Mifid IIFeb 7 2018

How to prepare for Mifid II's 10 per cent rule

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How to prepare for Mifid II's 10 per cent rule

The full rule is more complicated than this, but it almost seems designed to damage client composure and so prompt attempts at market timing. Having done quite a bit of work on how damaging such market timing can be to long-term returns, it is clear that investment managers subject to the 10 per cent drop rule need to do some serious thinking around the possible effects of the rule and how best to support their clients through future periods of market turbulence.

The full 10 per cent drop rule is a bit of a mouthful. It requires that investment firms, providing the service of portfolio management, inform clients by the end of the business day if the value of their portfolio depreciates by more than 10 per cent from the beginning of the last reporting period – reporting periods must be at least quarterly. It also requires disclosure at each subsequent fall of a multiple of 10 per cent.

Note that Mifid II does not treat discretionary and advisory client portfolios equally here – clients in discretionary portfolios need to be notified of 10 per cent falls, those in advisory portfolios do not.

What’s at stake?

So, what is the issue with keeping clients better informed? Surely more information is always better? In theory, yes. Also in theory, clients are not subject to greed or fear and always behave perfectly rationally.

In practice though, the rich field of behavioural finance demonstrates that we (and that includes all of us: clients, investment managers and advisers) are all too human and are definitely subject to both fear and greed.

And there is a worrying possibility that clients, who generally have less day-to-day experience with markets, will be ‘nudged’ into selling out of their portfolios by a notification of their savings having fallen by what they will likely feel is a significant amount.

Key Points

  • Mifid II means some clients will receive a notification when their portfolio drops by more than 10 per cent
  • Advisers need to be wary of notifications invoking irrational client actions
  • Selling out after a 10 per cent drop often does not lead to better outcomes

Is selling wrong?

This leads to a second, very important, question. Is selling after a 10 per cent drop actually such a bad idea?

There is another rich vein of academic research that suggests that trying to time the market tends to destroy long-term returns. However, we decided to be a bit more specific and to take a look at historic returns on the FTSE 100 through the lens of the 10 per cent drop rule. 

We assumed calendar quarter reporting periods and looked at total returns on the FTSE 100 (including dividends) since the last quarter of 2000. There were 13 quarters which would have experienced at least a 10 per cent drop, four of which would have experienced a 20 per cent drop.

We compared a hypothetical client who stayed invested in the FTSE 100 throughout against a hypothetical client who sold if their portfolio fell 10 per cent from their 31 December, 31 March, 30 June and 30 September statement values. While we assumed no interest was earned on holding cash, neither did we assume any transaction costs from buying and selling the FTSE.

One further wrinkle. Part of what makes market timing so hard is that it requires at least two timing decisions: when to sell and when to re-buy. For our simulation we used three ‘reasonable’ re-buying strategies, namely:

•    Clients always reinvest at the beginning of the next quarter.

•    Clients wait a bit longer to reinvest, re-buying not at the beginning of the next quarter but the beginning of the following quarter (or the next if there is a subsequent 10 per cent drop rule breach).

•    Clients follow a similar strategy when buying as when selling – they follow the markets closely and wait until the index has bounced by 10 per cent from its lows before reinvesting (that is, once there is superficial evidence of a recovery).

Winners and losers

To be clear, the period under review was not an ideal cycle to be invested as it assumes investing just before the bursting of the tech bubble in 2000 and includes the credit crunch sell-off in 2008.

Nevertheless, clients who remained invested would have seen their portfolios more than double over the period after factoring in dividends and share price growth. Annualised, this was 4.6 per cent a year. 

Those that panicked and sold out after every 10 per cent drop would all have done considerably worse. Sellers who reinvested quickest, at the beginning of the next quarter, would have done least worst – up about 70 per cent over the period (3.2 per cent a year).

Those that hesitated longer, reinvesting only at the beginning of the second quarter after a 10 per cent drop out, would have experienced poorer performance – up roughly 30 per cent overall, about 1.7 per cent a year.

But worst of all would have been the performance of those that only reinvested after seeing a 10 per cent bounce. The whipsawing volatility of the credit crunch would have been particularly cruel to these investors who would have experienced periods of pulling out after a big drop, missing the 10 per cent bounce and reinvesting just in time to experience another 10 per cent drop. They would have been up only 9 per cent over the period – 0.5 per cent a year.

The above results are pretty scary and do demonstrate just how damaging panic selling can be. But a note of warning about over-interpreting the results: changing the underlying index, the start date of the analysis and reporting period dates (say tax year end quarters instead of calendar quarters, for example) does alter the results and although in most cases market timing strategies underperformed it is possible to get some to outperform by choosing the inputs carefully enough. 

However, the key point is that the future will be different to the past and for the future we need robust strategies that give us the best chance of success. Quite apart from the bulk of historic evidence, it is also not hard to understand through general reasoning that for investments where greater than 10 per cent falls are very rare (most diversified investing), selling out after every 10 per cent drop guarantees that most falls are experienced while a lot of post-fall recoveries are missed.

Client composure

Bringing together the above strands, the 10 per cent drop rule is problematic because it is quite likely to damage client composure, and any selling as a result of that damage is very likely to harm long-term client returns and thus their long-term financial objectives.

However, to be forewarned is to be forearmed. Investment managers and the client advisers they work with already provide valuable behavioural coaching to clients during periods of market stress. They do, however, now need to go further and actively plan for how to best combat the negative effects of the 10 per cent drop rule when acting to preserve client composure in future. 

Nic Spicer is portfolio manager of PortfolioMetrix