently recruited Keryn Brock to our adviser team. Keryn joins us from BNY Wealth Management in Boston where she was an Assistant Portfolio Manager. She was responsible for a $400 million client base which consisted of high net worth individuals and families. Keryn’s strengths lie in asset allocation and investment planning, but previous experience with AllianceBernstein Global Wealth Management in London also mean that she is well rounded in US Tax, estate planning and financial planning.

We are also delighted to welcome Rebecca Davison to our Client Services team. Rebecca came across from HSBC Global Asset Management where she was responsible for administering clients’ accounts. Prior to this, she lived in Sydney, Australia for over a year where she worked for UBS and Investec on Government IPOs. Rebecca brings a great deal of experience to the role and will be a huge asset to the MASECO team.

Kind regards

The MASECO Team

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IndicatorsGDP Growth Rate %

Quarter* 2012 E 2013 E

US 3.0 2.1 2.2

UK -1.2 0.2 1.6

Euro Area -1.3 -0.6 0.7

Japan -0.7 1.7 1.5

* % change on previous quarter, annual rate Source: Economist (March 31, 2012)

Fixed Income Summary

Index YTM % Total Return YTD (%)

Spread to benchmark

(bps)

US Invt Grade (CS LUCI) 3.36 1.63 145.00

UK Invt Grade (CS LEI) 4.42 1.51 226.00

EUR Invt Grade (CS LEI) 2.86 4.72 196.00

JPM Emg Mkt (EMBI)+ 5.52 5.23 326.00

CS High Yield Index 7.16 5.01 610.00Source: Credit Suisse (March 2012)

Foreign Exchange

Index Spot Rate End 2011 Change

GBP/USD 1.5978 1.5541 2.83

EUR/USD 1.3317 1.2982 2.62

GBP/EUR 1.1998 1.1972 0.25

USD/JPY 82.29 76.94 6.95

GBP/JPY 131.49 119.57 9.96

CHF/USD 0.9039 0.9351 -3.32Source: Financial Times (March 31, 2011)

Interest Rates %

CBR* 3m LIBOR 12m LIBOR 10-yr Govt

US 0.00-0.25 0.4681 1.0485 2.2100

UK 0.50 1.0269 1.8631 2.2100

Euro Area (DE) 1.50 0.6753 1.3806 1.8200

Switzerland 0.00-0.25 0.1100 0.3920 0.8600

Japan 0.00-0.10 0.1957 0.5529 0.9900

* Central Bank Rate Source: Financial Times (March 31, 2011)

Economic Indicators

Unemploy-ment (%)

Current A/C Balance*

Budget Balance*

Industrial Production

US 8.3 -3.0 -7.8 4.0

UK 8.4 -1.4 -7.6 -3.8

Euro Area 10.7 -0.3 -3.3 -1.5

Japan 4.6 2.0 -8.3 -1.3

* % of GDP 2011 Estimate Source: Economist (March 31, 2012)

Real Assets

Index Price ($) Quarter (%)*

1 yr (%)*

5 yr (%)*

10 yr (%)*

Gold (Lon. PM) 1,662.50 8.59 15.53 20.23 18.62

Oil (WTI) 103.03 4.25 -2.98 9.34 14.67

S&P GSCI Commodity Index

688.71 6.79 -5.09 8.03 13.09

S&P Global REITs Index

333.36 10.99 6.93 -2.98 10.00

* Annualised Total Return Source: Morningstar (March 31, 2011)

Volatility Index

Index Current End 2011

YTD % Change

52 Week High

52 Week Low

VIX (S&P 500) 15.50 23.40 -33.76 48.00 13.66

VDAX (DAX) 18.81 28.59 -34.21 26.86 17.73Source: Financial Times (March 30, 2011)

Inflation %

Latest Year Ago 2012 E

US 2.9 2.1 2.1

UK 3.4 4.4 2.5

Euro Area 2.7 2.4 2.0

Japan 0.1 -0.6 -0.3Source: Economist (March 31, 2012)

Equity Summary

Index Value Quarter (%)* 1 yr (%)* 5 yr (%)* 10 yr (%)*

S&P 500 $ 1,408.47 12.59 8.54 2.01 4.12

Russell 1000 Value $ 426.92 11.12 4.79 -0.81 4.58

Russell 2000 $ (Small) 2,063.51 12.44 -0.18 2.13 6.45

MSCI EAFE $ 1,553.46 10.86 -5.77 -3.51 5.70

MSCI EAFE Value $ 2,499.94 8.75 -11.56 -8.50 2.57

MSCI EAFE Small $ 159.26 14.86 -6.23 -2.79 9.92

FTSE 100 £ 5,768.45 4.64 1.24 1.95 4.56

FTSE 250 £ (Small) 11,538.88 14.70 2.45 2.62 9.50

MSCI UK Value £ 4,231.59 2.44 0.52 -4.16 0.27

MSCI Europe € 91.00 7.87 -1.47 -4.00 1.06

MSCI Europe Value € 136.85 5.98 -6.45 -7.21 0.37

MSCI Europe Small € 182.10 15.68 -4.26 -3.73 6.01

MSCI Emerging Market $ 1,041.45 14.08 -8.80 4.67 14.13

MSCI AC World $ 333.30 11.88 -0.73 -0.19 5.33

* Annualised Total Return Source: MSCI Barra & Morningstar (March 31, 2011)

Geneva Zurich

7 Rue Versonnex Lintheschergass 23 1207 Geneva 8001 Zurich Switzerland Switzerland T +41 22 533 05 73 T +41 22 533 05 73 E enquiries@masecopw.ch W www.masecoprivatewealth.ch

MASECO Private Wealth is an independent wealth management firm specialising in developing and implementing financial planning and tax efficient strategies for individuals and families.

The partners strongly believe that during the last twenty years there has been a downgrading of relationship banking. Instead of the product driven model delivered by some institutions, we believe clients deserve sound, genuinely independent advice.

We have created a partnership that is the antithesis of the global private bank. MASECO Private Wealth is more focused, has no conflicts of interest and, most importantly, puts our clients first.

THE TORTOISE AND THE HARE | APRIL 2012 | MASECO PRIVATE WEALTH 8

MASECO Private Wealth S.A. & A.G. trading as MASECO Private Wealth. Registered offices at 7 Rue Versonnex, 1207 Geneva, Switzerland. MASECO Private Wealth S.A. & A.G. is authorised and regulated by l’Association Romande des Intermédiaires Financiers (ARIF), a Swiss Financial Market Supervisory Authority (FINMA) and a recognized self-regulated organization (SRO). MASECO Private Wealth S.A. & A.G. is an SEC Registered Investment Advisor in the United States of America.

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