It is often said that it is 'time' not 'timing' in the markets that is important. In light of this statement, how is one to interpret Mifid II’s, new 10 per cent drop rule which will see some clients receiving notification upon 10 per cent falls in their portfolios?
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.
